COVID-19, a new coronavirus, is showing potential of developing into a pandemic, and the news flow is delivering a steady stream of concerning updates. Equity markets, which had heretofore been complacent, kicked off Monday with a more than 1,000-point drop in the Dow, and the 10-year Treasury yield hit an all-time low as global growth prospects dimmed. Yet whether or not COVID-19 is going to be a temporary disruption to growth or the cause of a deeper downturn may not be determined for some time. Investors will likely have to contend with lower yields and heightened volatility for several months, at least.
Hope of successfully containing the virus deteriorated significantly over the weekend with news of fresh outbreaks in Italy, South Korea and Iran, bringing the virus to a total of 30 reported countries. Early indications that the virus could spread by air as easily as influenza and that infected people could be contagious early on – before they show symptoms – have only increased official concern. In short, while there continue to be more unknowns than knowns about COVID-19, the risk of a global pandemic is looking more likely.
Global growth concerns intensify
One immediate threat appears to be to global growth. Business activity in China was experiencing the green shoots of recovery from a phase one resolution of the trade war with the U.S. when an unprecedented quarantine of tens of millions of Chinese citizens across multiple major cities began in mid-January. This halt in regional activity is likely to have a significant impact on Chinese GDP through declines in tourism, transportation, retail and manufacturing, although data has yet to be released.
In Japan, Q4 GDP unexpectedly contracted by -6.3% year/year, a miserable outcome driven by broad-based weakness. This is not a strong footing from which to absorb a shock in sentiment or activity from COVID-19 on the economy. The virus-related disruption looks like it will next engulf South Korea, as the government there raised the threat level over the weekend to the highest alert in the face of hundreds of new cases.
Finally, Italy is now facing outbreaks in multiple cities. Evidence of an impact on the economy through tourism was immediately clear as the Venice Carnival, which typically draws 20,000 visitors, was cancelled. The chipping away at activity across these large national economies at a time when the world was already suffering from a dip in growth presents a potential threat of a global recession, or at the very least a bout of weak activity that could be a drag on the U.S. economy.
The U.S. economy remains solid, but is not impenetrable
The good news is that the U.S. economy remains the largest and most resilient of the large developed nations. U.S. growth ended 2019 at 2.1%, slightly above trend, and household consumption – which makes up 70% of the economy – remains supported by a low unemployment rate and high consumer confidence.
This does not mean the U.S. economy is inoculated against the virus, however. First, U.S. industry is dependent on inputs from China and the rest of Asia. Chinese manufacturing has already fallen sharply, which could cause a disruption in the global supply chain should it be sustained. Business sentiment could be impacted either because of falling international demand or because of uncertainty surrounding these global supply dynamics. The upcoming release of the ISM manufacturing data on March 2 will bear close watching.
But by far the largest risk is that the outbreak impacts U.S. household consumption. For now, this seems unlikely; consumer confidence is much more closely tied to job availability and wage growth. Should the worst-case scenario materialize and a domestic outbreak require some type of quarantine, clearly the impact to the consumer, and thus the economy, would be significant. This remains an outlier event with a small probability for now, thankfully.
Treasury rates plumb new lows
For the fixed income market, the outbreak of COVID-19 in early January caused rates to fall, reflecting higher caution about the global outlook. On Monday, rising risk of a pandemic sent the 10-year Treasury yield down close to 1.35%, an all-time low. This historically low level of yield reflects concern about global growth and a heightened flight to quality sparked by uncertainty. Yield curve inversion has deepened, with the 3M-10Y spread now at -18 bps, the lowest since October of last year. The bond market is, in a word, pessimistic.
Markets are now pricing in a more meaningful policy reaction, as the Fed funds futures curve shows more than 50 bps of rate cuts by the end of 2020. On Monday, Fed officials once again cited the coronavirus as a risk that was being closely watched, but reiterated that monetary policy was currently “in a good place.” Whether or not the Fed decides further rate cuts are warranted, ammunition is running low for monetary policy. We may have a return to an early-2019 environment where Fed officials have differing views on policy, adding to the uncertainty in markets.
Equities are no longer “priced for perfection”
Market sentiment has been starkly uneven since early January. While benchmark yields and commodity prices have maintained a more cautious outlook in the face of coronavirus headlines, equity markets quickly shook off the initial round of news regarding China’s outbreak as the S&P 500 hit an all-time high on February 19. With P/E valuations at 19.5, in the top quintile of historic valuation, markets seemed to be brushing off not only a rising risk of negative impact from the coronavirus, but any risk whatsoever.
That complacency seemed to crumble with a -3.35% drop in the S&P 500 on Monday, February 24. Keep in mind, the S&P 500 was at its all-time high as recently as February 19, and is down only -4.73% from its peak. The VIX, a volatility index that anticipates future equity market volatility, surged to over 25 on Monday, the highest level since January 2019.
Looking ahead, we expect volatility to remain heightened. Indeed, we have struggled to understand the complacency of the last month. There are multiple sources of uncertainty already, including looming U.S. tariffs on select European goods and a U.S. presidential election that could see a policy debate with sharply differing views. Indeed, the uncertainty surrounding Fed policy in reaction to the virus is enough to add to volatility.
Most analysts continue to see the COVID-19 outbreak as only a temporary disruption and are using the SARS outbreak as a model, anticipating one quarter of extremely weak growth that quickly and entirely reverses given rapid resolution. However, the current situation has already deviated from the SARS episode in many ways and could stand to have a more lasting impact. We are not experts on global epidemics, but given the paucity of prior cases to study, our view is that it is better to build a portfolio that can weather significant volatility and low interest rates ahead, rather than hope that the storm dissipates in front of us.