The infectious and mortality rates of the new coronavirus have become the main force driving the pendulum of investor sentiment toward fear. The move is all the more dramatic as investors had been positioned for a continuation of the historic bull market in equities and eager to take on new risks.
The coronavirus has surpassed the earlier precedents of SARS (2003) and the Swine Flu (2009). The World Health Organization declared an international health emergency, which will free up resources and boost efforts to contain the pathogen. It took roughly 20 months to devise a vaccine for SARS, and it is estimated that a vaccine is possible within a month or so now to begin the testing process. Although China is expected to return from the extended Lunar New Year on February 2, more than a dozen provinces and cities will be closed several days longer, which ballpark estimates suggest are responsible for a little more than 2/3 of GDP and 3/4 of exports. Supply-chain and business disruptions will likely last longer still.
Investors fear that the health crisis will turn into an economic crisis. Although President Xi is understood to be the strongest Chinese leader in a generation, the challenges that China faces are immense: U.S. rivalry and trade conflict, Hong Kong, Taiwan, and a highly leveraged domestic economy underpinned by deteriorating demographics. China recently reported its birthrate fell to a record last year. Still, some argue that the situation is even more dire as the official figures exaggerate both the population and the birth rate. More monetary and fiscal stimulus is expected to be delivered to cushion the impact. Some forecasts show the Chinese economy slowing to around 4.5% in Q1 20 from 6.0% in Q4 19.
Since the onshore yuan (CNY) stopped trading for the holiday, the dollar appreciated by a net of a little less than 1% against the offshore yuan (CNH). A catch-up move of roughly the same magnitude would bring the greenback toward CNY7.0. While the last time the dollar rose through that threshold, the U.S. accused China of currency manipulation, this time is considerably different. Moreover, of all times, this is the time when China could likely get away with manipulation if it wanted. It is not just because of the macro shock, but also because the U.S. has played the card once and relatively quickly reversed itself.
The MSCI Asia Pacific Index has fallen 3.7% since China's Lunar New Year holiday began. Hong Kong's Hang Seng is off about 5.8%. Taiwan's Taiex dropped a little more than 5%. Since the mainland holiday, the German 10-year Bund yield has fallen by about 11 bp, and the 10-year U.S. Treasury yield has fallen by closer to 18 bp. China's 10-year benchmark yield fell about 15 bp since the end of last year to dip below 3% for the first time since Q4 16 before the holiday.
China's Caixin PMI will have little new information. It will likely be ignored because events are evolving faster than can be captured in a snapshot of sentiment. On similar grounds, the January PMI readings more in the G10 are probably not going to be clean enough to give investors and businesses a strong sense of the economic toll of coronavirus. Also, the policy significance is likely to be minor, even if there was no contagion. First, few major central banks meet in February, which means that there will be another PMI report before most G10 central banks meet. Second, the bar to a change in policy is such that the PMI report is unlikely to shift expectations.
That said, the Reserve Bank of Australia is an exception. It meets on February 3 (the other two major exceptions are the Reserve Bank of New Zealand on February 11 and Sweden's Riksbank the following day). The market has grown more confident that the central bank will hold the cash rate at 0.75%. Before the December employment report (January 22), the market favored a cut.
The fires and drought are pushing up domestic prices, and the weakness in the Australian dollar (-4.2% in January against the U.S. dollar) may boost imported prices with a lag. The unemployment rate fell for the second consecutive month in December, and expectations for a rate cut fell from about 55% to less than 18%. This does not end the story. Investors have pushed out the rate cut expectations, and by midyear, a 25 bp cut appears to be entirely discounted.
Next week is important for the U.S. Two major political events take place. The first is the formal start of the U.S. presidential caucuses and primaries. Iowa is the standard-bearer. President Trump is running unchallenged on the Republican side, leaving the Democrat contest the focus. Two points are worth noting. First, in recent weeks Sanders appears to have moved into the lead. PredictIt.Org has been favoring Sanders since early December. Second, it does no matter so much because Iowa has had a mixed track record in anticipating the national candidate. Third, economic models (many emphasize the low unemployment rate) have consistently predicted a second term for Trump for some time. The positioning at PredictIt.Org has consistently favored this outcome as well.
The second major event is the following day: The State of the Union speech. This is usually not a big deal for investors, but what makes this year different is the president is likely to feel emboldened by the acquittal to be delivered by the Senate the following day, and his chances of being re-elected. Specifically, this may be the venue to formally announce the middle-class tax cut that has been suggested by Treasury Secretary Mnuchin and economic adviser Kudlow.
