The Coronavirus and your money. After an unprecedented 10% rally, which started in October of 2019, the stock market is finally hitting a rough patch. The quick spread of the coronavirus in China and around the world made investors nervous about the future of the global economy. The 2% pullback on January 31 wiped out most of January gains. Despite the quick recovery in early February, the outbreak of the virus in South Korea, Japan, Iran, and Italy triggered a massive sell-off on Monday, February 24. The major US indices dropped 3.5% in one day, with DOW falling over 1,000 points.
Investors seeking safety pushed the price of Gold to $1,650. The 10-year treasury rate fell to 1.34, and the 30-year treasury bonds now pay 1.85%. The price of crude oil fell to $51 per share.
About the virus
The coronavirus, called COVID-19, started in the city of Wuhan in the Chinese province of Hubei. Until now, there were over 80,000 reported cases in China and around the world and nearly 2,700 fatalities. The virus spread came on the heels of Chinese Lunar Year celebrations, which is a primary holiday and travel period. It is estimated that Chinese travelers make 3 billion trips in the 40 days surrounding this major Chinese holiday. Currently, more than 60 million people have been locked down in China alone.
The governments around the world have limited or directly banned travelers coming from China. Many foreign businesses like Apple, IKEA, Disney, and Starbucks have shut down stores and theme parks.
The impact on Wuhan
Wuhan is a major transportation and industrial hub in China. More than 300 of the world’s top companies have a presence in Wuhan, including Microsoft, German-based software company SAP, and carmakers General Motors, Honda, and Groupe PSA.
The total value of trade imports and exports in Wuhan reached $35.3 billion in 2019, a record high that was 13.7% above the previous year.
The Bear case
A continued outbreak of the coronavirus can shave off between 0.5% to 1% of the already slowing Chinese GDP. As the second-biggest economy, China is one of the largest importers of commodities and materials.
An extended lockdown will hurt sales of all foreign companies doing business in China. It can trickle down to the already fragile economies of the EU, Japan, and other export-oriented countries.
The lockdown in China will hurt the global supply chain and the limit the manufacturing abilities of companies making their products in China.
The virus outbreak in Italy, South Korea, and Iran creates a lot of uncertainty and puts pressure on local authorities to control the further spread out.
The previous virus threats (Ebola, SARS, Zika) hurt travel-related businesses and took several months before the markets fully recovered.
The Bull case
The US economy remains strong. The unemployment rate is at record low levels of 3.5%. Low-interest rates and low gasoline prices will support further growth in consumer spending and housing sales.
While not completely sheltered, the US economy is less dependent on exports to China.
The Fed has more room to cut rates if the US economy experiences a slowdown as a result of the virus.
The Chinese government is introducing a new monetary and fiscal stimulus package to support the economy.
Slowing GDP will make the Chinese government more willing to sign the Phase 2 trade deal with the US.
Pharma companies (reportedly Gilead and Moderna) are pursuing a virus vaccine.
Spring is coming. The warm weather could limit the impact of the virus around the world.
Keep the course. Have a long-term view and focus on achieving your financial goals.
Market volatility is a normal part of the investment cycle.
S&P 500 index pays a 1.8% dividend versus a 1.3% yield for the 10-year treasury. A long-term income investors may find it compelling to invest in dividend-paying stocks over bonds.
A significant stock pullback will be an opportunity to buy high-quality US companies.
The US economy continues to show resiliency despite increased political uncertainty and lower business confidence
The consumer sentiment – The US consumer is going strong. Consumer sentiment reached 93 in September 2019. While below record levels, sentiment remains above historical levels. Consumer spending, which makes up 68% of the US GDP, continues to be the primary driver of the economy.
Unemployment hits 3.5%, the lowest level since 1969
Wage growth of 2.9% remains above-target inflation levels
Household debt to GDP continues to trend down and is now at 76%.
Fed rate cuts – Fed announced two rate cuts and is expected to cut twice until the end of the year.
The 10-year treasury rate is near 1.75%
The 30-year mortgage rate is near 3.75%
While low-interest rates and low unemployment continue to lift consumer confidence, the question now is, “Can the US consumer save the economy from recession’?
The probability of recession is getting higher. Some economists assign a 25% chance of recession by the end of 2020 or 2021.
The ISM Manufacturing indexdropped to 47 in September, falling under for a second consecutive month. Typically readings under 50 show a sign of contraction and reading over 50 points to expansion. The ISM index is a gauge for business confidence and shows the willingness of corporate managers to higher more employees, buy new equipment and reinvest in their business.
