Coronavirus: A Moving Target

Summary

• While the coronavirus (COVID-19) outbreak appears to be easing in China, it is gathering speed in the rest of the world.
• We think lost output and earnings will be recovered, but expectations for containment of the outbreak and a short hit to Q1 growth alone are too optimistic.
• While it won’t insulate the economy completely, the virus may give political cover for the fiscal stimulus the economy needs to extend the current cycle well into 2021.
• The signs that we face a tough second quarter for earnings are growing, as guidance is pulled or downgraded.
• There may be too much policy easing priced into rates and bond markets, but not enough economic disruption priced into high yield and equity markets - more volatility is likely before the recovery arrives.

If you haven’t reduced risk, it’s probably not too late to do so; if you are already conservatively positioned, it may be too early to buy the dips.

As I put this edition of CIO Weekly Perspectives on paper first thing Friday morning, a brutally fast market correction has served to remind us that the coronavirus outbreak is a rapidly moving target.

On the one hand, last week confirmed that the Chinese authorities’ aggressive interventions are taking effect. The daily tally of new cases of coronavirus (COVID-19) began to slow, and both anecdotal evidence and responsive data such as shipping and utility usage showed China slowly getting back to work after weeks of operating at 50% capacity.

At the same time, however, the number of cases in the rest of the world overtook the number in China. Within days, Italy had reported more than 600 cases. That is concerning because the vast majority cannot be linked directly to China. As the European Centre for Disease Prevention and Control (ECDC) warned, this suggests similar levels of infection could become evident across Europe over the coming days and weeks.

A month ago, Erik Knutzen concluded that things were too uncertain to justify big asset allocation decisions. Things are still moving fast, but they have certainly moved enough for us to update our investment views. Brad Tank, Erik Knutzen, Health Care Research Analyst Terri Towers and I did so in a webinar for clients last Wednesday.

The headlines are that we think lost output and earnings will be recovered, but that the expectations for containment of the outbreak and a short hit to first-quarter growth alone - the prevailing view among market participants as recently as a week ago - were too optimistic.

With the caveat that Friday’s market is still ahead of us as I write, we believe that if you haven’t reduced risk, it’s probably not too late to do so; and if you are already conservatively positioned, it may be too early to buy the dips.

Fiscal Stimulus

Coming into 2020, while we clearly weren’t predicting a pandemic, we did say that market valuations made them vulnerable to exogenous shocks. One reason risk assets fell so hard last week was that they had been priced to perfection.

We were also forecasting that growing recognition of the limits of monetary policy could raise the probability of fiscal stimulus this year - an important ingredient for extending the cycle into 2021.

The coronavirus outbreak has raised that probability. Rates markets are now pricing in three Federal Reserve rate cuts for 2020 and Treasury yields are plumbing historic lows, but we think that’s premature. Financial conditions are already accommodative. More pertinently, cutting rates won’t help sick people get back to work, whereas handing $1,300 to every adult citizen (as Hong Kong announced it would last week) certainly will help to replace some missed paychecks.

Sure enough, the Bank of Korea held back from cutting rates on Wednesday, and both Fed and European Central Bank officials played down talk of rate cuts, even as the virus gave politicians the cover they need to loosen the fiscal belt. In Korea itself, the government is looking at an additional $8 billion of budget funding. More questions were being aimed at Germany’s constitutional debt limits last week. China has been intervening substantially to keep small businesses afloat.

Actions like these are unlikely to insulate the economy completely. The International Monetary Fund has cut its 2020 global growth forecasts modestly. Private sector forecast revisions have tended to be more pessimistic. We think 1% global growth in the first quarter and 2.9-3.0% for the year is a reasonable current estimate.

That doesn’t meet the IMF’s definition of global recession, but it brings the possibility closer. Over the coming months, the world economy will rest more than ever on the U.S. consumer. Last week, U.S. new home sales hit their highest levels since 2007, but reported coronavirus cases with no direct overseas link also started to climb and the U.S. Centers for Disease Control and Prevention (CDC) warned the public to prepare for the disease to spread.

In the short term, the economic impact could well be bigger than what was priced into markets at the close on Thursday, especially if U.S. news worsens. Once the worst is over, however, the additional stimulus response could be what the economy needs to extend the cycle further into 2021.

Supply Chains

What could this mean for risk assets?

The question is challenging for analysts because the impact of the virus has come too late to be reflected in recent fourth-quarter earnings but too early to be baked into guidance.

There have been warning signs of a tough second quarter. Some companies highly exposed to the technology supply chain around China have pre-announced earnings, for example. Apple (AAPL) withdrew guidance. Macy’s (M) flagged major supply chain issues for the summer. And Mastercard (MA), a weather vane for global demand, spoke about a two- or three-percentage point hit to top line growth.

Analysts came into the year expecting 5-10% earnings growth from the S&P 500. It now seems likely that earnings will be meaningfully weaker than expected in the first half of the year. The second half could bring a rebound, but the situation is still evolving. Flat or modest earnings growth for 2020 might suggest support for the S&P 500 Index at around the 3,000 mark that was touched last week, or a multiple of around 18 times - but we are likely to see volatility for months to come as companies get more visibility and clarify their guidance.

Longer term, it’s worth noting that some firms have expressed concern about the concentration of their supply chains in China. Rethinking that could have a range of positive and negative economic consequences for countries in Asia, in particular.

Longer to Wait

We think that what investors do now depends a lot on their starting point.

There may be too much policy easing priced into rates and bond markets, but not enough economic disruption priced into high yield and equity markets. At the time of writing, we believe there could be more downside and volatility to come before the upside in equity markets, probably in the second half of the year. It is probably not too late to take some risk off if you have been positioned for a benign environment, or if last year’s market rally has left your portfolio too biased towards equities.

At Neuberger Berman, many strategies entered 2020 positioned for higher volatility. In addition, we have dialed down emerging markets local currency and foreign exchange in some portfolios to reflect the disproportionate impact of the virus in Asia. Our positioning remains defensive, which we think is reasonable for the current environment.

In our view, the threat to global growth and markets is broader and more serious than most forecasters thought even a week ago. Recovery will come, but investors are likely to have longer to wait - and longer to prepare - before the time is right to add exposure.

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