Global market participants have priced in the imminent reopening of the Chinese economy, while the World Health Organization has cautioned that it is too early to declare that the virus is at its peak.
The coronavirus has the potential to turn an epidemic in Wuhan into a global economic event.
It is clear based on news flow over the weekend and into Monday’s early-morning session that it will be one to two more weeks at the least before the Chinese economy reopens. Foxconn, for example, a major supplier to Apple and the iPhone, has delayed the resumption of production, Bloomberg reported on Monday.
We are now concerned that the conditions are being created to spur a major risk-off move across equity and commodity markets and a corresponding safe haven move into U.S. government securities and gold.
At this point in the global health crisis we do anticipate a .01% drag on U.S. growth in the current quarter, with the risk of a greater hit should volatility through financial and trade channels dampen domestic economic activity.
China has become integral to the global supply chain. As such, the coronavirus has the potential to turn an epidemic in Wuhan into a global economic event, capable of crippling production within an interconnected global economy. The figure below shows a sample of economies from Europe to the Americas to Asia that will be affected by the shutdown of production and transportation in China.
The global economy operates only because a global financial market offers the ability to transact and to invest in its future. As has been the case in previous economic trauma over the past two decades, the price movement of financial assets can offer a real-time assessment of the potential damage to the economy and the risk of investing in its future.
In the 2007-9 financial crisis, the risk of an economic meltdown led to the freezing of liquidity in the money markets. In this coronavirus crisis — and with interest rates already at extremely low levels — we expect the global equity-market bubble to be most vulnerable to panic selling.
In the sections that follow, we will discuss the role of risk in the several financial markets and commodity markets during the SARS epidemic in 2003 and the current coronavirus outbreak. We find financial asset prices to be real-time indicators of economic stress, while commodity prices are subject to noncrisis production issues but are nevertheless important to watch.
While the equity market is subject to speculative behavior – remember irrational exuberance – you would expect the U.S. bond market to remain attuned to the direction of global growth, with yields rising along with the increased demand for investment during upswings, and yields falling along with a negative outlook for economic growth and a decreased demand for funding.
The risk of holding a bond until its maturity is built into the price of the bond; the longer the maturity, the more risk there is to holding a single 10-year bond rather than a series of 10 one-year money-market securities.
As such, bond yields can be deconstructed into, first, expectations of short-term interest rates over the life of the bond, and, second, compensation for the risk that short-term interest rates might deviate from those expectations. That risk component is referred to as the “term premium.”
During an economic slowdown – whether caused by a geopolitical event like a war or a pandemic that limits economic activity — one would anticipate, first, central-bank rate cuts and diminished expectations for short-term interest rates, and, second, an increase in uncertainty, which results in a negative term premium to compensate for an event-risk that could trigger a recession and deflation.
In the current environment – which consists of a global economic slowdown and a health crisis — expectations of short-term rates have dropped 75 basis points since the end of 2018 when the U.S. trade war was unleashed, and have fallen 8 basis points during the outbreak of the coronavirus. The term premium for 10-year Treasury bonds has fallen by 89 basis points during the trade war, and 27 basis points during the health crisis.
While it is difficult to distinguish the effects of the trade war and the epidemic, both will have a similar negative impact on economic growth, with global industry deprived of intermediate goods and as consumer demand is pushed lower in response to income effects. The drop in long-term interest rates represents the degree to which investors see an unhealthy and risky environment for expansion.
Unless the health crisis is quickly contained, we would expect long-term interest rates to continue to trend lower, resulting in an inverted yield curve — in which long-term interest rates are lower than risk-free money-market rates — that represents the short-term risk of a recession and the threat of long-term damage to potential growth.
Risk and foreign demand for Treasuries
During periods of stress, investors tend to seek a safe return, increasing their “safe-haven” demand for the guaranteed returns of U.S. Treasury bonds. Off-shore demand for U.S. Treasury bonds will tend to increase during periods when the U.S. dollar is expected to strengthen – increasing the return of U.S. securities for foreign holders – or simply when foreign exporters need a place to park their cash flow.
So there is often the case of increased safe-haven demand for Treasuries coinciding with increased transactional demand when U.S. economic growth is expected to support higher interest rates than foreign securities. As the figure below shows, purchases of Treasuries by foreigners increased by nearly 60% during the SARS outbreak in 2003.
Foreign purchases in the current cycle have not yet been released, but given the reaction of the markets, we would expect an increase in safe-haven demand until the crisis is resolved.
By the time of the SARS outbreak in 2003, the stock market was two years past the dot.com bust and the subsequent recession, and was just beginning the multiyear equity uptrend that would last until fraud in the mortgage market brought the global economy to a halt. During the 27 weeks of the SARS epidemic, the U.S. equity market dipped lower, but ended up increasing by a remarkable 14.5% by the end of the crisis.
