China rate cut shrugged off by Europe, but can the stock market rally last?
The big news on Thursday is that China has cut interest rates. The PBOC lowered its benchmark lending rate by 0.1% to 4.05%, hardly a large cut, but with inflation trending higher the PBOC have limited options. Chinese authorities have announced a raft of measures to help protect their economy from the effects of the Coronavirus, and after today’s small interest rate cut analysts across Asia are expecting further cuts to come in Q2, once the worst of the virus has passed. Chinese stocks surged higher on the back of the cut, the Shanghai composite rose nearly 2% and has nearly recouped all of its Covid-19 losses since the start of the year; however, gains outside of China have been less enthusiastic.
Do stocks care about Covid-19?
While fear levels over the virus and the potential impact on China’s growth run high in analyst notes and in the newspaper headlines, this same level of fear is not reflected in the price action of most risky assets. Even the Vix index, Wall Street’s fear gauge, has receded from the highs reached earlier in February. European and US stocks have surged to record highs this month even as the fears about Covid-19 have grown and the economic impact is starting to worry executives at some of the world’s largest companies. So why isn’t the fear impacting financial markets? Firstly, investors have to keep on investing – pensions funds, insurance funds etc, which keeps demand for certain stocks high even in periods of global panic. Secondly, Covid-19 is seasonal so it will come to an end, and there are hopes that a vaccine will be ready before the next flu season rolls by, thus there is a view that this is likely to be a temporary problem with temporary consequences. China’s economic growth is expected to be impacted by the virus, S&P, the ratings agency, is the latest outlet to predict China’s growth to slow to 4.4% if the virus peaks in April and for it to grow by 5% if it peaks next month. However, the out-break is likely to lead to pent up demand later this year, which could make up for sluggish growth - by China’s standards - in the first quarter of 2020.
Why there will be no quick economic fix from the coronavirus
So, are investors right to shrug off the fears of the virus and continue buying equities with abandon? Yes, and no, while we believe that the virus will come to an end and there will be some pent up demand that could heal the economic wounds from this virus, we share some views of analysts at Goldman Sachs who said yesterday that investors in US and European stocks are underestimating the risks of the coronavirus and a stock market correction is possible. While we don’t think a fall of 10% or more (the technical definition of a correction) in US and European stocks are on the cards in the near future, there are a few things that investors seem to be underestimating:
· A rise in under performing loans in China on the back of an extended shut down in vast swathes of the country.
· S&P believe that a “growth shock” in China could see underperforming loans rise to RMB 10.1 trillion, in the worst-case scenario.
· S&P also said that it could take years for domestic banks to recover from a surge in bad loans on the back of the Covid-19 outbreak, and there could be long term repercussions for some businesses who see their creditworthiness suffer.
This excellent analysis highlights how there may not be a quick fix for China’s economy as it attempts to recover from an unprecedented economic shutdown. Since China is an important player in the global economy, there could be widespread economic disruption from this outbreak, and the global economy is likely to suffer the consequences of a slow and prolonged recovery in China for many months to come. We believe that this scenario is not priced in to global equities right now, and if fears start to grow that China’s economic recovery could be slower than currently expected, then stocks may sell off.
Corporate concern over Covid-19 continues to grow
Added to this, eventually the corporate news may start to grate on stock market bulls, leading to a sell off. On Thursday the list of big corporate names to re-issue earnings or performance guidance on the back of the outbreak is staggering: hotel chain Accor says that the outbreak will dent revenues by EUR 5mn, Maersk has said the outbreak will hit earnings, Apple supplier Foxconn said its profits will be lower, Air France-KLM expects a EUR150-200mn hit to earnings and Quantas has cut flights to Asia on weak demand. Of course, there are some winners from the coronavirus, and games makers are one of them. Smartphone users in China have downloaded a record number of games and other apps as millions of people remain confined to their homes. Average weekly downloads of apps during the first two weeks of February have risen 40%. Unsurprisingly, Apple’s share price has recovered even though it issued a profit warning earlier this week on the back of the outbreak, as the virus leads to a surge in demand for Apple apps and the use of Apple products.
The Fed likely to remain ready to cut rates for the foreseeable future
Also protecting stocks in Europe and the US is the wave of global liquidity that is as key support for risky assets. The ECB, the Fed and the BOJ are all maintaining loose monetary policy stances. The Fed minutes released on Wednesday, suggest that the Fed will keep rates on hold this year, however they maintain ready to lower rates further if the economy needs support. These minutes were from a meeting at the end of January, before the coronavirus fears really caught on, thus, the Fed could take a more cautious approach at its meeting on 19-20thMarch. The Bank of England is looking like an outlier as it is unlikely to cut rates anytime soon after a strong pick up in wage growth and inflation last month. Retail sales, released earlier on Thursday, have also picked up strongly. Retail sales rose by 0.9% in January, excluding fuel sales rose by 1.6%, which was the fastest increase in sales since March last year. A pick-up in domestic growth that ties the BOE’s hands and stops them from loosening monetary policy even as global growth suffers, is one reason why the pound has fallen below the $1.30 level, and also why the FTSE 100 has not kept pace with some of its better-performing European and US peers.
Price action…
Overall, US and European stocks will look to the preliminary PMI reports for Europe and the US that will be released on Friday, for timely signals about how these economies have weathered the coronavirus. As long as the PMI reports don’t collapse, then we believe that stock markets could end the week strongly and brush off corporate earnings’ fears, for now. The oil price is also in recovery mode today, Brent crude is trading back above $59 per barrel, as commodity traders look towards the end of flu season, potentially as early as next month. The gold price remains steady, as investors continue to hedge long positions in other risky assets. We do not believe that gold will see a prolonged decline in its price until the coronavirus is well and truly behind us.
The yen is falling sharply, as the FX market reacts more strongly to the interest rate cut from China that is weighing on FX safe havens. The euro remains weak, and EUR/USD has fallen below $1.08 this morning. Unless we get strong PMI numbers for the eurozone on Friday, it is hard to see how the single currency can recover. It is the funding currency of choice right now, and we would expect the next level of support to come in at $1.0750. We would urge some caution about selling the euro with abandon at this stage, especially if the US President starts to complain about euro weakness, sparking threats of a currency war, as this could spook risk assets more generally and may lead to some short-term upward pressure on the euro.