The Cruelest Month May Come Early This Year

A year that launched on a burst of good economic data, a gentle market froth and a zest of nervous optimism now faces large air pockets in Asia, the U.S. and Europe. The threats may dissipate noiselessly, but we should know very soon if the base case is resilient enough to withstand the coronavirus, the U.S. elections and renewed trans-Atlantic trade friction.

The cruelest month is meant to be April, when hopes of spring are dashed by icy rainstorms. This year, it may arrive early. 

So far, the current outlook still looks pretty good. Fading political tensions around trade and Brexit, the logic goes, will allow ample central bank liquidity to bolster consumer confidence, financial markets and even a renewal in capital spending.

Until now, China’s efforts to support growth have been playing out nicely. Targeted spending and monetary support last year restored confidence that the government still had control of the slowing economy amid trade tensions with the United States and its own efforts to rein in excessive credit growth. The early results show recovery in economic activity with few inflationary pressures and fresh demand that offered good news to its neighbors.

CHINA ACTIVITY

Source: Factset. As of January 31, 2020.

SOUTH KOREA EXPORTS VS. GLOBAL EPS

Source: Factset. As of January 31, 2020.

We will know much more in the coming weeks if this story might unravel as we gauge how far and fast the deadly coronavirus spreads. For investors, the problem is that analysts make terrible doctors. Any downgrades to earnings forecasts require heroic guesses about the impact on economic activity, which are based on assumptions about damaged sentiment, which depend on highly uncertain models of contagion rates.

So far, the virus seems less fatal than the SARS virus that ultimately killed nearly 800 people in 2002–03. But China’s economy has risen from 4% of global GDP to four times that, and its flow of goods, services and people is far greater now than it was almost two decades ago. The end of the extended New Year’s holiday this week should prove especially telling as the country gets back to work and growth forecasts may have to be cut.

"For investors, the problem is that analysts make terrible doctors."

The U.S. economy is unlikely to come unraveled this month, but investors will be watching closely as the U.S. political picture comes into focus. The Democratic primary contest officially kicks off today in Iowa, followed by New Hampshire, Nevada and South Carolina later this month. Such a front-loaded calendar means that a third of all delegates will be pledged by the end of Super Tuesday on March 3. 

The polls are entirely unhelpful at this stage, as are the prediction markets. We may finish the month with a centrist candidate clearly headed for the nomination; or it could be one of the more extreme alternatives. Some suggest that wins for Elizabeth Warren or Bernie Sanders might ultimately support markets, as their success would boost President Donald Trump’s chances of winning re-election. But it’s a long time until November and even a small chance of a dramatic reorientation of U.S. economic policy will likely trigger volatility. 

And there is a third, potentially more unsettling scenario. With so many candidates enjoying so much financial support—not to speak of the self-funding billionaires—we might grind through the spring and early summer to arrive in Milwaukee on July 13 with three or more viable candidates and the added uncertainty of a messy brokered convention.

DEMOCRATIC PRESIDENTIAL NOMINATION POLL
RCP National poll average

Source: Real Clear Politics. As of January 31, 2020.

In Europe, the potential risks this month look a little more diffuse, but the economic recovery is more fragile, too. The official Brexit last week has apparently cleared a major uncertainty that dogged markets last year, and Prime Minister Boris Johnson has even banned the word from further official use. Meanwhile, economic sentiment has turned positive across the euro area, too.

EURO AREA AND U.K. PMI

Source: Factset. As of January 31, 2020.

But just as things are hardly ever as bad as they seem in Europe, they are also rarely as good as they seem. Britain’s new legal status merely kicks off another set of complex negotiations that need to deliver a revamped trade deal by December 31 or risk triggering disruptive change in tariffs. 

More damaging would be an escalation in trade tensions with the United States, as President Trump turns his attention from China to the European auto exports that he has publicly deemed a threat to U.S. industry and national security. There may be a path to avoid confrontation on European taxes targeting U.S. digital firms as long as progress continues on multilateral tax policy. But the 15-year-old row over government subsidies to Airbus and Boeing will surely escalate with a looming decision that is expected to favor Europe.

We all suspected that the sunny market scenarios for 2020 sounded too good to be true as we wrote them, although it was difficult to pinpoint exactly which clouds might appear first. The risks coming sharply into view this month will test the resilience of our cheery outlook sooner than expected.