Trade war – What started as tariff threats in 2018 have turned into a full-blown trade war with China and the European Union. The Trump administration announced a series of new import tariffs for goods coming from China and the EU. China responded with yuan devaluation and more tariffs. France introduced a new digital tax that is expected to impact primary US tech giants operating in the EU.
A study by IHS Markit’s Macroeconomic Advisers calculated that gross domestic product could be boosted by roughly 0.5% if uncertainty over trade policy ultimately dissipates.
Chinese FX and Gold reserves – China’s reserve assets dropped by $17.0b in September, comprising of $14.7bn drop in FX reserves and a $2.4bn decline in the gold reserves. China has been adding to its gold reserves for ten straight months since December 2018.
Political uncertainty – Impeachment inquiry and upcoming elections have dominated the news lately. Fears of political gridlock and uncertainty are elevating the risk for US businesses.
Slowing global growth – The last few recessions were all domestically driven due to asset bubbles and high-interest rates. This time could be different, and I do not say that very often. Just two years ago, we saw a consolidated global growth with countries around the world reporting high GDP numbers. This year we witness a sharp turn and a consolidated global slowdown. EU economies are on the verge of recession. The only thing that supports the Eurozone is the negative interest rates instituted by the ECB. China reported the slowest GDP growth in decades and announced a package of fiscal spending combined with tax cuts, regulatory rollbacks, and targeted monetary easing geared to offset the effect of the trade war and lower consumer spending. So even though the US economy is stable, a prolonged slowdown of global economies could drag the US down as well.
US Equities had a volatile summer. Most indices are trading close to or below early July levels and only helped by dividends to reach a positive quarterly return. On July 27, 2019, S&P 500 closed at an all-time high of 3,025, followed by an August selloff. A mid-September rally helped S&P 500 pass 3,000 level again, followed by another selloff. S&P 500 keeps hovering near all-time highs despite increased volatility, with 3,000 remaining a distinct level of resistance.
In a small boost for equities, the dividend yield on the S&P 500 is now higher than the 10- and 20- year US Treasury rate and barely below the 30-year rate of 2%.
For many income investors equities become an alternative to generate extra income over safer instruments such as bonds
Growth versus Value
Investing in stocks with lower valuations such as price to earnings and price to book ratios has been a losing strategy in the past decade. Investors have favored tech companies with strong revenue growth often at the expense of achieving profits. They gave many of those companies a pass in exchange for a promise to become profitable in the future.
However, while economic uncertainty is going up, the investors’ appetite for risk is going down. The value trade made a big comeback over the summer as investors flee to safe stocks with higher dividends. As a result, the utilities and consumer staple companies have outperformed the tech sector.
The IPO market
The IPO market is an indicator of the strength of the economy and the risk appetite of investors. In 2019, we had multiple flagship companies going public. Unfortunately, many of them became victims of this transition to safety. Amongst the companies with lower post IPO prices are Uber, Lyft, Smiles Direct Club, and Chewy.com. Their shares were down between -25% and -36% since their inception date. Investors walked away from many of these names looking for a clear path to profitability while moving to safety stocks.
Small caps have trailed large caps due to increased fears of recession and higher market volatility. Small caps tend to outperform in a risk-on environment, where investors have a positive outlook on the economy.
International stocks continue to underperform. On a relative basis, these stocks are better valued and provide a higher dividend than US stocks. Unfortunately, with a few exceptions, most foreign stocks have been hurt by sluggish domestic and international demand and a slowdown in manufacturing due to higher tariffs. Many international economies are much more dependent on exports than the US economy.
The Fed continued its accommodative policy and lowered its fund rate twice over the summer. Simultaneously, other Central Banks around the world have been cutting their rates very aggressively.
The European Central Bank went as far as lowering its short-term funding rate to -0.50%. As a result, the 30-year German bund is now yielding -0.03%. The value of debt with negative yield reached $13 trillion worldwide including distressed issuers such as Greece, Italy, and Spain.
Investors who buy negative-yielding bonds are effectively lending the government free money.
In one of my posts earlier in 2019, I laid out the dangers of low and negative interest rates. You can read the full article here. In summary, ultra-low and negative interest rates change dramatically the landscape for investors looking to supplement their income by buying government bonds. Those investors need to take more risk in their search for income. Low rates could also encourage frivolous spending by politicians and often lead to asset bubbles.
