The Covid-19 outbreak has hit the world economy hard with everyone now affected by the growing public health crisis.
The Covid-19 coronavirus is spreading like wildfire across the world, with cases now escalating outside China. Earlier today, it was confirmed that cases outside China exceeded those inside the country with market analysts largely confident that China has now contained the outbreak.
There is growing concern that the coronavirus will push dozens of economies into recession this year. Economic fundamentals, bond yields, currency rates and corporate debt markets are all suffering given the sudden disappearance of consumer demand and the halt to economic activity. Credit default swaps on sub-investment grade firms have surged to their highest levels in five years with market analysts fearful that as sentiment gets worse, credit risks could flare up and induce contagion of a financial variety in the form of counterparty risk.
According to data from Johns Hopkins University, in the US alone, more than 1,000 cases have been confirmed with authorities rallying to implement a raft of supportive fiscal measures including rumours of a payroll tax amnesty and other tax breaks for low-income earners.
At the time of writing, more than 100 countries have reported multiple cases of coronavirus infections, bringing the total to 126,000 globally with more than 5,000 fatalities. The World Health Organisation (WHO) has designated the outbreak as a global health emergency and a pandemic, thereby putting into effect various mitigatory measures such as travel restrictions and public event cancellations.
The impact on financial markets has been brutal and merciless.
All equity, commodity and bond markets are currently trading significantly lower with investors fleeing en masse out of risk assets into risk-off securities such as cash and sovereign debt. FX rates have also borne the brunt of the consumer-led drop off in demand.
The coronavirus-induced selloffs in all major stock indices have struck fresh lows after steep declines in recent days. US markets have plunged almost 30% in the past two weeks, alongside similar declines in Europe and Asia. One of the most striking aspects behind the market plunges is that the Federal Reserve cut interest rates twice in the past two weeks to its all-time low rate of “almost zero”, in addition to other measures including quantitative easing and better swap rates.
However, these measures are having a limited impact in slowing the financial fallout from such as sudden drop-off in demand.
Consumers are cancelling trips, not going out, not spending and retrenching all buying decisions to bare essentials and utilities. This sharp reduction in discretionary spending has hit all parts of all economies simultaneously, thereby putting deflationary pressures on individuals, businesses and policymakers alike.
Market participants are grappling with the rapid spread of the virus as well as uncertainty around a fiscal response to curb slower economic growth resulting from the outbreak.
Markets in all countries are tumbling with prices closing in bear market territory, down more than 20% below record highs set only last month, and putting to an end, an expansion that started in 2009 after the global financial crisis (GFC).
One of the most pronounced impacts has been the risk-off sentiment flowing through currency markets. Investors have rushed to the safety of the US dollar, the Swiss franc and the Japanese yen – very predictable moves that have escalated alongside confusion and uncertainty amongst market participants.
When it comes to currencies, the ones most affected by a downturn in China’s fortunes are the Australian and New Zealand dollar: both are closely linked to China’s economic performance because it is their largest trading partner.
Since the Chinese government announced the coronavirus in January this year, the Australian dollar has fallen by almost six cents against the US dollar, from US$0.70 to as low as US$0.61 today. Over the same period, the New Zealand dollar has fallen by more than 10% against its US counterpart. However, the dollar’s greatest gains have come against the Norwegian krone with an eye-watering 16.6% appreciation year-to-date.
The krone (as well as the Aussie and Kiwi dollars) have felt the brunt of the FX impact, not only because of risk aversion but also because oil prices have plummeted from over $60 per barrel in January to around $28 per barrel today – a decline of over 50%.
Saudi Arabia and Russia have locked horns over oil supply, aiming to maintain market dominance by adding market share. The result has been added oil supply into an already oversupplied market while global demand for oil was already slowing before the emergence of the coronavirus. Given the brewing oil market war between Saudi Arabi and Russia, oil prices – and by extension, the currencies of large oil export countries – have been under severe pressure.
Commodity currencies have fallen across the board, including against the Euro and the Yen, yet again reinforcing their roles as commodity currencies that reflect positive sentiment in times of risk-on markets, and by the same token, drastic declines in times of uncertainty.
