By Richard Dunbar, Head of Economic and Thematic Research, Aberdeen Asset Management
The novel coronavirus (COVID-19) that emerged in China’s Hubei province late last year has now spread to more than 50 countries. The outbreaks in Japan, Korea and Italy are particularly serious, but the number of cases is climbing rapidly elsewhere.
Initially, the stock market’s reaction to the virus was muted. Most investors appeared to believe that the problem would be largely confined to China and were willing – perhaps too willing – to view it as posing only short-term challenges for the global economy.
But as the outbreaks outside China accelerated, the initial complacency evaporated. The last week of February was the worst for the world’s equity markets since the height of the global financial crisis in 2008. Now that that the virus’s economic impact appears likely to be more severe than initially expected, markets have moved rapidly to price this in.
The importance of data
So, between the complacency of the first weeks of 2020 and last week’s panic selling, how should professional investors react? One of the things I’ve learned in years of looking at these events is that it always pays to keep a cool head and continue to concentrate on both the data and on the quality and valuation of the assets that we own.
Clearly, the economic impact of COVID-19 will be more considerable than many imagined earlier in the year. The world is much more ‘enmeshed’ than in the past, and China, which has been in virtual shutdown for several weeks, now accounts for a much larger share of global economic activity than it did in the past. Companies’ inventories are low and supply chains are more complex than ever. In addition, the precipitous fall in some commodity prices and the increasing caution of consumers across the globe may lead to cashflow problems for some companies – particularly those with a little more leverage. All this means that data will certainly get worse before it gets better. But it is not yet clear how bad the overall economic impact will be.
Authorities must act
One important consideration is that governments and central banks can take swift and decisive action. Everyone accepts ammunition is running low in monetary policy, but central bankers do still have some firepower left.
This week’s 50 basis point cut in U.S. interest rates has demonstrated this willingness and ability to use monetary policy as one of the tools to alleviate the effect of the economic impact of the virus. Investors’ initial cautious reaction may hint at some skepticism as to the efficacy of this tool. However, at least it is being used. In conjunction with others, it use does demonstrate some resolve from the global community.
Central banks globally continue to be helped by the fact that they no longer need to worry about inflation for the time being. As well as the prospect of some further easing of interest rates, we’re also seeing increasing talk of a fiscal response to the crisis in China and India and elsewhere. A positive response by politicians and central banks could go a significant way towards offsetting the damage caused by the outbreak and will provide considerable reassurance to investors.
Already, some of last week’s market fear has started to recede – albeit considerable uncertainty remains. Investors currently appear to be taking a more considered approach. Last week’s sell-off was one of the fastest in the past 40 years, and was somewhat indiscriminate. So it’s possible that more of the virus’s economic impact may now already have been factored in. The big issue for us, then, is whether this was merely a correction or the start of a more significant downturn.
The answer, as always, will lie in the data as it becomes available to us. We know that the coronavirus is, at the very least, going to be a pothole in the world’s economic road. We just don’t know how deep it will be and how long it will go unrepaired. Global bond yields show that markets are starting to price in a full-blown recession – with U.S. 10-year Treasury yields breaking through 1%. But it’s not yet clear that recession is inevitable, and any overreaction will give way in time to a recovery. So, as professional investors and analysts, we have a lot of work to do.
One key metric that we’ll be watching very carefully is China’s purchasing managers’ index (PMI). The speed at which the PMI recovers will be crucial. If we are seeing infection rates peak in China, as some believe, the PMI will indicate how quickly economic activity will return to normal.
In the next couple of weeks, we’re likely to see a fair bit of volatility in the markets as investors grapple with these questions. At Aberdeen Standard Investments, we’ll be keeping our heads down, blocking out the noise and doing the hard work of research. That should lead to a considered assessment of whether the COVID-19 outbreak is likely to lead to a recession or merely a short-term slowdown. That assessment will enable us to adjust our portfolios appropriately. And we will, of course, be keeping our clients well informed as our thinking evolves.
Foreign securities are more volatile, harder to price and less liquid than U.S. securities. They are subject to different accounting and regulatory standards, and political and economic risks. These risks are enhanced in emerging markets countries.
Fixed income securities are subject to certain risks including, but not limited to: interest rate (changes in interest rates may cause a decline in the market value of an investment), credit (changes in the financial condition of the issuer, borrower, counterparty, or underlying collateral), prepayment (debt issuers may repay or refinance their loans or obligations earlier than anticipated), call (some bonds allow the issuer to call a bond for redemption before it matures), and extension (principal repayments may not occur as quickly as anticipated, causing the expected maturity of a security to increase).