The Yield Curve
The yield curve shows what interest rate an investor will earn at various maturities. Traditionally, longer maturities require a higher interest rate as there is more risk to the creditor for getting the principal back. The case when long-term rates are lower than short-term rates is called yield inversion. Some economists believe that a yield inversion precedes a recession. However, there is an active debate about whether the difference between 10y and 2y or 10y and 3m is a more accurate indicator.
As you can see from the chart, the yield curve gradually inverted throughout the
year. Short-term bonds with 3-month to maturity are now paying higher interest
than the 10-year treasury
The spread between AAA investment-grade and lower-rated high yield bonds is another indicator of an imminent credit crunch and possible economic slowdown.
Fortunately, corporate rates have been declining alongside treasury rates. Spreads between AAA and BBB-rated investment grade and B-rated high yield bonds have remained steady.
Repo market crisis
The repo market is where banks and money-market funds typically lend each other cash for periods as short as one night in exchange for safe collateral such as Treasuries. The repo rates surged as high as 10% in mid-September from about 2.25% amid an unexpected shortage of available cash in the financial system. For the first time in more than a decade, the Federal Reserve injected cash into the money market to pull down interest rates.
The Fed claimed that the cash shortage was due to technical factors. However, many economists link the shortages of funds as a result of the central bank’s decision to shrink the size of its securities holdings in recent years. The Fed reduced these holdings by not buying new ones when they matured, effectively taking money out of the financial system.
Gold has been a bright spot in our portfolio in 2019. After several years of dormant performance, investors are switching to Gold as protection from market volatility and low-interest rates. In early September, the precious metal was up nearly 21% YTD, but since then, retracted a bit.
Gold traditionally has a very low correlation to both Equities and Bonds. Even though it doesn’t generate income, it serves as an effective addition to a well-diversified portfolio.
The Gold will move higher if we continue to experience high market volatility and uncertainty on the trade war.
The US economy remains resilient with low unemployment, steadily growing wages, and strong consumer confidence. However, few cracks are starting to appear on the surface. Many manufacturers are taking a more cautious position as the effects of the global slowdown and tariffs are starting to trickle back to the US. An inverted yield curve and crunch in the repo market have raised additional concerns about the strength of the economy.
Despite the media’s prolonged crisis call, we can avoid a recession. The recent trade agreement between the US and Japan could open the gate for other bilateral trade agreements. Given that the US elections are around the corner, I believe that this administration has a high incentive to seal trade agreements with China and the EU.
The market is expecting two more Fed cuts for a total of 0.5% by the end of the year. If this happens, the Fed fund rate will drop to 1.25% – 1.5%, possibly flattening or even steepening the yield curve, which will be a positive sign for the markets.
Those with mortgage loans paying over 4% in interest may wish to consider refinancing at a lower rate.
Market volatility is inevitable. Keep a long-term view and maintain a well-diversified portfolio.
The end of the year is an excellent time to review your retirement and investment portfolio, rebalance and take advantage of any tax-loss harvesting opportunities.
About the author:
Stoyan Panayotov, CFA, MBA is the founder of Babylon Wealth Management and a fee-only financial advisor in Walnut Creek, CA, serving clients in the San Francisco Bay Area and nationally. Babylon Wealth Management specializes in financial planning and investment management for growing families, physicians, and successful business owners.
If you have any questions about the markets and your investments, reach out to me at firstname.lastname@example.org or +1-925-448-9880.
You can also visit my Insights page, where you can find helpful articles and resources on how to make better financial and investment decisions.
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So far 2019 has been the year of breaking records. We are officially in the longest economic expansion, which started in June of 2009. After the steep market selloff in December, the major US indices have recovered their losses and reached new highs. The hopes for a resolution on trade, the Fed lowering interest rates and strong US consumer spending, have lifted the markets. At the same time, many investors remain nervous fearing an upcoming recession and slowing global growth.
S&P 500 in
S&P 500 hit an all-time high in June, which turned out to be best June since 1938. Furthermore, the US Large Cap Index had its best first quarter (January thru March) and the best first half of the year since the 1980s.
treasuries rates declined
Despite the enthusiasm in the equity world, fixed income investors are ringing the alarm bell. 10-year treasury rate dropped under 2%, while 2-year treasuries fell as low as 1.7%.