From yield to value
The spectre of a multilateral central bank response and ultra-low rates in all G20 countries at the same time is likely to mean that yield differentials become a non-factor for traders.
Risk avoidance and maintaining cash positions in USD, JPY and CHF is the clear motive for large corporates while assets such as gold and silver are suffering given their inherent tie to the US dollar. Alongside the coronavirus outbreak, gold prices have remained flat, declining 4% so far this year while silver prices have plummeted by 30%.
Dollar bulls are keeping gold prices capped although as the flight to US dollars eases, there is a good chance that as dollar longs are unwound, a strong gold rally then ensues as pent up demand for the metal and long-term physical demand remains strong for both metals.
As a further pressure point on the FX market, the International Monetary Fund (IMF) has announced that FX interventions and capital flow management measures could “usefully complement” other monetary policy actions with the group’s head Kristalina Georgieva explaining that additional stimulus will be necessary to prevent long-lasting economic damage with the IMF receiving interest from at least 20 countries for ongoing loan programs, in addition to 40 existing programs already in operation.
Furthermore, central bank swap lines to emerging markets may be also be needed, according to Georgieva.
The People’s Bank of China (PBOC) has already reduced interest rates and pushed an additional 1.2 trillion yuan (US$170 billion) into the Chinese banking system in a bid to boost the country’s economy. Looser monetary policy has also been enacted as emergency measures in the US, the UK, Japan, New Zealand and Australia as a means of making borrowing conditions more amenable.
Extraordinary central bank and fiscal stimulus measures are only just beginning.
It’s worth remembering that most companies remain worryingly reliant on short-term capital and overnight lending – a caveat that had troubling consequences for millions of companies that became overly-reliant on margin debt in the global financial crisis over a decade ago.
In China, the lack of tourism, which accounts for 6% of China’s GDP, combined with limited movement in and out of China itself, does not bode well for China’s growth this year. China’s currency has weakened sharply against other currencies and is now setting record lows below 7 yuan per dollar, a level the pair has not traded at since 2008.
The question for investors is when will the coronavirus be brought under control, given the immense response from public officials. Governments are throwing everything at the problem including interest rate cuts, tax breaks, fiscal spending, government borrowing and international cooperation.
However, the coronavirus epicentre is China, and this is where the brunt of the economic fallout will be felt.
It is now overwhelmingly clear that the Chinese economy will be hit hard in Q1 2020 but how far this will translate into impacts on other world markets and currencies is uncertain.
According to economists surveyed by Bloomberg, China’s annual GDP growth is expected to slow to 5.9% while countries like Italy are expected to tip into recession, but whether these forecasts actualise is entirely dependent on how quickly public authorities can contain new cases.
In China, new coronavirus cases have now fallen to a trickle while Western countries are going through what China did a few weeks ago, and predictably, slowly executing blanket bans, event closures, quarantining entire cities and enforcing curfews.
A lesson from history
The best analogue, or contrast comparison, to what’s currently happening with the coronavirus is the SARS outbreak in 2003. After the SARS virus was identified and its spread became a public health emergency, a rush to reduce risk by investors prompted significant market declines amidst nervy investor sentiment.
However, SARS did not prompt widespread closures and supportive financial measures.
For the time being, the reaction to the coronavirus outbreak is similar, but whether it follows the same pattern as SARS i.e. a relatively short-lived impact on markets, is largely dependent on how widespread the outbreak becomes, and its mortality rate.
In the case of SARS, the initial impact was to push the commodities index lower by almost 10% in March 2003 as SARS became known globally. The negative impact was short-lived because, by late June, commodity markets had largely recovered after the World Health Organisation declared that SARS was under control.
The same is likely to occur with coronavirus.
Once authorities contain its spread and its ultimate mortality rate is better understood, an announcement from an authoritative agency such as the WHO is likely to lead to a sharp rebound in market sentiment. It is widely expected that despite the widespread shutdowns, economic recovery will eventually ensue, and thereby, put a new bid into equities and commodities as well as taking the pressure off and risk-off currencies and bond markets.