Coronavirus Watch: Time to Row Close to Shore

March 9, 2020
Coronavirus Watch: Time to Row Close to Shore, Market Commentary

The China-based coronavirus threatens to become a global pandemic. Unfortunately, its reach didn’t stop at China’s geographic border, as a number of countries in Europe, Asia and the Americas have reported cases. 

The number of reported cases of the illness continues to climb. The number of new cases is declining in China (albeit still positive), while cases reported outside of China are accelerating. Cases reported in the United States are now national in reach. Some believe the viral spread in the United States has a long way to go.     

Economic Impact of Coronavirus – Overview

From an economic standpoint, the economy of China and the world are struggling to grow under the weight of the virus. Travel and trade activity have slowed, as concern about the spread of the virus has grown. Economists have shaved expected economic growth rates (gross domestic product – GDP). For example, the Blue Chip Economic Indicators monthly survey suggests first quarter GDP growth expectations in the United States has shrunk from 2.3% to 1.6%. The same survey suggests overall 2020 U.S. GDP growth has declined to 1.9%.   

The deceleration in expected economic growth is global in its reach. So far, the deceleration in growth appears to be more intense in some of the emerging economies (China as an example) than in the United States. J.P. Morgan’s economic team has lowered its expectation for China’s GDP growth rate to 4% (annualized number) during the first quarter of this year. Many analysts we observe suggest growth in China is contracting at a 2% – 4% range. It’s difficult to accurately forecast China’s growth rate, as the folks in Beijing tend to provide information which, to put it nicely, accentuates the positive. So, how much has China’s economy been impacted? It is hard to say. 

But globally, economic growth expectations appear to be in contraction. 

Where We Have Come From

We entered 2020 with the expectation that U.S. GDP growth would be around 1.5% for 2020. We also thought global GDP growth would be 2.7% for 2020. Both of these forecasts were well below many forecasts that economists were making a few months ago. Those consensus forecasts are now more in line with our view of growth deceleration in 2020.

Of course, we couldn’t forecast that the slowing economic growth was going to be due to the coronavirus as we came out with our “Flying at Low Altitude” economic thematic piece late last year.  We saw the maturity of the cycle, as evidenced by such low unemployment rates, a Federal Reserve that had been raising interest rates only to start the process of ease (typically what happens before the onset of a recession) and serious economic weakening abroad. All of those factors led to our view of slowing economic growth, an environment where an external shock might have the capability of creating real issues.   

These noted factors are still present. We now layer the coronavirus variable on top of those issues. The probability of significant weakening of growth has risen, in my view, and is being reflected in various polls. So, are we revising our economic growth outlook further toward the downside? Not at this time. We need to see further evidence of the impact of the coronavirus over the short-term. That being said, it appears the majority of the negative economic impact on both global and U.S. growth should occur during the first half of 2020. We wouldn’t be surprised to see U.S. GDP growth slow to 0% – 1.5% during the first half of this year.

What is the Problem?

The major economic problem associated with the virus is a supply shock to the world, which is working its way through distribution channels. What is supply shock about? The world’s manufacturing power is centered more on emerging economies – including China – than has been the case historically. As people become ill with the virus, they are told to stay home and not come to work. Many factories in China, and in other locations globally, have been shutting down as workers become ill. 

Due to low inventory levels (just-in-time inventory practices), many factories and distribution centers around the world are becoming starved for supplies. Herein lies the crux of the economic problem with the current virus spreading globally. Left unchanged, this trend is starting to negatively affect overall economic growth on a global scale.

How much impact could the supply disruption problem have on various economies and how long will the supply disruptions last?

Countries with economies that are more heavily exposed to import/export growth rates stand to be negatively affected more than countries with economies that are more self-reliant. Why? As supply chains shut down because workers become sick and stay home, exports that feed manufacturing channels become dislocated. Below is a list from World Bank of countries with import/export levels as compared to overall GDP (as of 2018): 

Table showing trade as compared to GDP by country

As can be seen, Europe’s main economies are highly oriented to trade activity. Much of the trade in Europe is between European countries, but the message here is clear. If the world is starting to slow, and import/export rates are to be impacted, European economies may suffer more than others. Japan’s GDP growth rate has turned negative. We wouldn’t be surprised to see major economies in Europe start to show negative GDP growth rates as the uncertainties of BREXIT, interrupted supply chains and a rising tide of coronavirus infections all weigh heavily on the continent.