We continue to observe a persistent yield inversion with the 3-month treasury rates higher than 2-year and 10-year rates. Simultaneously, the spread between the 2 and 10-year remains positive. Historically, a yield inversion has been a sign for an upcoming recession. However, most economists believe that the 2-10-year spread is a better indicator than the 3m-10-year spread.
Gold is on
Gold passed 1,400. With increased market volatility and investors fears for a recession, Gold has made a small comeback and reached $1,400, the highest level since 2014.
Bonds beating S&P 500
Despite the record highs, S&P 500 has underperformed the Bond market and Gold from October 2018 to June 2019 S&P 500 is up only 1.8% since October 1, 2018, while the 10-year bond rose 8.7% and Gold gained 16.8%. For those loyal believers of diversification like myself, these figures show that diversification still works.
Stocks lead the rally in Q2
Consumer Staples and Utilities outperformed the broader market in Q2 of 2019. The combination of lower interest rates, higher market volatility and fears for recessions, have led many investors into a defensive mode. Consumer staples like Procter & Gamble and Clorox together with utility giants like Southern and Con Edison have led the rally in the past three months.
stocks are still under all-time high levels in August of 2018. While both
S&P 600 and Russell 2000 recovered from the market selloff in December o
2018, they are still below their record high levels by -13.6% and 10%
International Stocks disappoint
Developed and Emerging Stocks have also not recovered from their record highs
in January of 2018. The FTSE
International Developed market index is 13.4% below its highest levels. While
MSCI EM index dropped nearly 18.3% from these levels.
After hiking their target rates four times in 2018, the Fed has taken a more dovish position and opened the door for a possible rate cut in 2020 if not sooner. Currently, the market is expecting a 50-bps to a 75-bps rate cut by the end of the year.
As I wrote this article, The Fed chairman Jerome Powell testified in front of congress that crosscurrents from weaker global economy and trade tensions are dampening the U.S. economic outlook. He also said inflation continues to run below the Fed’s 2% target, adding: “There is a risk that weak inflation will be even more persistent than we currently anticipate.”
The unemployment rate remains at a record low level at 3.7%. In June, the US economy added 224,000 new jobs and 335,000 people entered the workforce. The wage growth was 3.1%.
The US consumer
confidence remains high at 98 albeit below the record levels in 2018. Consumer
spending has reached $13 trillion. Combined with low unemployment, the consumer
spending will be a strong force in supporting the current economic expansion.
The Institute for Supply Management (ISM) reported that its manufacturing index dropped to 51.7 in June from 52.1 in May. Readings above 50 indicate activity indicate expanding, while those below 50 show contraction. While we still in the expansion territory, June 2019 had the lowest value since 2016. Trade tensions with China, Mexico, and Europe, and slowing global growth have triggered the alarm as many businesses are preparing for a slowdown by delaying capital investment and large inventory purchases.
truce for now
The trade war
is on pause. After a break in May, the US and China will continue their trade
negotiations. European auto tariffs are on hold. And raising tariffs on Mexican
goods is no longer on the table (for now). Cheering investors have lifted the
markets in June hoping for a long-term resolution.
rates remaining low, I expect dividend stocks to attract more investors’
interest. Except for consumer staples and utilities, dividend stocks have
trailed the S&P 500 so far this year. Many of the dividend payers like
AT&T, AbbVie, Chevron, and IBM had a lagging performance. However, the
investor’s appetite for income could reverse this trend.
As I was writing this article the S&P 500 crossed the magical 3,000. If the index is able to maintain this level, we could have a possible catalyst for another leg up of this bull market.
elections are coming
The US Presidential elections are coming. Health Care cost, rising student debt, income inequality, looming retirement crisis, illegal immigration, and the skyrocketing budget deficit will be among the main topics of discussion. Historically there were only four times during an election year when the stock market crashed. All of them coincided with major economic crises – The Great Depression, World War II, the bubble, and the Financial crisis. Only one time, 1940 was a reelection year.
S&P 500 Returns During Election Years
The US Economy remains strong despite headwinds from trade tensions and slowing global growth. GDP growth above 3% combined with a possible rate cut lat and resolution of the trade negotiations with China, could lift the equity markets another 5% to 10%.
Another market pullback is possible but I would see it as a buying opportunity if the economy remains strong.
If your portfolio has extra cash, this could be a good opportunity to buy short-term CDs at above 2% rate.
If you have any questions about the markets and your investment portfolio, reach out to me at email@example.com or +925-448-9880.
You can also visit my Insights page where you can find helpful articles and resources on how to make better financial and investment decisions.