February Investment Strategy - Central bank put, again…
- The trickle of soft and hard data now available to gauge the global economic impact of the Covid-19 epidemic suggests supply-side disruption effects for now exceed the impact on demand. Supply-side effects are harder to treat with policy stimulus.
- Market is now expecting quite a lot from central banks. In the case of the European Central Bank, we think raising the quantum of corporate bonds purchases would be a likely avenue.
- Both bonds and equities like the fact that a central bank put exists, but both are now re-evaluating more sanguine outlooks for the virus spread, while equity markets will have to deal with corporate earnings challenged by supply-side disruptions.
Covid-19 – a supply shock for now
Twice in 10 days the Chinese authorities have changed the way new Covid-19 cases are counted in Hubei, which means that most of the “epidemic projection” exercises, which have been so popular in the market, are now obsolete. However, the World Health Organisation (WHO) has suggested good progress in containing the virus in China.
Focus is now shifting to the propagation of the epidemic outside China, and the emergence of “autonomous contagion points” in South Korea, in a city where 5% of the national population lives is concerning. In Italy, some sort of restrictions is now implemented in regions contributing more than half to the country’s GDP. We are now starting to get a trickle of soft and hard data which can help us gauge the global economic impact of the crisis. So far and very tentatively, it seems that supply-side disruption is emerging before demand-side effects kick in.
South Korea has released foreign trade data for the first 20 days of February and reassuringly total exports did very well with growth of 12.4% year-on-year (yoy) – although this was boosted by more working days in the month. But at the same time, imports from China fell by a whopping 18.9%. This is a clear signal that supply-chains are under stress.
The same applies to the Euro area. At face value, the unexpected rebound in the German manufacturing PMI in February was also reassuring, but half of it came from a statistical artefact: A steep rise in “suppliers delivery time” mechanically raises the overall index because it is normally a signal of “overheating” (suppliers finding it difficult to cope with demand). This time it reflects the disruption in supply lines triggered by difficulties with Chinese components.
We suspect that – short of a swift resolution of the epidemic – demand-side effects will emerge in the next batches of data, but the supply-side issues are problematic in their own right – and are much less “treatable” with policy stimulus. To a large extent, the resilience of financial markets had hinged on a sanguine outlook for containing the virus and expectations of policy support. We think the early consensus of a swift “v shape” recovery is looking increasingly shaky. We were more cautious than most on the global outlook before the epidemic. We are happy to remain below consensus now.
Thinking about plan B
A shift in market expectations for the Federal Reserve (Fed) and the European Central Bank (ECB) since the emergence of the Covid-19 epidemic has been swift. One month ago, market pricing had the Fed cutting by less than 25 basis points (bps) by the end of January 2021. It is now pricing nearly 50bps, with the first cut materialising by the summer of 2020 (Exhibit 1). Our own (pre-epidemic) baseline was 50bps worth of cuts at the end of the year and we now consider the risk of a Q2 easing, despite the constant stream of central bank commentary stating that it is “too early” to tell.
Even for the ECB, the market is starting to price some further reduction in the deposit rate. We continue to think the bar for this is high. The main benefit of such a move would be to depreciate the euro, but the market is already spontaneously producing that, while the central bank has been increasingly ready to acknowledge the side effects of such policy.
We think that if the European economy were to sour further, raising the purchases of corporate bonds would be the ECB’s favoured approach. Indeed, on that aspect of quantitative easing, the political and technical limits are much less stringent. This would not necessarily boost activity, but at least it would help support financial stability if a deterioration in economic activity were to raise default rates.
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