Bedrock’s Newsletter for Friday 21st of February, 2020

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 Friday, 21st of February 2020

“Prophesy is a good line of business, but it is full of risks. “

 

– Mark Twain

 

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Markets have been on a downward slide since late Thursday morning when investors suddenly woke up to the economic threat posed by the coronavirus outbreak. Previously content in a liquidity-induced slumber – and seemingly oblivious to events on the ground in China – markets first began to stir when Apple issued a revenue warning on Wednesday due to challenges reopening supplier Foxconn’s vast iPhone manufacturing plant in Zhengzhou. Stumbling, bleary-eyed into the harsh light of day, investors were then further jolted by the news that coronavirus cases were on the rise in South Korea where authorities discovered that a religious cult had become a hotbed of infection. As of Friday morning, the country has confirmed more than 200 cases of covid-19 (with 100 overnight), while the cities of Daegu and Cheongdo (where the virus is most prevalent) have been left all but abandoned. In addition to having the most coronavirus cases outside China, South Korea also has the world’s twelfth largest economy. Should the virus spread throughout the country and quarantine measures be imposed, North East Asia will take another severe economic blow this quarter. Meanwhile, beyond the 38th parallel in North Korea, little is known about how far the coronavirus has spread. Of course, Kim Jung-un has approached the issue of containment with characteristic restraint, executing anyone who breaks quarantine after travel to China. However, given the poverty in the People’s Korea, the fragility of its healthcare system, and the sheer mendacity of its leadership, a humanitarian catastrophe could yet befall the Hermit Kingdom.

 

In other coronavirus news this week, Russia has temporarily banned all Chinese nationals from entering the country and, together with Turkey, the Kremlin is now limiting meat imports from China; Hong Kong’s flagship carrier Cathay Pacific has issued a profit warning after having cancelled 2/5 flights due to take off in February and March; Chinese auto sales are down -90% in February; a bus carrying returnees from Wuhan has been attacked in eastern Ukraine; two passengers on the cruise ship docked in Japan under quarantine have died, with 531 of those onboard infected; and the PBOC has cut its benchmark rate (again), even as S&P warned of a possible $1.1tn spike in bad loans by Chinese banks due to the outbreak. Confirmed cases now stand at more than 76,000, with 2,130 deaths. None of this is good for economic aggregates or corporate earnings (although it does appear to have driven a 20% increase in Deliveroo orders in Singapore from 27 January to 16 February). And where fundamentals go, markets must surely follow, even if the lag can be torturous. Longer-term, the rise in Chinese non-performing loans and the large-scale monetary and fiscal stimulus efforts in recent weeks represents a major step backwards for an economy that desperately needs to deleverage in order to grapple with its mountainous corporate debts. We still do not know how or when the outbreak will end, but its effects are likely to linger on for some time yet. As such, we are happy to be defensive across portfolios.

 

On the subject of safe havens, the gold price has soared higher this week as a combination of ultra-loose monetary policy and economic anxiety pushed it well-beyond $1620 per ounce (despite the dollar making gains as well). The ocean of liquidity sloshing about global markets has to find a home, and the yellow metal looks like a decent bet when Greek government bonds offer less than 1% yield and equities are at all-time highs amid a major crisis in the world’s second largest economy. We have had a positive view on gold since Q3 last year and the trade has been a strong one. Of course, the coronavirus was not on our radar late last summer, but when sentiment detaches from reality and investors fly too close to the sun, the most likely direction is down.

 

Staying with Asia for now, Japan released a raft of disappointing economic numbers this week, including Q4 GDP which was down -1.6% QoQ. President Shinzo Abe wants to close the country’s gaping fiscal deficit and gambled that weak retail spending in the wake of a long-overdue consumption tax hike (from 8% to 10%), which was implemented in October, could be offset by introducing a system of cashback points for small retailers and pledging a $120bn fiscal stimulus package for 2020. However, he was wrong and consumption spending fell -2.9% over the quarter. Ouch. That said, fiscal policy was not solely to blame for the weak economic outcome. Business investment also fell -3.7% in Q4 due to the US-China trade war and a dispute with South Korea over reparations for Japanese colonisation of the peninsula. It is no wonder, then, that industrial production clocked in at -3.1% YoY in December driven by a -12.5% monthly fall in machinery orders. Japan faces many structural, economic and demographic challenges and is harmed by its underdeveloped relations with most of its neighbours. This quarter, it could very well slip into a technical recession (i.e., two consecutive quarters of negative GDP growth), as covid-19 rampages through its largest overseas market. And the preliminary PMI surveys for February certainly suggest as much, with the composite index coming in below expectations at a contractionary 47.0. The Olympics should bring a much-needed demand boost in the summer, but that remains some way off. The Yen fell 2% against the dollar from Wednesday’s open to Thursday’s close, bucking its traditional safe haven role amid concerns about the domestic economy. Mrs Watanabe is MIA.

 

One region where the data were better than expected this week was Europe. German manufacturing is still very much in the doldrums – the February flash manufacturing PMI sits at 47.8 (which is higher than the 44.8 that markets expected, but still weak). But flash PMIs for France and particularly the UK were more encouraging, with the UK manufacturing PMI hitting a 10-month high of 52.8. The UK’s composite PMI figure, meanwhile, was flat on January’s level at 53.3, which suggests that the country will see modest GDP growth in Q1 thanks to the uptick in sentiment since the election in December. French manufacturing came in just shy of the 50-mark, but services propped up an overall composite reading of 51.9 which is equivalent to low but positive growth. Europe is more exposed than America to events in EM and the coronavirus outbreak in China is likely to forestall a manufacturing recovery of any great scale. But the results in the UK at least are strong given the tough global backdrop.

 

The US data was the biggest surprise this week. February flash services, manufacturing, and composite PMIs all missed, with services performing the worst at 49.4 (vs. 53.4 expected). The data has reinforced the sell-off in equities and bond yields have fallen sharply (the 10y yield is now below 1.5%). Should the preliminary data be confirmed at month-end, the US is in the enviable position of being able to cut interest rates to support growth without falling below the so-called zero-lower-bound. We are therefore not convinced that the change in economic data supports a change in our long-standing view that the US economy will outperform the rest of the world in 2020. We await the angry Trump tweet blaming Jay Powell – and China.