Economists become Virologists as Markets Sicken Investors

The coronavirus that originated in China has sent into motion large financial and economic forces that are dominating the investment landscape.  The first line of defense was to contain the virus in China, but the largest lockdown in history did not work.  The next line of defense was Japan, South Korea, Italy, and Iran.  This firewall did not hold either, and the US CDC and German Health Minister warned of a coming epidemic.  Cases have been reported in more than four dozen countries, with different levels of public health and reliable information.

While it is serious, the overall fatality has been elevated by the initial deadliness in Hubei.  Outside of China, the fatality rate is closer to 0.4% or four-times the mortality of the seasonal flu.   The economic and financial disruption is significant.  Initial conditions are critical, and the Chinese economy, which is now closer to a fifth of the world's economy compared with 4% in 2003 when SARS emerged, was already slowing. Debt-fueled growth led to questions about the health of the banking system.  Japan contracted sharply in Q4 after the sales tax was increased (again), and the country was hit with devesting typhoons.  Its exposure to China via trade and tourism may cut short its recovery.  The German economy stagnated in Q4, and its reliance on exports and China's auto market means Q1 20 is unlikely to be materially better.

The market is skeptical of Chinese data unless it fits into its preconceived ideas, and the PMI released earlier on February 29 did precisely that.  The composite PMI fell to a record low of 28.9.  It was at 53.0 in January. Recall that during the Great Financial Crisis is had bottomed at 38.8.  The non-manufacturing survey also hit a record low (29.6 from 54.1).  The manufacturing survey slumped as well (35.7 from 50.0).  There has been a real effort to get the economy moving forward, and the worst of the shutdown is likely passed. Since the data confirms, more or less, what investors had envisioned from photos and anecdotes, there may not be an adverse reaction to the news.  

Investors had begun the year taking on risk in various forms, equities, emerging markets, carry-trades, and short volatility.  Many expected that the long-term decline in interest rates was over.  Given the exposures and leverage, a smaller spark could have arguably spurred the long-overdue correction in the stock market.  The slide spurred more sales by other market participants, including passive investors.  US bonds yields have sunk to unprecedented levels. The implied yield on the December 2020 fed funds futures contract has fallen by around 75 bp this year.   The change in expectations of overnight money accounts for the bulk of the 77 and 71 bp decline in the 10-year and 30-year yields, respectively.   

Amid heightened speculation of an inter-meeting move,  Federal Reserve Chairman Powell issued a rare unscheduled statement while the markets were open ahead of the weekend.  While acknowledging that the "economy remains strong," Powell indicated that the Covid-19 posed "evolving risks to economic activity" and that Fed would "act as appropriate" to support growth.  For Fed-watchers, these were word clue that increased the likelihood of a rate cut.  Indeed, the odds of a 50 bp move jumped following Powell's statement, which also appeared to help stabilize the equity market.  

The US had and continues to have among the highest interest rates among the high-income countries. This makes it expensive for levered accounts to use the dollar as a funding currency.  Among the hedge funds and commodity trading advisers, the yen and Swiss are typically used.  However, the euro was increasingly used as well.  It was weaker than the Swiss franc and cheaper than the yen.  As risk assets were sold, the funding currencies, including the euro, were bought back.

The "smile hypothesis" about the dollar is being tested now and found wanting.  The "smile hypothesis" is the idea that the dollar does well in very good times or very bad times, but not so well in normal times.  The precise definition of good and bad times is not always clear, but the concept has proven useful.  As the S&P cratered 12% over the past six sessions, the Dollar Index has seen this year's gains more than halved.  In terms of drama in the capital markets, surely the past week has been historic.  US stocks and the dollar, and gold had benefited alongside risk assets and were sold as those plays were unwound. 

Under other conditions, the economic data in the week ahead would set the tone, but in the current environment, they play second fiddle to market positioning and anxiety around the Covid-19.  The flash PMIs steal the thunder of the final report. Still, this time, investors may be particularly sensitive to downward revisions as it may reflect the deterioration of conditions as new data was reported.  Given the mood of the investors, there is an asymmetrical bias.  The downside reaction to disappointment is likely to be more impulsive than an upside surprise, which would probably be discounted because it is not picking up the recent impact of the virus. 

