In brief

• The Federal Reserve announced a 50 basis points interest rate cut after an emergency meeting overnight.
• This is unlikely to be a “one and done” rate cut as Fed Chair Jerome Powell stated that the Fed was “prepared to act appropriately” against a backdrop of rising risks posed by the Covid-19 outbreak.
• Even accounting for policy stimulus from global central banks and governments ahead, we see significant scope for market volatility as investors recalibrate their growth expectations on the back of developments in the Covid-19 epidemic. Our base case is that the virus outbreak would not derail the long-term economic expansion.
• While the outbreak is escalating, investors should avoid areas of clear risk, for instance, industries such as travel, hospitality, restaurants, offline retail and entertainment.
• As rates continue to fall, the search for yield will continue to be a structural driver of markets. In this case selective quality dividend-yielding stocks, such as Singapore REITs, might be attractive.
• There will always be opportunities even in uncertain times like this. Investors should review and maintain a diversified portfolio, while monitoring for opportunities to switch into companies with solid long-term fundamentals.

In the beginning, there was peace

The year began with seemingly reasonable expectations. Receding trade war concerns, supportive monetary policy and a general sense of geopolitical stability had firmed expectations that global growth would improve. Markets faced a speed bump when US-Iranian tensions escalated, but this too passed without a lasting impact on global markets.

Indeed, 2020 held great promise. The tracks looked clear. The gravy train seemed poised to make further progress.

The coronavirus outbreak has shaken these convictions. There is a general repricing of risks as expectations are now up in the air amid heightened uncertainty about a health epidemic.

Worse than expected

At the onset of the coronavirus outbreak, markets in Asia were the hardest hit. This was expected. Asian economies were the most exposed, not just due to geographical proximity, but due to the integration of economies over the past few decades via global, interconnected supply chains. Extreme measures were taken to contain the virus epidemic in China including the lockdown of cities, widespread factory closures and mandatory quarantines. China’s shock therapy has started to bear fruit with the steady decline in new cases domestically, but this had come at the cost of widespread disruptions to supply chains.

China’s latest official manufacturing and non-manufacturing Purchasing Managers’ Indices (PMI) (Chart 1) serve as a preview of the potential economic damage wrought by these drastic but necessary policies. Both indicators slumped to record lows, sharply underperforming consensus expectations, which while weak, still looked somewhat buoyant. This is to be expected given the sudden and widespread economic stoppages over the past weeks. This is likely to foreshadow a deluge of potentially disappointing data ahead as Asia reels from the shock to economic activity in the region.

China’s deeply disappointing data might also trigger a review of earlier economic forecasts, perhaps pencilling in a deeper economic fallout than what was initially anticipated. Nevertheless, February’s data will likely mark the bottom of this year, as the Chinese government gradually eases its containment policies and allow workers to return to work. The cogs of production have begun to turn, and the normalcy of everyday life is expected to return. Yet, with there being cases of reinfection, the worry remains about a potential second wave of infections as containment policies are lifted.

Widespread disruption

Admittedly, global stock markets had initially reacted as if Covid-19 was an Asia problem, almost as if there was a proverbial wall around Asia that made Europe and the US immune to its woes. Sure, markets were rattled somewhat by the outbreak, but the market sell off was far more severe and persistent in Asia. In fact, markets in the US and Europe were riding high before the sudden slide in the last week of February.

Whispers of concerns about a global contagion came to a crescendo after the number of confirmed infections outside of China suddenly spiked (Chart 2). Developed countries such as South Korea, Japan and Italy reported waves of infections which stirred fears of an uncontrollable spread unless drastic actions were taken. This would invariably mean disrupting economic activity to contain the spread of the virus.

For Italy, it meant putting about 11 towns in the industrialised and wealthy north under strict lockdown. For Japan, it meant suspending school for some weeks. For South Korea, it meant work stoppages at some production facilities for car manufacturers and raising the disease crisis alert to red.

Quarantines and leave of absences from work impacted aggregate labour supply, hitting production while measures to curtail movement impede retail sales and squeeze consumption growth. These effects are further magnified via the web of interconnected supply chains. Taken together, global growth will likely take a beating, the extent of which will depend on the period these disruptive policies are left in place. The OECD had warned as much.
Gauging the cost of disruption

In a sense, China has shown the way – shock therapy works to contain the virus but comes at great economic costs. While the spread of the virus in other countries has not reached China-level proportions, governments might still take action that seem disproportionate to the risks in view of limiting the spread of the virus while they still have the space to do so.

