The sharemarket response was a reflex one. Markets are factoring in rate cuts even though central banks in most major economies have little room to cut further, and even though long-standing ultra-low rate regimes in Europe, Japan and historically low rates in this economy (which may be about to go even lower) haven’t exactly sparked surges in economic activity.
The Fed does have more scope to move than most, with the US central bank currently targeting a range of 1.5 per cent to 1.75 per cent for its federal funds rate (the equivalent of our cash rate). US financial markets are factoring in cuts of at least 50 basis points this year, perhaps as soon as this month.
Sharemarket investors have been conditioned to see rate cuts as bullish for equities because that has been the experience since the financial crisis as investors have been forced to accept increasing risk for positive returns.
Bond investors tend to be more conservative and more risk-conscious. They, too, are pricing in rate cuts but appear to have a more pessimistic outlook than their equity counterparts.
The US 10-year bond yield has fallen from 1.92 per cent at the start of the year to 1.15 per cent, an historic low. A month ago, before markets properly appreciated the threat of COVID-19, the yield was 1.65 per cent.
Two-year Treasury notes have similarly tumbled. At the start of the year their yield was 1.57 per cent and even a fortnight ago it was still 1.42 per cent. Overnight the yield was 0.81 per cent.
Those bond market settings don’t reflect any expectation that the impact of the virus will be fleeting and shallow.
Already the global manufacturing industry is being ravaged by the virus. JP Morgan’s Global Manufacturing PMI (purchasing managers’ index) fell 3.2 points to 47.2 per cent in February, the lowest level since the financial crisis, with new export orders also falling to GFC depths.
US data shows activity in its factories is flat-lining but also that supplier delivery times are starting to extend, an indication that the disruption to global supply chains is only just starting to impact industrial activity outside China.
Aviation has, of course, been hit early and hard. It is a canary in the global economy.
On Monday the International Air Transport Association referred to traffic collapsing on key Asian routes, a complete wipeout of bookings to Italy, many carriers reporting 50 per cent no shows across several markets and one carrier saying bookings were down 26 per cent across its entire network.
That’s probably a better indicator of the strength and depth of the current impact of the virus than factory-level data, where the effects will be lagged.
Central bank action and, indeed, governments’ fiscal stimuli are, as discussed yesterday, more of a palliative for the virus-inflicted economic ills spreading through the glove than a cure.
It might help highly-leveraged companies and individuals, and maybe put some kind of floor under consumer spending and business investment, but can’t directly address the threat posed by the spread of the virus.
As the virus spreads, with more infections and deaths outside China being reported daily, the likelihood of the impact peaking this quarter – by the end of this month – is diminishing rapidly and the economic impacts are spreading and deepening.
Even when the virus is finally contained there will be a lag between its peaking and the economic rebound that the experience of past epidemics, such as the SARS outbreak in 2003, suggests will occur.
The sharemarket’s optimism that rate cuts will help materially offset the impacts of the virus doesn’t reflect the uncertainties around that assumption.
The S&P500 is still trading at just under 18 times consensus forecasts for this calendar year’s earnings. While that’s down from its peak of just over 19 times recorded before the market cracked last week, it is still well above the historical average of just over 15 times earnings.
It’s also a multiple of US corporate earnings that don’t appear to have been re-based to take account of the virus, perhaps because the impacts are at this point unquantifiable. That means, of course, that the actual multiple of 2020 earnings might well be significantly higher.
Although the US market is, even after Monday’s bounce, still 8.7 per cent off its peak, investors might still – almost certainly are – miss-pricing the risk that the virus will materially dent corporate earnings.
The flight to safety by bond investors suggested by the falling yields suggests that not only are they more risk-conscious and risk-averse but that they have a better appreciation of how to respond to incalculable risks.
Stephen is one of Australia’s most respected business journalists. He was most recently co-founder and associate editor of the Business Spectator website and an associate editor and senior columnist at The Australian.