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Weak, and confused. Central banks have responded to coronavirus with looser monetary policy, which has helped increase the yield gap between core government bonds and stocks. Any further stock market falls, and/or bond market rallies, will accentuate this gap- in favour of stocks. When coronavirus eventually passes, stocks may prove irresistible on a relative valuation basis. But in the meantime, we have to suffer deteriorating economic fundamentals that threaten corporate earnings, and hence share prices and credit ratings. The attractive dividend yield gap will be a trap if companies dividends are heavily cut.
As the spread of coronavirus around the world accelerates, the risk of it triggering a global recession have increased. This was highlighted earlier in the week, when the OECD cut its world GDP growth forecast for 2020 from 2.9% to 2.4%. It suggested the number could halve again if there is no plateauing of global infection rates. Global GDP growth of below 3% is often associated with recession. The muted reaction by investors, to the Fed’s dramatic 0.5% emergency interest rate cut on Tuesday, illustrates scepticism over central banks’ ability to boost confidence and support demand in the face of an infectious disease.
We do not know if the virus will generate a V-shape hit to the global economy, or if the effect will be a more damaging and longer-lasting U-shape. The threat posed by coronavirus has changed in recent weeks, and become more complicated for policy makers: it is no longer just a supply shock to the global economy, caused by Chinese factories closing and interrupting global manufacturing supply lines. Coronavirus now poses a demand shock, as consumers everywhere look set to travel, shop and socialise less over the coming weeks and possible months. In the longer term, coronavirus could accelerate the de-coupling of China’s economy from the western developed nations as multinational companies diversify their supply chains out of China.
A rather chilling leading economic indicator is the JP Morgan Global Manufacturing PMI, which measures the confidence of purchasing managers of manufacturing companies. Having reached a nine-month high of 50.4 in January, it fell in February to 47.2, the lowest since May 2009.
Risk assets, such as stocks, industrial materials, and high yield debt, continue to appear vulnerable to further sell-offs. Some were judged by market analysts as ‘priced for perfection’ even before the coronavirus outbreak, in particular U.S stocks. This is illustrated by a look at the price to book value ratio of the S&P500 index. Yesterday this measure of value stood at 3.32 times. This is lower than the 3.5 times achieved a fortnight ago, the highest since the dot com bubble, but at 3.22 it is still higher than just about all times since 2002, despite the 13% correction on the index we saw last week. Other valuation measures tell a similar story..
However, recent interest rate cuts from the Fed and other central banks (such as Canada and Australia), do improve the relative valuations between safe haven and risk assets – in favour of risk assets. With the 10 year U.S Treasury yield now just below 1%, and the yield on the FTSE World Index of stock markets up to 2.6%, there is an attractive yield gap for investors willing to take on risk. Indeed, once the coronavirus begins to fade, we may see a strong recovery rally helped by these improved relative valuations. The Bank of England and the ECB have yet to act.
With an extremely large $300bn liquidity injection made a month ago by the People’s Bank of China, together with a lowering of its bank lending rate. These measures are intended to shore up demand in China, as well as a highly leveraged banking system. The sum compares with the $50bn the IMF has promised to make available to countries affected by the virus, and the scale of the Chinese liquidity boost should do much to help keep small and medium sized businesses afloat (although there is a risk that credit reaches only the bloated state-owned companies).
On a similar theme, the Achilles Heel of the financial markets is perhaps the U.S credit market. Many analysts judged this to have been also ‘priced to perfection’ before the sell-off, when its value was equivalent to a record 47% of U.S GDP. Around half of the just under $7 tr market sits on the lowest rung of investment grade, as companies deliberately sought out investors eager for any yield. But this makes the debt vulnerable to being downgraded to junk category (which would force many institutional investors to sell). June sees a spike of $200bn in maturing debt, much of it in sectors badly affected by coronavirus such as airlines, travel and energy. Will this the debt be repaid by the companies? If it has to be rolled over, at what price in terms of yield and credit rating? Who are the lenders?
Coronavirus has demonstrated the advantages of a multi-asset investment approach over investing purely in stocks. A portfolio comprising of equities and bonds, and alternative non-correlated assets, will have seen a significantly lower fall last week than one containing just stocks. In view of the uncertainty ahead, but the likelihood of an eventual recovery in risk assets once new cases of coronavirus plateaus, this approach is perhaps the most suitable for the long term investor to pursue.
Joe Biden’s surprising comeback will have upset the Kremlin, whose attempts to influence the presidential election -according to U.S security officials- are focused on supporting Bernie Sanders and Donald Trump, and avoiding a moderate president with a known suspicion of Russia. For investors, Biden represents a less obvious threat to the sectors that had come under fire from Sanders and Elizabeth Warren, such as pharma, banks, big tech and energy. Should his success after Super Tuesday continue, we can expect to see relative outperformance of stocks in these sectors as the risk of a fresh wave of corporate regulation after November’s presidential election fades.
Coronavirus dominates the FX markets at present, but it has not had a noticeable impact on sterling. Traditional safe haven currencies such as the Swiss franc, Japanese yen have rallied a little against the pound, together with the euro. Currencies seen to be sensitive to China growth have weakened, notably the Aussie and New Zealand dollars, along with emerging market currencies in general, have weakened a little. Sterling, currently at $1.28 and EUR 1.15, is piggy-in-the-middle.
However, once coronavirus passes this calm is likely to end. FX traders will return to closely watching what the U.K government is able to negotiate with the E.U and the U.S on trade, with sterling likely to be much more sensitive to the outcome of negotiations with Brussels than with Washington.
Trade talks with the E.U started on Monday, with the E.U demanding that the U.K sign up to alignment to their rules on workers’ rights, environmental standards and state aid. In return the U.K will receive tariff and quota-free access to the single market, for goods that meet E.U standards. The response from the U.K has been to loudly promise never to surrender control over the three issues, therefore not to commit to alignment, and to walk out of negotiations if the E.U continue to insist on this and prepare for a no deal Brexit in December.
A compromise is likely, given that the ruling Conservative party is itself keen to demonstrate to its new supporters in northern, traditionally Labour-voting constituencies, that it values workers’ rights and the environment. The ideologues in the party, who wanted to create a ‘Singapore on the Thames’, have been silenced. Indeed, the U.K government boasts that its standards in these and many other areas are higher than E.U rules mandate, and will remain so. Perhaps the U.K can be allowed to publicly claim that alignment does not apply to any E.U trade deal, while having given an undertaking to mirror E.U law in the areas concerned (similar to Switzerland). Such a compromise would require constant policing by the E.U, and this may prove to be a stumbling block. A cross-Whitehall study, published in November 2018 that found might cost between 2% and 8% of GDP over a 15 year period (15 years is a standard time frame that economists use when modelling long term scenarios).
The U.K government’s Department for International Trade said on Monday that a free trade deal with the U.S will increase U.K GDP by between 0.7% and 0.16% over the next 15 years. The small size of any gain arises from the (currently) comparatively minor role of the U.S as an importer of U.K goods, taking just 10% of U.K exports compared to just under 50% that go to the E.U. In addition, the U.K government is limited in what it can offer the U.S, given that it has vowed not to open up its public services (including the NHS) to American competition, and it seeks to maintain standards for consumers on food production. The modesty benefit of a U.S trade deal will be in contrast the rhetoric accompanying it, with both Prime Minister Johnson and President Trump wanting to claim credit for a deal.