Market Participants Work With Probabilities
Opinions are difficult to develop when so little is understood about the virus. Our view coming into 2020 was that global growth would pick up modestly versus 2019. The outbreak of the virus means that, at best, economic data will remain distorted through the first quarter and at worst, risks to the downside will have risen sharply. Of greatest concern is that we really cannot predict the timeframe or full impact.
Analyses of past viral outbreaks provide some clues on potential outcomes, but we caution relying on this approach. China’s economy has changed significantly since 2003, both in its size, mix of services/manufacturing and role in the global economy. China accounts for 17% of global GDP today versus 4% at the time of the SARS outbreak. Within China, according to World Bank data, services’ share of GDP is now ten percentage points higher than in 2003. From an economic standpoint, the past may not be a helpful prologue.
Consequently, we expect the market to react to the news cycle, focusing on expert opinions and facts as the situation unfolds. This applies to good news as well as bad news. For example, if the outbreak in Europe is smaller than currently feared because of its advanced health care system, the probabilities of severe scenarios decline. In this scenario, investors would likely have a good appetite for risk assets. Recall that the S&P 500 was at a record high barely two weeks ago until sour sentiment knocked it down. Sentiment could snap back just as quickly as it fell.
Watch the Consumer and the Fed
The US consumer had very positive momentum prior to the outbreaks in China and Europe. The January employment report coupled with respectably solid consumer confidence should provide enough momentum to support spending and economic growth if the outbreak in the United States is muted. However, a pullback in consumer spending, driven by fears of travel or gathering in public places, could create a transitory reduction in GDP. Of greater concern would be anything that damages the overall employment picture. Over the coming months we will be watching several early warning indicators very closely, including:
- The number of people reporting they are working part time for economic reasons
- The average workweek and aggregate hours index
- Layoffs, unemployment claims and duration of unemployment
The odds of the Fed easing this year have sharply escalated – Fed funds futures are fully pricing-in a cut by April. However, incoming data through the first quarter have, by and large, been better than expected. Based on reported data, there would be no reason for the Fed to act. The trouble is that none of these releases captured the rapidly growing risks caused by the COVID-19 outbreak.
Recent Fed speak has offered some hints of a change in position. Richard Clarida, vice chair of the Fed, has spoken of a “meeting by meeting” approach. While the Fed may typically like to wait to see the risks translated into data, there seems to be little benefit in waiting. Given the acute downside risk to the outlook, the Fed will likely err on the side of caution, with a March meeting rate cut now in the offing.