The coronavirus outbreak is the epicentre causing extreme volatility in financial markets. The number of confirmed coronavirus cases outside China continues to rise and Italy has quarantined the whole country. There are reports in the media of consumers resorting to panic buying of staples in the shops whilst holiday and general travel plans are likely to have been curtailed, which could detract from growth.
On top of the coronavirus, crude oil prices have fallen sharply on the back of an aggressive price war between the Saudis and Russians. Both major energy producers plan to raise crude oil output at a time of weakened demand. Moreover, credit spreads have started to rise, raising the spectre of corporate debt defaults and potential contagion in financial markets.
Given this backdrop, the outlook for top-line sales growth is looking increasingly uncertain, with company earnings expectations are set to be revised down for 2020. In the near-term, while there is potentially more room for equity downside until coronavirus cases peak, markets could recover if the Federal Reserve sounds more willing to provide greater funding (liquidity) for the markets during these volatile times. This has started to happen, with the Fed significantly increasing the amount of available short-term funding to the US financial system. Furthermore, the Fed could also cut interest rates again at its upcoming meeting on the 18 March and possibly announce quantitative easing (the expansion of its balance sheet through largely, Treasury purchases) to alleviate longer term funding issues.
Looking further out, based on the regression of relative equity/bond returns with the global manufacturing Purchasing Managers Index (PMI, a proxy for growth) since 2006, we outline three market scenarios over the next year.
Slump Scenario (#1): Assuming coronavirus cases continue to escalate over the year, stress rises in financial markets and the global manufacturing PMI falls to the trough level of 33.8 seen during the Global Financial Crisis (GFC) in 2008, then global equities could underperform bonds by as much as 30%.
Stall scenario (#2): Coronavirus cases begin to taper off in line with the normal flu season over the coming months. Policy easing then allows for a stabilisation in the global manufacturing PMI at its current level of 47.2. Over the next 12 months, we estimate that equities could outperform bonds by around 4%.
Recovery scenario (#3): Accommodative policy of interest rate cuts by major central banks and more credit pumped into the Chinese financial system, as well as buoyant labour markets, provides opportunity for the global economy to recover. Assuming the global manufacturing PMI rises to around 51, then equities could outperform bonds by 14%.
Right now, we do not have compelling enough reasons to believe the coronavirus could cause a GFC-style global economic contraction. It is an exogenous supply shock and has little to do with internal economic imbalances (e.g. financial leverage). As a result, notwithstanding short-term downside risks to the global PMI prints, we think the most likely outcome is scenario #3, where global growth and equities recover over the next 12 months.
Nevertheless, should the coronavirus outbreak extend well into 2020, demand is likely to suffer and increase the risk of a global output slump. That would put further downward pressure on stocks. How policy makers react will be key to the trajectory of markets. For example, global equity markets fell sharply following President Trump’s suspension of a “unilateral” travel ban on many European nations entering the US for 30 days. Markets will be looking for a more coordinated fiscal and monetary response by the world’s major economies to keep the global economy growing, while also containing the coronavirus outbreak.
*Source: Refinitiv Datastream, data as at 13th March 2020
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