Financial markets across the international economy are extracting a powerful toll on portfolio valuations amid a volatile landscape. Financial market volatility has reached the point where global central banks will have little choice other than to put into place greater monetary accommodation to bolster financial conditions and to stem what is becoming a crisis of confidence among investors in the ability of the government sector to adequately address the crisis.
China’s role as a supplier of intermediate goods would be difficult to replicate quickly should the virus not be contained.
For a majority of the two months since the coronavirus (Covid-19) was first identified as an unknown infection in Wuhan, China, global markets reacted reasonably well. Despite a rising human toll as the disease spread throughout the world, financial markets did not respond. But given what happened over the past week and the continued volatility to start this week, that is no longer the case.
Supply chain shock
The first reaction might be to say that the disease is spreading quickly across the world because of China’s central position in the global supply chain. But that might be missing the point. After all, the 1918 Spanish flu infected one-third of the world’s population and killed an estimated 50 million people, including 675,000 Americans, according to the Centers for Disease Control and Prevention. All that occurred without a global supply chain.
Still, China has become centrally important to worldwide manufacturing, both as a supplier and as a consumer of goods. The impact of a shutdown on China’s civilian life (or life in any developed country) will undoubtedly have an immediate and negative impact on commercial activity among its trading partners – the importance of which has finally been noticed by the financial markets.
China’s role as a supplier of intermediate goods would be difficult to replicate quickly should the virus not be contained, and that should only add to sustaining the global manufacturing recession. Of course, economies in close proximity to China have a larger dependence on China’s manufacture of intermediate goods, but there will clearly be an impact on worldwide production if even one automobile company in Milan or the U.K. has to scramble for parts.
China’s role in the U.S. economy runs the gamut from basic material to intermediate parts to durable goods to the consumer goods that stock the shelves of American retailers. Shipments of goods at Pacific seaports from California to Vancouver have been in decline since November 2018 — when the trade war took hold at the onset of the global manufacturing recession – and the growth rate of shipping containers loaded with exports and imports have been negative for the past 11 months.
While it’s too early to separate the impact of the ongoing manufacturing recession from the decline in global growth specific to the shutdown of normal activity in China and elsewhere, we have to assume that the sharp drop in shipping activity at U.S. ports will not turn around on a dime. That implies a drop commercial activity that will have an effect on every downstream commercial enterprise, from a drop in swipes at truckstops along the highways to reduced hours for production workers, no matter how long the outbreak lasts.
Moreover, the rebound following the abatement of the crisis will be somewhat more elongated than that which is expected. Currently most market participants are anticipating a V-shaped recovery, which is not consistent with the restarting of supply chains. This is part of the reason why we have revised down our U.S. real GDP growth forecast to about 1.0% in the first quarter of 2020, and about 1.2% growth for the year.
For the money markets, this reduction in economic activity implies a loss of confidence for lenders who are already pricing in higher default risk for commercial loans. In the past four weeks, the interest-rate spread between 3-month commercial paper (Libor rates) and risk-free overnight inflation swap rates (OIS rates) have jumped from near zero to 20 basis points. The bond markets are also demanding higher interest rates for longer-term loans for both investment-grade and high-yield (junk) bonds.
Don’t jump to catastrophic conclusions
While these jumps in spreads imply some loss of confidence and a higher cost of doing business, it is probably too soon to jump to a catastrophic conclusion. As the longer-term figure below indicates, the 20 basis-point jump in money market rates are far less than the meltdown in commercial lending in the run-up to the 2007-9 global financial crisis, and there have been several bumps since then that suggest this is too early to make a judgment on the eventual outcome.
Furthermore, this crisis is not a financial crisis, but as has been discussed in the news media, but instead is a supply crisis. Although the interest-rate markets will ultimately reflect the increase in risk and the continuation of the manufacturing recession at the least, it is doubtful that the interest-rate markets will be the main show on the way down.
If there is a bubble to be burst, then the logical candidate seems to be the equity market. Despite the best efforts by the Federal Reserve, interest rates remain stubbornly close to zero and investment remains stubbornly low. And with little return or appetite for holding fixed-income securities, the stock market remains the only game in town for investors searching for yield.
With the demand for equities so strong, the return for holding a portfolio of the S&P 500 has been an astonishing 14% per year on average since the financial crisis. That, of course, has been aided and abetted by the 2017 corporate tax cuts, which resulted in equity buybacks (rather than the investment that it was purported to promote).
The nature of bubbles
As with all bubbles, whether it was the housing bubble of the early 2000s, or the dot.com bubble of the mid-1990s, or the junk-bond crash of 1989 before that, it takes only a slight loss of confidence to be the catalyst for a significant sell-off.
As the figure below illustrates, significant losses have afflicted the major equity markets over the course of just the past week. There were signs of a correction on Friday, though, perhaps as investors began buying on the way down or perhaps as the market held out hope for the best of possible outcomes to the health crisis.
It’s too early to tell. As the scientific community has repeatedly told us, there is no way at this point to know how this virus will continue. It would make the most sense for the business community to look for other options along the supply chain.