It is hard to say how long the supply disruption problem will persist. How long will the virus problem be with us without a cure? We don’t know, nor does anyone else. We suggest that the supply constraint problem may be with us for at least the next calendar quarter or so.

The Other Shoe

The other economic shoe that may fall in this tale is the demand side of economic activity. If people are afraid to travel, go out to eat, or participate in group activities, the economic growth that these actions foster will likely be negatively impacted. It is too early in the viral spread for this to have happened to any great level. We hope it doesn’t come to this. But, an outright decline in demand for various services (air travel, convention activities, sea-going cruises) may eventually occur, dampening demand for various discretionary spending items.   

Our Economic Outlook

We’ve been of the opinion for some time that the current business cycle – with an expansion that started in the second quarter of 2009 – is becoming mature. The boom phase of the cycle has been in play for some time. We’ve observed that boom phases have been followed by recessions – it has only been a matter of time. 

While we sense the probability of global and U.S. economic recession has increased, we currently believe the world will escape an outright economic recession this year, due specifically to the coronavirus, and the supply disruptions that this is causing. It is too early to make a definitive call, but as noted above, the Blue Chip survey suggests there is a 30% probability that our economy will enter a recession this year. We suggest that probability is a little low. According to the Brookings Institute, historically, the U.S. economy has been in recession 12% of the time since 1970, so the probability of being in recession is markedly higher than normal.1

One key indicator as to the direction of the U.S. economy over the next few months will rest on job creation and small business sentiment. If small businesses stay positive and continue to hire people, the U.S. economy should continue to grow while many segments of the rest of the world show signs of contraction, as we believe consumption activity should remain buoyant in this positive environment. The U.S. consumer is a key to domestic economic growth. If consumption activity shows resilience to the virus news, then our economy should be in decent shape. However, if we see serious deterioration in small-business sentiment, we suggest an outright contraction in the U.S. economy may not be far behind.   

What Were They Thinking?

The Federal Reserve reduced interest rates, continuing the trend that it kicked off last year. The recent Fed rate decrease of a full 50 basis points (1/2 of 1%) occurred between their regular meetings. We don’t see how a 0.50% reduction in short-term rates is going to positively affect the building economic problems, which are driven by supply-side disruptions. Monetary policies are primarily designed to affect weakening demand, not weakening supply. We don’t see how the interest rate move is going to help anything besides perhaps the creation of more capital market volatility.

In its release, the Fed stated the move was an emergency action (a somewhat radical statement by the Fed in itself). A couple of comments are appropriate in our opinion. 

  • The move represented the sharp slap of monetary policy. Over the last 10 years, the Fed has moved rates – both upward and downward – by .25%. The .50% move was the first interest rate change of this magnitude since December 2008, during the middle of the financial crisis and the last economic recession. Short-term interest rates were 1.5% prior to the reduction; now they are 1%. The Fed spent one-third of its monetary interest-rate ammunition…for what?
  • As stated above, the move occurred between meetings – a signal that the Fed sees something is broken in the economy. The Fed was going to meet in March and only needed to wait two weeks to make this move on a nonemergency basis. One goal of the Fed is to be viewed by the market as both the lender of last resort and a cornerstone of strength, not a body that bends to the whims of politicians or markets. 

We are of the opinion that the Fed didn’t make a mistake by lowering interest rates by .50%, it made a blunder. 

Recession Not Our Core Forecast – But Risks are Rising

Does all the above mean the United States is heading toward, or, in recession? We don’t believe so, but the risk of the U.S. economy falling into recession has increased over the last month. What has happened over the last month is the virus situation has changed from a risk to an unknown variable. A risk variable is a factor with a set of known outcomes. This was the case with the coronavirus when it was contained in China. Now that the virus has spread globally, it has become an unknown factor. This is a factor that is so complex, and the outcomes so varied, that investors and policy makers are having a hard time discounting this problem. 

Last Word

When things would get economically dicey, an old, late friend of mine would say “it’s time to row close to shore, boys.” It isn’t time to jump out of the boat but rather to be careful and thoughtful.

1Brookings Institution

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