A Look at the Chinese Economy in Light of Coronavirus: The main headline for markets so far this year has been the developments surrounding the spread of the coronavirus, also referred to as COVID-19 (the shorthand for “Corona Virus Disease 2019”). So far, data from February depicting the virus’ effects on economies, particularly China’s, has been trickling in and the picture is about as expected. China’s official manufacturing purchasing managers’ index (PMI) dropped to 35.7 in February from 50.0 in January, below the 38.8 figure reported in November 2008. The non-manufacturing PMI (a gauge of sentiment in the services and construction sectors) also dropped to 29.6 from 54.1 in January, the lowest since November 2011. This is in light of earlier reporting that travel from the Lunar New Year holiday was down 50% from the previous period a year ago. It is clear the virus, or more precisely, the government's response and containment plan, has had an adverse effect both on the movement of the population and on real economic indicators. When the virus comes under containment, the key things to watch going forward will be the amount of lag that shows up in the data (i.e. how many months it takes for the slowdown/stoppage from the beginning of the year to work through) and how quickly the economy can get back into growth/production mode.
Our Takeaways: Basically, all of China's reported economic metrics halved in February from where they started the year. This is obviously incredibly bad, however, absent any other shocks to the global economy, it is not unbelievable to think that production could resume and stabilize relatively quickly. Depending on the response from the Chinese government, there may even be a period where the economy runs hot to try and catch up with the lost productivity from the coronavirus shutdown. This is what would be reasonably expected if all of the reported facts are true and assuming the return to work is, as was proclaimed by several of the economists and officials referenced for this letter, already underway. Yet, if a rapid resurgence in production numbers does not happen, then it is possible there is something else afoot that could spell trouble for global supply chains and companies reliant on Chinese goods. One thing that we think is important to unpack is the effect the Chinese government's quarantine policy had on the movement of people and how that relates to factory/production activity. According to the Wall Street Journal, about 40% of China's workforce is made of migrant workers - people who are from a particular region (often a poorer, rural area) that pick up and move because of the prospect of better economic opportunity. This is similar to the trend of urbanization and younger people having a higher propensity towards larger cities than more rural environments, but at a more significant scale. Unlike in the U.S. where this trend is largely driven by recent college graduates that are seeking out the higher paying jobs in cities to compensate for the large amounts of debt they accrued while obtaining their degree, Chinese migrant laborers tend to be poorer and from poorer rural villages, and they are seeking out the relatively higher paying minimal labor/services jobs available in the big cities. This trend came together with the Lunar New Year tradition of returning home for the holiday which, for many of these migrant laborers, was far from the factory or job where they work. Looking at these two statistics together, you should now be able to see how significant of an effect the confluence of the timing of the Lunar New Year holiday and the outbreak of the coronavirus has had on the output of the Chinese economy. While gathering reliable information is often difficult, at least anecdotally, still only a very small percentage of workers have returned or have been able to return to their posts leaving factories significantly understaffed. Now, where this could become problematic is if the situation is really worse than what is being reported and if factories are so far behind on this year’s production that they will not be able to catch up. According to Gavekal, a global consultant, factory production - particularly for high demand items for things like electronics - only has about a 3-week buffer in the annual production schedule to meet quotas for 4th quarter demand. This is potentially a huge black swan shock for the economy, particularly in the U.S. where consumer spending has been powering much of the continued growth. We may have a few more weeks before things become exceedingly critical, but depending on how transparent companies have been (or how good the information they have received has been) we may have already crossed into the territory of supply chain disruptions that will affect the 4th quarter shopping season.
The Monetary Policy Cure for the Novel Coronavirus: Is there, in fact, a monetary policy cure for the virus’ impact on economies? It appears we will get the opportunity to find out ourselves. Just before this letter went to publication, the Fed lowered rates by 50 basis points in a surprise move ahead of their regularly scheduled March meeting. Prior to this announcement, there has been a growing narrative from market participants that such an action from the Fed will not be able to contribute in a significant manner to the economy for this crisis as it has in previous crises. People such as Jens Peter Sorensen, Chief Analyst at Danske Bank, have been quick to note “the COVID-19 virus is keeping people from work, the supply chain is disrupted and tourists are not going to Italy. Monetary policy can do very little.” Or Guggenheim Partners global CIO Scott Minerd who referred to monetary policy as being “impotent” when trying to combat the kind of shock caused by the coronavirus outbreak.
