Global markets have gotten a reality check as the coronavirus spreads. While most expect this to mirror previous viral outbreaks, the ongoing uncertainty has markets fearing the worst. Here, we try to put this current outbreak into perspective but find that we are facing a unique situation. Until the scope of the outbreak becomes clearer, risk sentiment will remain negative.
The coronavirus Covid-19 continues to spread. New clusters have sprung up in South Korea, Italy, and Iran. Spain has quarantined a resort in the Canary Islands after an Italian tourist tested positive, while Austria, Croatia, France, Germany, Greece, and Switzerland have all recorded their first cases. Brazil and Algeria too. Many of these new cases in Europe are people who had recently been in Italy. However, some of the new cases have appeared in patients who have not traveled to China nor been in contact with someone who had. This hidden chain of infection is unnerving markets, to put it mildly. The Centers for Disease Control and Prevention (CDC) warned yesterday that an outbreak in the US is a matter of when, not if.
The World Health Organization defines a pandemic as an uncontained worldwide spread of a new disease. The Ebola virus has killed thousands but has been largely confined to West Africa and so it is not considered a pandemic. Health officials have not yet declared the current outbreak a pandemic, but we believe that it is only a matter of time. According to WHO Director-General Tedros, “For the moment, we are not witnessing the uncontained global spread of the virus. Does this virus have pandemic potential? Absolutely, it has. Are we there yet? Not yet.”
The search for a treatment is under way. A compound called remdesivir has been rushed into clinical trial in China. Results of the trial could be available within weeks. Elsewhere, another company has just shipped its first vaccine for a clinical trial at the National Institute of Allergy and Infectious Diseases and could be ready for testing by late April.
The IMF just cut its global growth forecast. The agency sees global growth slowing by 0.1 ppt to 3.2% in 2020. The IMF also trimmed its China growth forecast this year to 5.6% from 6.0% previously and expects normal growth to resume by Q2. To state the obvious, we think these forecasts are 1) based on incomplete information and 2) too optimistic and likely underestimate the final impact of Covid-19.
Senior International Olympic Committee (IOC) Dick Pound warned that the 2020 Summer Olympics planned for Tokyo is at risk. He added that the games would most likely be canceled rather than delayed or moved to another venue. Pound estimated that there is a 2-3 month window for the IOC to decide ahead of the planned July 24 opening ceremonies. He stressed that the IOC is relying on consultations with the WHO on any decisions. Japan officials are of course pushing back against the possibility of closing but it’s really out of their hands at this point,
A BRIEF HISTORY LESSON
Incubation period: 5-10 days
Length of outbreak: December 2013-January 2016
Total cases: 28,646
Fatality rate: 70%
Ebola was first diagnosed in 1976, starting in South Sudan and spreading to Zaire. While thought to be related, it turns out that they were two distinct Ebola viruses. In Sudan, 284 were infected and 151 died, while in Zaire, 318 were infected and 280 dies. There were numerous localized outbreaks that followed in Zaire (1995 and 2003) and Uganda (2000, 2007, and 2012). It wasn’t until the 2014 Ebola outbreak that the virus spread to many other countries. After the initial outbreak in Guinea in March 2014, it rapidly spread to neighboring Liberia and Sierra Leone. There were 11 documented cases in the US; 9 contracted the disease in Africa and 2 were nurses that treated an Ebola patient.
Severe Acute Respiratory Syndrome (SARS)
Incubation period: 2-7 days
Length of outbreak: November 2002-July 2003
Total cases: 8098
Fatality rate: 9.6%
The first case appeared in the province of Guangdong in November 2002. Government officials did not notify the World Health Organization (WHO) until February 2003, which allowed the virus to spread unchecked in the early stages. The WHO issued a global alert in March 2003 as cases eventually spread to 26 countries. There were 8 documented cases in the US. The WHO finally declared SARS contained on July 5, 2003.
Middle East Respiratory Syndrome (MERS)
Incubation period: 5-6 days
Length of outbreak: September 2012-June 2015
Total cases: 2506
Fatality rate: 34.4%
The first cases appeared in Jordan in April 2012 but was only recognized as MERS much later. A patient was admitted to a hospital in Saudi Arabia in June 2012 with a lung infection. Doctors could not find the cause and he died shortly thereafter. Subsequent tests led to the discovery of the new MERS coronavirus. In September 2012, British health officials discover the virus in a visitor from Qatar. By April 2014, Saudi Arabia and UAE start to report a rapidly increasing number of cases. MERS then spread to other countries, including Greece, Malaysia, the Philippines, and the US. The two documented US cases were healthcare workers that had lived in Saudi Arabia. There have been subsequent outbreaks, including a large cluster in South Korea that began in May 2015 and traced to a traveler in the Middle East.
