I am going to write mostly about the economic impact of the Covid-19 coronavirus outbreak today. But I have one or two other pieces to add here as well.
The pre-coronavirus global economy
I think we’re getting a better handle now on where we were before the novel coronavirus hit China. As I have been saying, the US economy was doing relatively well. And I started the year cautiously optimistic that it would continue on that path. If it weren’t for the coronavirus, I doubt we would even have to worry about a recession in 2020.
The rest of the world is a different case altogether. There was a bounce in global manufacturing PMIs and in European PMIs in Q4. But, the numbers are still weak. Data coming out of Germany, in particular, were weak. The numbers show that industrial production in Q4 2019 was actually falling in December. So, even if we hadn’t had the Covid19 outbreak, we still wouldn’t be out of the woods in Europe.
Japan was in even worse shape. They wanted to close the budget deficit with a consumption tax hike because of advice from the likes of the OECD. And they failed, as they have multiple times in the past. Instead of closing the budget gap, likely they added to deficits as GDP sank an annualized 6.3% in Q4. And this is even before the coronavirus impact was felt. Prime Minister Abe said he felt he had to raise taxes to “fund” changes to the social security system. But, by raising taxes, he simply sucked money out of the economy and cratered growth, just in time for this Black Swan potential pandemic outbreak.
I would sum up the situation by saying the US was above stall speed, while Europe was below it and Japan was in a potential recession. For the US, the hit to growth has to be severe and sustained to change the trajectory. But this Covid-19 outbreak could yet make that happen.
The hit to China and elsewhere
As of this morning, the death toll in China had climbed to 1,868. And there were 1,886 new confirmed infections, bringing the total to 72,436. I see no firm indication the pace of infections has declined. We are only now starting to come to grips with what the coronavirus means for China’s economy. Data indicate that China’s economy is running at something like 40-50% of capacity. The timing couldn’t have been worse for the service sector. China was celebrating the lunar New Year and restaurants, cinemas, hotels, transportation companies, and retail outlets were expecting a pickup from that. Instead, look at what shopping looks like in Beijing right now. It’s a ghost town. And Beijing isn’t even where the outbreak has been virulent. This is an absolute disaster for the economy.
Incredibly, indications are that the Chinese may be sticking to a 6% growth target, according to the Global Times. This seems laughable when private forecasters like JPMorgan are already saying they see the growth rate slowing to an annualized 1%. You would need a heroic V-shaped recovery to get to 6% from there. It’s not going to happen, except via fraudulent data output.
Meanwhile, the hits to the rest of the world are mounting. Hong Kong is getting decimated. Coming on the heels of the economic fallout from the pro-Democracy protests, it could be a death blow for retail and tourism there. The global tourism and airline industries are going to be hurt by a lack of cross-border tourism, a lack of flying and the lack of spend from Chinese tourists abroad. The hit to supply chains is just beginning. For example, according to the BBC, South Korean auto manufacturer Hyundai suspended car production because of problems with a supply of parts from China. I could go on citing statistics, but you’ve seen the news stories on this.
In terms of the global developed economy, the US is in the best shape to sustain some momentum, Japan is in the worst and Europe is vulnerable.
Asset market response
The initial response from asset markets was panic. And financial conditions tightened aggressively when the virus first hit. At the time, I was saying the effectiveness of any policy response could be measured in days, not weeks or months. But financial conditions eased – so much so that equity prices around the world have been hitting new highs. Unfortunately, this isn’t sustainable given what the economic impact means for earnings. And I think Apple’s warning yesterday may mark a change in momentum.
The bond markets are already back in panic mode, with the 10-year Treasury at 1.55% and the 30-year breaking 2% this morning. The 3 month-2 year spread is now negative. And markets were showing a 71% chance the Fed cuts by July. I would say we’re back to where we were when the outbreak started, with the ability of a policy response misstep measured in days rather than weeks or months.
The Fed has already been talking about fising liquidity issues. Last week, I pointed to Randal Quarles’ speech he gave a couple of weeks. But, even though I think Quarles is telling us that a Standing Repo Facility is coming eventually, he is also not supportive of a Standing Repo Facility yet. That tells you that changes at the Fed to gear up for a potential liquidity crisis are not going to happen overnight. And that means the repo market is still vunerable, dependent on ad hoc Fed decision-making to avoid hiccups that significant; tighten financial conditions or lead to a crisis.
I am still thinking a lot about a potentially seismic shift in the political landscape occurring.
In Germany, the latest news is that Chancellor Merkel’s party, the CDU, may force her to step down early. There is no obvious successor in the CDU though. And her coalition partner SPD is fed up with serving as junior partner in an alliance with her party. The two parties are not natural allies; they are historic rivals. And the SPD has to feel their polling strength is being sapped by having to compromise toward the center-right, where the CDU is, when the pull on the left of center is decidedly to the left. The SPD could lose significant chunks of their base to the Left Party and the Green Party, especially among the younger electorate. On the right, the AfD Party will continue to rise as the power vacuum grows, with Merkel being openly questioned. The radicalization of the electorate will continue to increase.
In the US, the rise of Bernie Sanders in the Democratic primaries, combining with the consolidation of Trump’s control over the Republican Party, means we have a starkly polarized and radicalized electorate, just as in Germany. I have been writing a lot about the appeal of socialism to Millennials. But, there is also the appeal of using government to break the back of concentrated industries, to regulate big tech and reduce the influence of money in politics. This is much more virulent on the left than it is on the right. A coronavirus-created slowdown might bolster the Democrats. And if Sanders (or Warren) win the Presidency, it won’t be anything like the ‘change you can believe in’ under Obama.
Question: if Trump loses will he (and his supporters) cede power peacefully? That’s not a question you would have asked about Bush 41 or Bush 43. But, I think it’s a legitimate question to ask now.