With the country count rising by the day, the disruption to economic activity might be far more widespread than anticipated. The spread of the virus will also test the resilience and robustness of affected countries’ healthcare infrastructure. For the most part, developed economies, with more advanced heath care systems, look well-placed to address the health impact. Emerging economies might face some trouble in this respect.

It is the uncertainty about the potential scale of the outbreak and associated macro-economic disruption that is particularly unnerving. Do highly levered companies with weak balance sheets have the capacity to survive the virus-induced economic storm? Could the potential failure of such corporates trigger a recession? How will supply disruptions impact companies’ earnings and their bottom-line? In the midst of heightened uncertainty, risk taking is the first to go.

Admittedly, it might be too early to discern any material economic impact from the coronavirus outbreak in lagging hard economic gauges. Yet, sentiment data like the US ISM manufacturing index showed a slip in manufacturing activity in February from a month prior, with the new orders index contracting for the month. This suggests that there has been some hit to business sentiment from the spread of the coronavirus globally, which could mar the global growth outlook and dent expectations over corporate profits should the situation deteriorate.

Financial conditions tighten, likely necessitating some central bank support

The result has been a spike in market volatility and a steep slide in equity markets, as investors rush to exit into the reassuring arms of low risk government bonds. Market turbulence over the past week had deepened the inversion of the 3M-10Y US Treasury yield curve and resulted in substantial tightening in financial market conditions. The bond market is expecting a sharper slowdown in growth -- possibly a recession -- that would merit deeper interest rate cuts.

Hence, it’s little wonder that the Federal Reserve took the unconventional step to issue an unscheduled statement endorsed by Fed Chair Jerome Powell 90 minutes before the end of a volatile trading session last Friday to calm nerves. The statement did not have to make explicit reference to the Federal Open Market Committee’s (FOMC) intention to cut interest rates at the upcoming March meeting for it to be read as such. Its unexpected delivery was signal enough that a rate cut was coming.

Both the Bank of Japan and European Central Bank offered similar soothing words of potential policy support while a G-7 teleconference of finance ministers and central bankers raised the prospect of coordinated action. Markets soared as investors took comfort in the possibility of decisive action. Expectations for a coordinated effort was high.

Alas, the teleconference came and went, and market expectations were deflated as the G-7 provided only a statement promising to pull all available policy levers, stopping short of committing to any specific concrete plans. 

The Fed shocked more than they awed

Meanwhile, the Federal Open Market Committee (FOMC) announced an off-schedule emergency interest rate cut of 50 basis points, bringing forward what markets had already expected would come during the scheduled meeting in March. The market’s initial surge and sudden collapse was telling and underscores the heightened sense of uncertainty about the current situation. Indeed, the Fed’s “shock and awe” policy treatment left most in shock rather than in awe.

Besides tighter financial market conditions and wavering sentiment indicators, it is difficult to cite any recent meaningful hard economic data that point to a material worsening of the economic outlook such that the Fed could not wait two weeks to react with some policy easing at a scheduled meeting.

Aside from the questionable politics of the move, there are three points to make in explaining the markets’ dive. 

• The signal matters more than the substance

Firstly, the signal of the Fed’s policy move mattered far more than the substance of the policy. The last time the Federal Reserve delivered an inter-meeting 50 basis points rate cut was in early 2008, during the throes of the financial crisis. The US central bank typically reserves such action for situations where the economic outlook had darkened substantially, as per the dot com bust of 2001 and the great financial crisis of 2008. Given the significance of the timing behind such unscheduled moves, the market immediately drew parallels between the current virus-induced crisis and the recession-inducing crises of the past.

Could the Fed be staving off a projected recession with this rate cut? For the most part, hard economic data in the US do not paint the picture of an economy careening into a recession, save for some shaky readings for certain business sentiment indices. The Fed’s abrupt rate cut suggests that the outlook might be worse than what was initially anticipated and considering that they have access to far more information than Wall Street, this immediately triggered a repricing of expectations. Perhaps they knew something that Wall Street did not.

A 50-basis point rate cut is typically a boon for risk assets, but if the move signals an outlook that is far worse than expected, it does little to assuage fear. It’s little wonder that the 10-year US Treasury yield fell to record lows -- below 1% -- even after the rate cut, as investors are now expecting a deeper crisis than they had before. 

• The scope for policy easing has narrowed

Secondly, with policy rates now between 1-1.25%, the scope for more rate cuts have considerably narrowed. The Fed can only afford four 25 basis points rate cuts before confronting the zero-lower bound that would force the central bank to undertake unconventional action in the form of explicit forward guidance (i.e. commitment to keep future interest rates low) and balance sheet policies (i.e. quantitative easing) just to support the economy.

