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Monthly Market Commentary - February 2020

Although stock markets started 2020 in a euphoric mood with Phase 1 of the US-China trade deal and signs of economic stability in the eurozone and China boosting the outlook for global growth, any improvement is now likely to be delayed by coronavirus. Given the timing during China’s Lunar New Year holiday and the behavioural response, some planned consumption – particularly travel and tourism – may not be recovered. While other epidemics had no lasting impact on financial markets, a period of uncertainty seems inevitable in the short term.

Emerging markets have been hardest hit and fell around 8% between mid-January and the end of the month. Developed markets suffered less, losing between 1% and 4%. US shares weathered the outbreak and were largely unchanged over the month. In the UK, large and medium sized companies were down over 3% but small companies held up relatively well. Political and Brexit developments meant sterling drifted back to $1.29. The prospect of slower growth saw global bond yields fall with the UK 10 year gilt down to 0.52% – just above the low in late summer 2019. Copper, iron ore and oil prices all fell sharply while gold rose to $1,589.

At this early stage, it is very difficult to assess how the coronavirus will affect China and economies like Hong Kong, Thailand and Vietnam where collateral damage is most likely. Comparisons with SARS ignore the huge changes in the Chinese economy over the last seventeen years – not least that GDP growth is now estimated to be 5.5% against 11% in 2003.

The impact is likely to be determined by behavioural response rather than the number of deaths. On this occasion the Chinese authorities have been far quicker to disclose and respond to the outbreak. Wuhan has been “locked down”, the New Year holiday extended, and a public health emergency declared in surrounding provinces and major cities.

While this is clearly affecting travel, sectors such as entertainment and shopping, industrial production and trade will also be disrupted by the extended holiday. Although the rate of infection is high, the death rate (currently just over 2%) is low compared with SARS at 9%. If infections peak in February/March, initial estimates suggest that first quarter GDP could fall by 1%. The authorities have announced carefully targeted stimulus measures to cushion the blow but strategic rebalancing of the economy towards services means recovery is no longer simply a matter of recouping lost production and could therefore be more protracted.

The impact on other major economies will vary. Eurozone manufacturing data was showing some signs of improvement. German companies – which are highly sensitive to Chinese growth – spent much of last year running down inventories but several indicators, including the reasonably reliable ZEW investor confidence survey, were starting to signal an upturn. Renewed stimulus measures by the European Central Bank has reduced Italy’s borrowing costs and should avert a recession while Spain is settling into a more sustainable growth pattern after several exceptional years.

The US consumer remains key to the global economy but even here the anticipated cyclical upturn will be muted as business investment and manufacturing is likely to remain soft while trade tariffs and the Boeing’s decision to suspend production of the troubled 737 Max feed through the supply chain. US employment numbers continue to be supportive, albeit growth is slowing, and – with the “Super Tuesday” primaries only weeks away – attention will start to focus on the November election when President Trump will promote “Tax cut 2”. Meanwhile, the Federal Reserve left interest rates unchanged last month but stressed its desire to see inflation return to the 2% target.

The UK formally left the European Union on 31 January and is now facing an uncertain transition period that could lead to an uncomfortable adjustment in 2021 if the government decides not to extend its self-imposed 31 December deadline. Given the short timeframe to formulate a new UK/EU relationship, the outcome may be a fudged free trade agreement.

A deal ensuring zero tariffs on exports and giving sensitive industries relative freedom from regulatory barriers for a provisional period would probably include various conditions with detailed negotiations on a more permanent solution dragging on for years. Although this would avoid a “cliff-edge” move to World Trade Organisation tariffs, additional customs and compliance costs could increase the risk of recession in 2021 if corporate capital expenditure does not recover.

The eventual outcome will depend on how closely the UK is willing to remain aligned with the EU on issues such as regulation and labour mobility. While business confidence improved in January, discretionary consumption – particularly retail sales – has weakened. “Getting Brexit done” might not deliver the growth fillip markets are hoping for. The Bank of England Monetary Policy Committee decided against cutting interest rates in January despite highlighting softening employment and hiring intentions and moderating wage growth. Its estimate of 0.9% GDP growth indicates that a rate cut is on the cards if the economy shows signs of further weakness.

Q4 2019 corporate results have been better than anticipated and – despite expectations of a year-on-year decline – US sales and earnings growth in most sectors was marginally positive. The exceptions were energy and mining which are still contracting. The largest upside surprises were consumer discretionary and IT with large tech, software and 5G doing well.

Forward estimates of a 9% increase in 2020 earnings are, as usual, over-optimistic at this point but – providing coronavirus is brought under control – the background of nominal GDP growth and supportive financial conditions suggests that 4%-5% should be achievable. Taking advantage of market weakness to add to positions appears the best course of action once the infection rate has peaked but a degree of caution is warranted until then.

While valuations are not extreme, they are not cheap. This leaves the potential for any disappointing news flow to have a disproportionate impact. In addition, some companies have geared up their balance sheets to fund share buybacks but this is only sustainable while interest rates are low and cash flows strong. Aside from these caveats, there are few end-of-cycle bear market indicators and on balance we continue to favour risk assets over fixed interest for long-term investors.

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