Looser fiscal policy by itself does determine a currency's direction, which is why the euro may not rise if Germany was to use its fiscal space, which nearly everyone and their sister outside of Germany have advocated. Monetary policy is the key. Loose fiscal policy and tight monetary policy is the best mix for a currency. It is what Reagan-Volcker had that drove the dollar higher from the late-1970s through the mid-1980s. It was what Germany pursued when the Berlin Wall fell.
It is the recent U.S. policy mix with the combination of tax cuts and increased spending, while the Fed was tightening. However, this time the Fed has an easing bias. Powell stressed at last week's press conference that the Fed was committed to its 2% inflation target. The risks also continued to be to the downside. The December fed funds futures contract implies an average effective rate of 1.16%. The current effective rate has been around 1.55% until month-end pressures lifted it. This means a full 25 bp rate cut, and a little more than half of a second cut is priced it the market.
In a like vein, if Germany cut taxes (as the CDU is advocating) and increased social spending and infrastructure investment (as the SPD is advocating) on top of the 62 bln euro program to facilitate a transition away from coal, would the ECB respond by hiking interest rates? The fragility of the eurozone economy was brought into relief last week when both France and Italy unexpectedly reported economic contractions in Q4. German annual figures had shown that Europe's largest economy nearly stagnated in the last three months of 2019.
The eurozone's core CPI fell to 1.1% in January (from 1.3%), according to the preliminary official estimate. It has not been above 1.5% since 2012. Headline inflation has been all over the board. It finished 2018 with a 1.6% increase year-over-year. It was halved to 0.7% in October 2019 and has doubled from there to 1.4% in January. The ECB is not in a hurry to raise rates regardless of Germany's fiscal stance. Looser fiscal policy and easy monetary policy is often associated with challenging economic times that usually weigh on a currency.
The most important data point next week is arguably the U.S. employment report. That, coupled with the auto sales report, capture the main drivers of the economy—employment, income, and consumption. These are ultimately cyclical indicators, and despite talk that the business cycle has been repealed, Using a 12-month moving average to smooth out the noise, nonfarm payrolls peaked in February 2016 at 260k. Last year, they averaged 176k, and are headed lower, as January 2019's 312k increase drops from the comparison to be replaced perhaps by the median forecast of the Bloomberg survey, which calls for about a 155k increase. Investors may be sensitive to any sign that the slower job growth is putting upward pressure on unemployment or underemployment rates.
Given the base effect, average hourly earnings will likely move back above 3% from where they had fallen in December for the first time since mid-2018. The increase in the minimum wage in 22 states directly impacts almost 7 mln employees (ranging from a 10-cent an hour adjustment for inflation in Florida to $1.50 an hour increase in New Mexico and Washington). Disappointment with earnings growth fans concerns about the consumer that pulled back in Q4 19 and downgrade growth prospects.
An auto is the most expensive durable good purchase the typical American households will make. Auto sales are also cyclical, as one might expect. The 12-month average peaked in December 2016, near 17.5 mln vehicles (seasonally adjusted annual rate). They have fared well but softened. The 2019 average was 16.9 mln. In 2018 and 2019, with one exception, auto sales did not move out of a 16.5 mln to 17.5 mln range.
Canada also reports January employment data on February 7. Although Canada created 50% more jobs in 2019 over 2018 (300k vs. 200k), it proved volatile, and the growth of full-time positions was virtually unchanged at a little more than 172k. A weak report will boost confidence that the central bank's neutrality will give way in Q2 to a rate cut. Still, U.S. rates are falling faster than Canadian rates, and Canada's 2-yar rate premium has edged toward 10 bp after turning to a discount a week ago.
However, the other drivers of the Canadian dollar are drags. Commodity prices have fallen, and the CRB Index is off five consecutive weeks for a little more than 9%. Crude oil prices have fallen for four weeks. March WTI is off around 17.5% during this run and briefly traded below $52 for the first time since last October. The Canadian dollar also often seems sensitive to the risk appetite, and the performance of the S&P 500 offers a handy proxy. The S&P 500 has fallen for two consecutive weeks and the combined loss of about 2.75%. It has fared better than most equity markets. The Dow Jones STOXX 600 fell 3% last week and about 0.2% the previous week. the MSCI Emerging Markets Equity Index fell 4.1% last week on top of 2.4% in the week prior. While we had expected the U.S. dollar to trade higher, it is now approaching levels (~CAD1.3300-CAD1.3330) that have met selling pressures over the past six months and may shift near-to-medium-term risk-reward considerations.