There might be some uneasiness about the lack of policy space, especially in the throes of a deeply uncertain situation. 

• Too blunt an instrument for a health crisis

Thirdly, Fed Chair Jerome Powell had readily admitted that monetary policy has limited macro-economic impact in view of the nature of the current crisis. Mr Powell characterised the issue best when he said, “A rate cut will not reduce the rate of infection. It won’t fix a broken supply chain.”

Theoretically, the rate cut would ease financial market conditions and shore up business sentiment somewhat. It lends a helping hand for firms that might be struggling with debt, allowing them to refinance at a lower rate and ride out a potentially turbulent time ahead. Lower borrowing costs are also expected to encourage firms and consumers to bring forward investment and spending plans.

The wheels of economic activity might spin faster with encouragement from lower interest rates, if the virus epidemic is under control. Yet, until we’ve reached the peak of infection, the cloud of uncertainty over demand will keep firms and consumers cautious.

Meanwhile, as Fed Chair Powell noted, lower interest rates do little to remedy disruptions to supply chains. Perhaps the realisation that monetary policy is too blunt a tool to deal with such exogenous supply shocks might have led to some adjustment of seemingly inflated expectations about its effectiveness. After all, monetary policy is not a panacea in a health crisis.

More easing ahead

The language of the Fed’s recent policy announcement against the backdrop of an exogenous shock and tepid inflation supports the view that this is not a “one and done” rate cut.

In the event that the outlook continues to deteriorate, we do think the Fed will make one to two more 25 basis points rate cuts at its scheduled meetings in March and April.

Old fashion Keynesian economics to the rescue

The Federal Reserve is not alone in this effort. In fact, it is just one in a line of central banks that have eased interest rates recently to support flagging economic activity. Yet, it is the biggest and most globally important among them. The Reserve Bank of Australia and Bank Negara have already cut interest rates, while many others have signalled intentions to do so, with the Bank of Canada and Bank of England set to follow their lead. On the fiscal front, Singapore, Hong Kong, South Korea and Italy have announced expansionary budgets to deal with the current crisis.

Indeed, following China’s playbook, countries dealing with the outbreak of the virus will have to the combat the current crisis with a two-pronged approach.

• The priority is to first contain the spread of the virus, invariably with heavy-handed containment policies that will cause necessary disruptions to economic activity. Business and consumer confidence may suffer and only recover with the certainty that the epidemic is under control.
• To offset the drags that these policies might wrought, governments will have to undertake a mixture of expansionary fiscal and monetary policies. For the developed world, amid the seemingly narrow monetary policy space, countries will have to resort to good ole fashion fiscal stimulus to jolt economic activity, no matter how averse some governments may be to run a budget deficit (i.e. Eurozone post austerity). Typically, these policies work through the economy with a lag, which means governments would need to announce these plans early so that the measures start to bear fruit once the epidemic is contained and normalcy returns.

It remains to be seen if and how the G-7 would coordinate these policy responses. There are great benefits to coordinating government actions in the face of a global virus threat. A comprehensive plan delineating the specific policies that will be implemented would go a long way to assuage market concerns. A flimsy statement about commitment to support economies does little to inspire confidence, in which case, the G-7 bungled a pregnant opportunity to arrest the decline in global markets.

Follow the leader

With the dramatic move on Tuesday, the Fed has set a decisive tone for easing monetary policy ahead. Other smaller central banks are bound to heed the call for greater monetary policy easing. Fiscal policy is another matter altogether.

Nevertheless, we believe markets will remain volatile for some time to come as expectations about the economic costs of the coronavirus outbreak continue to evolve with new information. A wide dispersion of possible outcomes underscores the uncertainty inherent in the current market situation. This will only lead to market turbulence.

Our base case remains that this virus outbreak is unlikely to derail and upend the long-term economic expansion. Against this view, there are still strong merits to stay invested. However, while market valuations have come off, we still think it might be too early to buy this correction.

Investors should adopt a long-term view about their investments. In this case, market volatility and bouts of indiscriminate selling during risk-off phases opens up opportunities to accumulate stocks of companies with solid long-term fundamentals that may remain relatively unscathed from the virus outbreak. Investors should also stay clear from the line of fire and avoid industries such as travel, hospitality, restaurants, offline retail and entertainment as they are in direct risk of the economic fallout from an escalation in the virus outbreak.

The hunt for yield will remain a strong theme as global interest rates fall. To this end, quality dividend-yielding stocks such as Singapore REITs might be an attractive yield and defensive play, although they are not fully inoculated from the vagaries of the current uncertain environment.