Our Takeaways: This is becoming a fairly widely shared narrative ahead of the move by the Fed. In theory, it is correct. Monetary policy should be a very ineffective salve for something that has such direct real-world implications such as what we are seeing from this virus. Although, the element most market commentators might be missing is the lengths beyond interest rate-based measures that the Fed, and/or other central banks globally, might be willing to implement as a means of dealing with the effects of the panic. They, the market commentators that is, seem to be lulled into the idea that central banks won't switch to more aggressive tools or even use the current situation to attempt previously untried methods to try and stabilize the economy. Currently, the market expectation is that Fed Funds rates will go below 1% before the end of 2020. The fact that the futures market is pricing/expecting a sub-1% rate target before the end of this year would have been difficult to imagine a year or two ago. Such an aggressive monetary policy stance would typically be taken leading up to, or in light of, a recession. While data has not been phenomenal by any stretch of the imagination and equities (at least until recently, and even still depending on who you ask) have been well within overpriced territory, there has not been an overwhelming sign based upon recent economic data that the U.S. is heading for a recession. To this end, the Fed has been framing many of their recent moves as "precautionary" measures to proactively try and prevent the next recession, but this narrative is less and less believable when looked at relative to the economic backdrop and the aggressiveness of their actions. On their own, 25 and 50 basis point cuts seem relatively minor, and to a certain extent somewhat meaningless, at this end of the curve they are huge movements. Put another way, the markets are expecting a nearly 37.5% decrease in rates over the next three quarters. This would have been like the Fed cutting rates from 5.02% in 2007 to 3.14% (which they ended up doing in the run up to the financial crisis cutting rates to a low for the year of 3.06%). All of this is not to mention additional QE measures or other, more dramatic, tools the Fed may attempt to help stimulate the markets if panic really begins to grip investors.
Searching for Earnings Outside of Big Tech: Fourth quarter earnings for the S&P 500 came in at +2% compared to the same period last year, which is pretty good albeit not great. During the same period, the “FAAMG” (Facebook, Amazon, Apple, Microsoft and Google parent Alphabet) grew their fourth quarter earnings by 16%. As it turns out, if you remove this stellar performance for these 5 companies, the earnings growth for the S&P 500 would have been 0% for the fourth quarter demonstrating just how significant of an impact these players are having on the current market environment. And the further you go down in size, the worse the picture gets. The Russell 2000, which is an index of publicly traded small cap companies, saw its constituents’ earnings decline 7% in the fourth quarter.
Our Takeaways: Beginning with the poor performance of small cap companies, which is a trend we have highlighted several times in previous notes, it is becoming increasingly difficult for most smaller firms to compete against the mega cap players. The somewhat new development is, as it turns out, even the mega cap players are not doing that well if you exclude all but the most successful, high-tech companies that have become extremely dominant within their respective industries or in areas where they compete have a near duopoly on the market (e.g. Apple and Alphabet essentially have complete control over, and get a cut of, every application that goes on a mobile phone). This however is a double-edged sword. The threat for these incredibly large and powerful companies still remains large scale public and/or governmental backlash over their size and monopolistic power over the markets with which they operate. Probably for the first time in history, and to a certain extent as a result of the power some of these companies put in the hands of individual consumers, the threat of their downfall is not just possible from the trust busting powers of the federal government, but also from a grassroots movement from everyday consumers. Facebook got a small look at how that backlash could manifest itself in the wake of the 2016 election/Cambridge Analytica scandal. It ultimately fizzled out, but with today's culture being a minefield of hot button issues, a more perilous miss step by one or several of these companies may only be a matter of time.
Updates on Real U.S. Economic Indicators: January’s industrial production numbers were soft once again posting a 0.3% decline. December saw its figure revised down to -0.4%. BMO Capital Markets rate strategist, Jon Hill, summed up the market’s concern best by saying, “The drop in factory output is particularly concerning as over the past 50 years, we've only seen one instance where IP slowed this much YoY without a commensurate recession.” However, this fact alone isn't an immediate cause for panic. Several contributing factors have been at play the last several months. Most notably has been the outright fiasco at Boeing surrounding their 737 MAX aircraft. Another has been the unusually warm winter the U.S. has experienced which decreased demand for utilities with utility production numbers down 4% in January.
Our Takeaways: Starting with the point about Boeing, if this is truly having such an outsized impact on production numbers, then this softness could persist for a while. Boeing still has yet to put out a clear roadmap for how they are going to bring the 737 MAX production back on track and even if/when they do, federal regulators will have to give the final sign off before Boeing is able to move forward. With this having become such a highly publicized fiasco, we would expect that regulators will be cautious with this one. Turning to the weather, as mentioned this year has been unusually warm which has definitely been reflected in soft numbers around utility production, but also asset prices for input goods such as oil and natural gas. However, given the slowdown in China from the coronavirus outbreak, it is difficult to assess the effect of warmer weather on production and asset prices independent of weak demand. For right now, both of these areas remain firmly in the “to be monitored” camp for at least the next several months.
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