Incubation period: up to 24 days
Length of outbreak: December 2019-current
Total cases: 80,980 and rising
Fatality rate: 2%
Looking at the attributes known (so far) of the Covid-19 virus, none of the previous viral outbreaks give much insight into how bad this current one can get. We can already see that the spread is much faster, but the fatality rate is much lower. The longer incubation period suggests potential for an even faster spread in the coming weeks, however. As of this writing, there has been no testing being done yet in the US and so there haven’t been any reported cases beyond those that have been evacuated out of China and Japan. From an economic standpoint, China is a much greater part of the global economy and global supply chain than previous outbreaks. As such, the risks to global growth are much greater than previous viral outbreaks.
The dollar is up YTD against every major currency. Unsurprisingly, CHF and JPY have held up the best due to safe haven flows, but the dollar remains king. The Antipodeans and Scandies are the worst performers YTD, and these growth-sensitive currencies are likely to continue underperforming as the global outlook dims. Simply put, we believe that the US economy is best positioned to deal with the impact of the coronavirus.
As Italy struggles with the coronavirus, we reaffirm our bearish bias on the euro. It is the third-largest eurozone economy after Germany and France, meaning two of the top three were already struggling to grow even before the virus hit. With the industrial north of Italy on lockdown, the final impact on the economy are yet to be determined but recession risks are rising significantly. Moreover, Italy has far less fiscal space to respond to the virus than other countries in the region, so it’s an unfortunate coincidence that it was struck the hardest. Italy’s national debt is around 130% of GDP and the budget deficit was expected around -2.5% for 2020 even before the virus hit.
With global growth at risk, it’s no surprise that EM has taken it on the chin. The dollar is up YTD against every EM currency as well. INR and IDR have held up the best, which is perhaps not too surprising given their relatively limited links to the China supply chain. BRL and ZAR are the worst performers YTD. That said, anecdotal reports suggest that positioning is a lot cleaner now in EM, especially in local equity and rates side, so losses may be less dramatic from here.
Global equities are finally taking notice. MSCI World is -2.9% YTD, with the Pacific at -6.8% vs. Europe at -3.1% and North America at -1.3%. MSCI EM has fared worse, naturally, at -6.0% YTD. Emerging Asia is -4.9% YTD vs. -3.1% for EMEA and -1.3% for Latin America. Until the length and breadth of this global coronavirus outbreak becomes clearer, we think it will be impossible to call a bottom. And we must stress that this is more than just panic selling. Corporate earnings will be significantly impacted by the coronavirus and so equity prices must adjust to reflect this.
Market are weaving a very dovish story for the Fed. Yet, we’re not convinced. Are Fed rate cuts really going to have any effect on what is basically a supply shock from overseas? China needs to get its factories running to replenish the global supply chain and we don’t see how lower US rates would address that.
Would such Fed cuts be meant to support the stock market? That is a very dangerous path for the Fed but of course, we can’t rule it out after Powell basically bent the knee back in early 2019. We understand markets are working in an environment of high uncertainty and so they are pricing in worst-case scenarios. We continue to believe that the Fed should save its ammo for a time when rate cuts can actually make a difference.
For now, the Fed is taking a wait-and-see approach to the coronavirus. Next FOMC meeting is March 18, when new Dot Plots and staff forecasts will be released. We do not think the Fed will cut rates next month, but it should tilt more dovish to set the table for eventual easing. WIRP suggests over 25% odds of a cut then but rise sharply thereafter. Markets are basically pricing in two 25 bp cuts by the September 16 meeting, with one cut fully priced in by the June 10 FOMC meeting. Another cut is getting priced in by early 2021, which would take the target range down to 0.75-1.00%.
Global bonds are attracting safe haven flows. Virtually all developed market government bonds have seen their yields fall YTD. The yield on 10-year US Treasuries are -56 bp YTD and is the top performer. With inflation likely to remain low and most central banks shifting into dovish mode, core government bonds are likely to remain bid. Peripheral bonds are likely to underperform, however.
The US yield curve has flattened a lot this year, but the move has started to stabilize. However, it’s way too early to sound the all clear. At -17 bp, the 3-month to 10-year curve is the most inverted since September 24. The US 10-year yield stands at 1.35% after trading near 1.31% yesterday, eclipsing the previous all-time low near 1.32% from July 2016. Besides the US, several other countries have seen their yield curves invert. These include the UK, Canada, Hong Kong, Singapore, Norway, and Denmark. Sweden is flat but likely to invert soon.
Bottom line: Stay underweight equities, EM, and commodities and stay overweight the dollar, Swiss franc, yen, and core bonds. We believe the IMF is being much too optimistic about the global impact of the Covid-10 virus. The situation is still developing, and the long incubation period suggests there is more bad news coming in terms of global infections. That said, the fatality rate is low, but the economic impact is heightened due to China’s unique role in the global supply chain.
Until proven otherwise, the sharp downdraft in global growth and ensuing recovery is still likely to follow a typical V-shaped pattern. However, the V is likely to be deeper than previous viral outbreaks. The US has not yet been significantly impacted by the virus, but markets are pricing in a very dovish Fed, which we think overstates the likelihood that the aggressive easing will be needed in the US.