At the end of last year, when we forecast two Fed rate cuts in 2020, we did not anticipate the coronavirus, the lockdowns, and the disruption of supply chains.  We were concerned that the record-long US expansion was turning down and that with inflation below target, the Fed would take out additional insurance in the form of lower rates to extend the recovery.  In fairness, the US economy appears to have begun the year on firm footing.  Most January economic reports were better than expected, but we suspect unseasonably warm weather inflated the data. 

The February employment report on March 6 will set the tone.  Government jobs are rising in the election year, so the cleaner signal is gleaned from looking at the private-sector.  The private sector added an average of about 160k jobs a month in 2019 and surged to 206k in January.  It is likely to fall back to trend in February.  The manufacturing sector is expected to have shed jobs for the third consecutive month.  The government's payrolls may have expanded by around 35k in February after a 19k increase in January.

Average hourly earnings peaked at 3.5% year-over-year last February.  Average wage growth stood at 3.1% in January and is expected to have slowed to 3.0%.  It has not been slower than 3% since July 2018.  Meanwhile, the unemployment rate is hovering near the cyclical low of 3.5%. 

Autos are the largest good that American households purchase.  The purchases are cyclical, and the 12-month moving average typically peaks in the middle of the business cycle. The 12-month moving average rose in February 2016 at 17.57 mln.  Last year, US auto sales averaged 16.91 mln.  After a 16.84 mln pace in January, auto sales are expected to have slowed a little in February. 

The eurozone sees preliminary February CPI.  The headline and core rates are expected to converge at 1.2% from 1.4% and 1.1% in January, respectively.  It won't move anyone's needle.  The same is true of January's unemployment report (expected to be unchanged at 7.4%), while January retail sales likely recovered from the 1.6% month-over-month slide in December. 

Under Draghi, and now Lagarde, the ECB has pressed members with fiscal space to use it.  The bar to easing is high. The next effect is that the US 2-year premium over Germany has fallen to new 3.5 year lows near 185 bp. It peaked near 355 bp in November 2018. 

The UK reports the February PMI and auto registration, but more important than the economic data for sterling has been brinkmanship tactics even before the trade talks with the EU begin in the week ahead.  Prime Minister Johnson warned that if the EC denies it the Canadian-like agreement, the UK will walk away from talks at the end of Q2.  The EC negotiators have made it clear that such a deal with the UK would require regulatory alignment, which the UK cannot accept.  This issue is to the trade talks that Ireland was to the divorce agreement, nearly impossible to resolve without transgressing redlines of one side or the other. 

Two G10 central banks meet in the first week of March.  The Reserve Bank of Australia meets on March 2, and the Bank of Canada meets on March 4.  The market has brought forward an anticipated cut by the RBA. Previously it had been discounted for near mid-year. The derivatives market is has priced in about 20 bp of a cut (~80%) now.  A week ago, less than three basis points were discounted.  The reason Australia has been able to avoid a recession for more than 20 years has a great deal to do with the rise of China.  Its exposure is now a significant liability, and this is on top of the devesting fires.  It has also lost its interest rate premium.  The currency cut through support like a hot knife in butter. Given the implied volatility, a break of $0.6000 this year (2008 low), cannot be ruled out.  

The Bank of Canada stood steadfast in the face of three Fed cuts last year.  Even after softening its neutral stance as the economy weakened, a rate cut did not look imminent.  However, in recent days the market has moved to discount about an 80% chance of a cut, up from around 20% a week ago.  We had thought a cut in Q2 was more likely and looked for a dovish hold now.  The roughly 25% decline in oil prices in the first two months of 2020, and more broadly, a 13% decline in the CRB Index, speaks to a deterioration of Canada's terms of trade.  It is paying a premium of 20-25 bp to borrow for two years over the US, the most since September 2017.  The inversion of the Canadian yield curve also warns that policy is restrictive.  However, inflation is firm, fiscal policy may be a more efficient lever, and the economy appears to have recovered from a soft patch, growing 0.3% in December.  

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