The challenge of thinking a couple of steps ahead

Thinking a couple of steps ahead is helping to contain a deeper washout for broad equity markets at the moment.

The human toll from the coronavirus worryingly continues growing, with the World Health Organization on Thursday declaring an international public health emergency over the outbreak, while companies and countries increase preventive measures. But so far the selling pressure linked to the epidemic has been relatively contained, with a clear divide between haven and riskier assets.

The distinction is evident in Europe’s Stoxx 600, which is now a touch lower for the month after being up 2.1 per cent in mid-January. Utilities and healthcare stand out as havens for this market, while major economically sensitive sectors, such as carmakers, basic resources, energy and the travel/leisure industry, are sharply lower for January.

For the S&P 500, it’s a similar story, but with its vaunted technology sector accompanying utilities at the top, while energy and materials are notable decliners. True, the S&P 500 has clipped much of its 3.1 per cent gain set in mid-January. Still, in broad terms the correction remains modest in tone.

Such resilience does surprise some, though. John Velis at BNY Mellon thinks “there is some degree of ‘optimistic complacency’ at work”, adding: 

“It’s hard to imagine that even under the best-case scenario, China doesn’t take a large economic hit. Thus, to us, it seems that some risk market pricing is far too sanguine.”

Still, he concedes:

“Perhaps they’re looking two moves ahead, to the eventual stimulus to come out of Beijing.”

A nasty growth shock for China is ultimately seen spurring a hefty round of stimulus, an outcome that will drive asset markets once the epidemic peaks. The prospect of stimulus is highlighted by the offshore renminbi weakening through Rmb7 per dollar earlier on Thursday. The offshore rate trades outside of mainland China.

Before then, there are some amber lights flashing. Risk assets have enjoyed a great run in recent months so it doesn’t take much to flush out the late arrivals, which can snowball. Grounds for a larger correction requires a lot more bad news, but, as the global macro strategy team at Citi notes, holders of risk assets should be prepared: 

“[A] further international outbreak of the virus is highly probable, and this will weaken sentiment, making the dichotomy between markets and fundamentals even more stark. Of course, there will be a time to buy a dip in risk assets but it might not be here. Further downside is likely unless/until monetary juicing accelerates.”

Another important point is raised by DWS, particularly as there has been little shortage of comparisons with the Sars epidemic. The asset manager writes:

“Anyone wishing to draw comparisons, particularly with the Sars epidemic of 2002/2003, should bear in mind, however, that the market was then close to its low point and that the mood among companies and investors was generally very weak. This time the virus has been hitting a capital market that has had one of its best starts of the year, with new record highs, especially in (growth) stocks, low volatility and, most recently, investors who are once again very optimistically positioned.”

In economic terms, China and Asia today constitute a far more important presence in the global economy. This region was expected to keep the global economy ticking in 2020 as the US slowed and Europe was in recovery mode.

China’s service sector is also much larger than was the case during the Sars epidemic from 2002 to 2003. This means broader activity could take longer to recover from the current shutdown. Here is Citi’s take along with a couple of charts: 

“The service industry contributes 10ppts more to Chinese GDP now than in 2003 (now 53%), whilst EM Asia’s contribution to Global GDP has almost doubled since then.”

The longer-term view is that a dip-buying opportunity awaits as the threat of a recession still looks low. While that’s a reasonable basis for thinking ahead, the question of correctly timing the turn in asset prices is very much an art.

Quick Hits — What’s on the markets radar

Havens such as gold remain in demand, while flows into government bonds on Thursday pulled the 10-year Treasury yield back under that of three-month bills. A renewed inversion of the yield curve takes us back to October. Beyond the hit to global growth from the coronavirus, the bond market also doubts the Federal Reserve can spur higher inflation and growth by sticking to the policy sidelines this year. 

Thursday’s release of US growth for the fourth quarter revealed an annual rate of 2.1 per cent, but beyond the headline there were some points of concern. Oxford Economics notes:

“More than 70% of the Q4 advance in output came from a temporary collapse in imports, while business investment remained subdued and consumers spent more cautiously.”

Thursday’s much-anticipated Bank of England meeting was a far less knife-edge affair than markets expected. The Monetary Policy Committee voted 7 to 2 for steady policy, whereas interest rate futures were evenly split between a cut or the overnight base rate staying at 0.75 per cent. At least economists can take a bow as only 16 of the 61 surveyed by Bloomberg forecast a rate cut. Of course, leaving markets thinking your interest rate meeting is a coin toss does not speak well about the central bank’s efforts at communication. 

The MPC’s decision lifted the pound towards $1.31 (a climb that began just before the statement was announced, again, not a good look), and attention will now focus on the upcoming March budget and just how much fiscal stimulus beckons from the government.

For advocates of an “insurance” rate cut, the final insult came when the MPC lowered its outlook for the UK economy and estimated an average rate of 1.1 per cent over the next three years. Hardly an upbeat view as Brexit looms on Friday. 

Dean Turner at UBS Wealth Management notes:

“Economic data has been mixed, but there has been some speculation around the prospect of a post-election bounce. Recovering activity reduces the need for a rate cut for the time being. In our view, the economy is likely to run into further challenges this year and therefore we still expect the Bank of England to cut rates at some point in the next six months to give the economy additional support.”

Indeed, the BoE has stepped away from indicating a gradual tightening stance, leaving the door open to an easing in the coming months. 

Silvia Dall’Angelo at Hermes Investment Management said:

“A rate cut is still pretty much on the table and will be deployed in coming meetings if the pick-up in economic activity suggested by recent surveys does not materialise.”

For now, she believes the BoE “is saving its limited ammunition for when it might be more needed, also depending on how negotiations with the EU develop”.

As for life outside the EU, Dhaval Joshi at BCA Research predicts another round of Brexit tension looming for UK assets before the year-end. As Dhaval explained over tea and cake earlier this week, the playbook has been one of “a gradual ratcheting up of tension ahead of a hard deadline to focus minds and force progress”.

For the pound and UK assets, this likely entails better progress later in the year or, as Dhaval, says: “A ‘fudged resolution’ at the eleventh hour in which both sides blink — because neither side is prepared to go over the cliff edge.”