Published on Feb. 10, 2020
Equity Commentary | January 2020
Stocks were flat during January, as gains early in the month may have been subsequently offset by concerns over the developing coronavirus pandemic. Economists have already begun reducing first quarter GDP estimates for China as a result of work stoppages and travel restrictions implemented by the Chinese government. It is difficult to ascertain the ultimate impact that the outbreak will have on China’s economy, as well as business activity globally, but our analysis of prior epidemics may be useful in this regard. During the SARS outbreak of 2002-03, which also originated in China, the economic impact was largely contained to one quarter, and due to a rebound in subsequent quarters, Chinese GDP for the full period was largely unaffected, in our opinion. SARS did not appear to have much of an impact on US economic activity, although there was a temporary decline in certain confidence surveys.
In assessing the stock market impact of prior epidemics, including SARS, MERS, Ebola, and the avian flu, the typical pattern was an initial selloff, followed by a fairly quick recovery. However, there are a number of important differences between the current outbreak and the precedent examples. First, the Chinese economy is far larger than it was during the time of the SARS epidemic, in absolute terms and in terms of its portion of global GDP. Second, global supply chains have become tightly integrated over the past decade and China plays a key role in supplying goods to the rest of the world. Third, with the total cases of coronavirus within China now exceeding 30,000 (and growing), this outbreak is far larger than the number of known SARS cases, which was believed to be approximately 8,000. Finally, we don’t have a good read on the accuracy of the data coming from China on the extent of the outbreak. Some believe the true numbers are far higher. For these reasons it is difficult at this point to predict the ultimate economic impact of the outbreak, though we will continue to closely monitor the situation.
The phase I trade agreement between the US and China was signed during January. As part of the deal, China agreed to purchase an incremental $200 billion of US goods and services, while also committing to protect intellectual property rights and further open up its financial markets. While the majority of the tariffs imposed by the US on Chinese imports will remain in place, the tariff rate on the $120 billion of Chinese imports which were implemented in September will be halved from about 15% to 7.5%. President Trump has noted that the rest of the tariffs may be rescinded as part of a potential future phase II agreement.
Some financial analysts have been skeptical regarding the deal due to a lack of enforcement mechanisms should China not fulfill its obligations. In our view, however, the fact that the majority of the tariffs are still in place will act as a strong incentive for China to cooperate. We think the key risk to markets currently in this regard is that there now appears to be a good deal of positive investor sentiment on trade, perhaps bordering on complacency. While we are encouraged that the initial phase of an agreement is in place, we think that there are significant uncertainties regarding next steps. Little has been revealed regarding the timing and substance of a potential phase II agreement, and, given how the negotiations have played out thus far, it is conceivable that talks could again turn contentious and additional tariffs could be threatened. We are however, encouraged by the potential boost from increased Chinese purchases of US agricultural products. The domestic farm supply chain has been depressed for some time now, and we believe that a significant increase in exports to China could materially enhance the growth profile of the industry.
US economic data was mixed in January, as we saw indications that the manufacturing sector continued to struggle while much of the remainder of the economy appears to be in better shape. December’s ISM manufacturing survey was particularly weak, coming in at the lowest level since 2009. The employment and new order components of the survey also were at multi-year lows. However, more recent data has shown an improvement, along with regional Federal Reserve manufacturing surveys for January which in aggregate came in well ahead of analyst expectations. The service sector looks to be in much better shape as both the ISM and Markit’s gauges of industry activity for December exceeded expectations and came in at levels consistent with modest growth.
The housing industry also appears to be healthy, as it continues to benefit from low mortgage rates. Housing starts and existing home sales for December each bested analysts’ projections, and according to the NAHB homebuilder survey for January, prospective buyer traffic reached a high for the current economic cycle. While new and pending home sales did miss consensus expectations for December, we believe that much of the shortfall was the result of inventory constraints, as opposed to any reduction in demand. With momentum carrying over into January, we believe that 2020 is shaping up to be a good year for the housing market, and we are optimistic that this may create a tailwind for broader economic activity as well.