This year, at the start of the coronavirus outbreak, it could be argued that the current equity-market upswing is showing signs of fatigue — evidenced by two dramatic loss episodes in 2018. (The 2018 losses came about after imposition of the trade tariffs and when Fed rate hikes were thought to threaten U.S. growth.)
Still, the U.S. equity market has been on a tear throughout 2019 and into the first weeks of 2020, despite the ongoing global slowdown and manufacturing recession. Since November 2018, the S&P 500 index has increased by nearly 19% while its market capitalization increased by 14%. And in the five weeks since the end of 2019 and the start of the coronavirus outbreak, the S&P 500 index has increased 2% while the market cap decreased by 0.6%, suggesting some targeted losses.
Although the equity market has been immune to the global economic slowdown – arguably because of the market being awash with cash from the 2017 tax cuts – there is the risk of the equity market being vulnerable to a moderation of consumer spending, with the coronavirus the tipping point.
The VIX index is the benchmark for equity market risk, with the argument that investors prefer stability. Volatility did pop up above normal levels at the start of the SARS crisis in 2003, before retreating as the economic recovery developed. In 2020, the VIX jumped to 16 from 13, a not insignificant increase from before the coronavirus was identified.
Market participants follow the VIX index closely, though the public is accustomed to following announcements for the Dow Jones Industrials and S&P 500 indices. All those measures provide an accurate assessment of market sentiment that is not necessarily relevant for the direction of the economy. Nonetheless, an increase in volatility or a dramatic drop in stock prices has shown to be an indication of an overbought market and the catalyst for a financial and economic crisis in the making.
Crude Oil Since the advent of shale production and alternative-energy technologies, the crude oil market has become truly global, with North American production creating a glut of supply that — since its peak in 2008 — has driven down the price of crude oil to near-unprofitable levels in today’s dollar terms.
Despite the advances in production and automobile efficiency, and changing tastes for commuting, you would nevertheless expect the demand for energy to diminish during economic slowdowns, driving down the price of crude oil. This was the case during the 2003 SARS epidemic when crude prices fell by nearly 24% at their lowest level during the six–month crisis before recovering.
During the coronavirus outbreak, crude oil prices have dropped by 17% since the start of the year. With the increased role of China in the global supply chain in manufacturing, a slowdown in production due to Coronavirus restrictions could conceivably result in a lessening of demand for energy until the Coronavirus outbreak is contained.
Soybeans Keep in mind that U.S. exports of soybeans are nearly twice the level as they were in 2003 during the SARS epidemic when the price for soybean futures rose and then dropped nearly 5% lower by the end of the episode.
With transportation to and from China limited during the Coronavirus outbreak, we would expect the demand for soybeans to lessen. Indeed, soybean contracts have dropped 5% from the end of the year until the first week of February as China literally shut down normal life.
Copper Copper is the glue that keeps the digital age going, and its supply is becoming more and more limited, according to some reports. There are other conductors of electricity (like gold, silver and aluminum), but it’s copper that electrifies U.S. consumers, with prices in 2020 about four times more than in 2003.
Because of the universality of electronic devices in our current culture, we would have to assume that the coronavirus outbreak in 2020 would have had a larger impact on the demand for copper than a similar outbreak nearly two decades ago. Copper prices declined by 10% during the SARS epidemic before retracing those losses and gaining 3% by the end of the crisis. In 2020, copper prices have already lost nearly 9% since the outbreak of the coronavirus, and its direction will be determined by the degree of economic inactivity and loss of income caused by the virus countering developments at the mines that have the potential to limit supply.
Aluminum Aluminum is an input to the production of technological and automotive products and we would assume its demand would be subject to overall economic trends.
In fact, during the SARS epidemic, the price of aluminum declined by nearly 6% during the episode, and ending 4% down by the time SARS was contained.
In this current health crisis, the price of aluminum has increased by 3% since the coronavirus was acknowledged. So why would prices increase if demand for aluminum is going down in sync with the global economic slowdown? The answer appears to be because of fears of a dwindling supply as aluminum producers close down because of the drop in demand.
Gold According to some market participants, gold is a store of value during episodes of inflation. With that logic, during times of economic slowdowns – when the threat of inflation should be receding – the demand for gold should decrease along with its price.
During the SARS epidemic, the price of gold fell 18% from its pre-crisis level of $77 per ounce to as low as $63. By the end of the crisis, gold prices had recovered to $80 for a 4% gain.
In this recent environment of a global slowdown, gold has increased in price by 60% from $64 in November of 2018 to $102 in February 2020, perhaps because of safe-haven demand for gold during a period of the economic uncertainty resulting from the ongoing trade war and political upheaval in the United States and the United Kingdom.
During the coronavirus outbreak, gold prices have slipped 3% from $105 at the end of 2019 to $102 in the first week of February. Given the erratic nature of the gold market, it would be hard to look at gold as anything but speculative.