Return of the bear

In short

• Risk assets suffered meaningful declines in February and through early March, with safe havens such as U.S. Treasuries providing few ports in the storm.
• Central banks and governments alike appear willing to release a level of stimulus not experienced since the global financial crisis.
• Our overall expectation is for a steadying of the global economy in the second half of the year, as pent up demand is released, and supply chain disruptions subside.

With the expansion of infection in coronavirus – more specifically denoted as COVID-19 - from China to 115 countries as of this writing, the threat of meaningful demand downshift in both the consumer and business sectors resulted in a sharp move lower in risk assets through February and the first week in March.

While many investors initially compared the expected economic experience to that of earlier outbreaks – such as SARS, MERS, and West Nile, to name a few – it is clear that the uncertainty around transmission, number of asymptomatic cases, and lower mortality point to a broader economic impact. Compounding the potential risks, global stocks came into the year after significant gains and trading at high multiples, as investors expected a re-acceleration of growth to translate to revenue and earnings growth to justify those multiples. Instead, expected declines in travel, gaming, and other lifestyle experiences such as restaurant dining weighed on stocks, with losses expanding as companies restrict travel and withdraw guidance amidst the uncertainty. In addition, capital expenditure is likely to be on hold, at least in the short term, further delaying momentum in parts of the economy which had underperformed during the two year China trade impasse.

In response, stocks experienced rapid and significant declines. Year-to-date through March 9th, the S&P 500 was down -14.7%, and small cap names, not surprisingly, were off over -21%. The pain has been felt outside of the United States as well, with international developed stocks down -15.7%, and emerging markets equities declining -14.8% despite gains off the bottom for Chinese names. Commodities and high yield bonds have both been pummeled by an escalating crude oil price war between Saudi Arabia and Russia, while high quality bonds have seen massive inflows driven by a desire to reallocate to safer havens. In fact, the 10 Year Treasury fell intra-day to an all-time low of 31 basis points before recovering some ground.

In response, central bankers and governments alike have pledged support and stimulus. In the U.S., the Fed acted quickly to stem what it perceived as a threat to “its maximum employment and price stability goals” by lowering interest rates by 50 basis points in a rarely seen intra-meeting move. (An additional cut at the upcoming meeting is likely as well.) Other central banks such as the European Central Bank and Bank of Japan maintain their interest rates at essentially zero, and therefore would need to stimulate financial conditions through their balance sheets or other mechanisms. China is likely to continuing cutting its benchmark lending rates as necessary, and is most certainly willing to initiate fiscal spending to claw back from a slowdown which sent the country’s Manufacturing PMI down to 40.3 in February – its lowest level ever. Perhaps the most pressing concern now is around the fiscal response here in the United States, which could take the form of small business loans, a payroll tax cut, or a more transformative spending package. As of this writing, it appears that a “wait and see” approach is the plan – but should cases increase, the pressure to act will increase as well. Our view is that this burst of stimulus, coupled with better transparency around transmission and a plan for care and containment of COVID-19, will create a supportive backdrop for the global economy in the back half of 2020.

In focus: much ado about oil

Complicating the narrative surrounding the economic impact of COVID-19 was a decision made by Saudi Arabia to significantly cut the price of oil to their customers, as an act of retribution to Russia for refusing to limit production in last week’s meeting against the backdrop of lower demand. This created significant disruption in both the equity and bond markets, prompting concerns about cash flow for highly levered energy companies, and resulting in pressure on liquidity in the bond market as the threat of higher defaults clouds the environment. While traditionally we view a drop in the price of oil as a net positive, given the broad positive impact to both consumers and businesses NOT in the energy industry, a drop of this magnitude will materially impact the opportunity for U.S. shale players to remain profitable, and thus is likely to curb capital expenditure in the near term. Couple this with the reality that the price of oil was already being pressured lower on demand fears, and the acknowledgment that the decline in consumer spending in the U.S. due to modified behavior has only begun, and the risk off trade has once again taken the reins.

Perhaps most concerning about this move is the dislocation in the bond market, as mentioned above. Admittedly, bonds issued by lower quality energy companies led declines, but the overall market has experienced spread widening as well. While the last significant equity market decline in the fourth quarter of 2018 did not bring about significantly higher spreads, the threat of economic slowdown and impairment of cash flow generation amongst lower quality, often smaller companies has resulted in a lack of demand for lower quality credit. This leads to concerns about the health of these companies, and the potential economic impact of a meaningful pick up in defaults – all of which bears worth watching in the weeks ahead.

What we’re watching: consumers have been the foundation for economic growth following the 2008-2009 recession, and expectations were for spending to continue in earnest.

2020 was set to be a year in which global growth re-accelerated on the back of a simmering of trade tensions between the U.S. and China and the continuation of easy monetary policy by central banks. Economic data out of the gate in January was strong, and save Chinese data, is not yet reflecting the uncertainty inherent in the spread of COVID-19. As such, we remain focused on the magnitude of the decline in global demand, both from consumers and businesses, in order to gauge the potential longer term impact from this particular outbreak.