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Following decisive central bank easing, a reflation theme is taking hold of markets, driving a powerful rally. It likely has further to run, but ultimately will depend on a lasting resolution of the Sino-US trade conflict.
The global economy had been on the mend in late Q3 when global manufacturing PMIs bottomed and began to recover. This was commonly held to presage an extension of the current record-long expansion and fuelled a strong stock market rally into year-end. In December, even EM currencies and commodities which had long been in the doldrums had begun to recover. This benign reflation narrative has since encountered two negative shocks. First was the assassination of Iran’s Major General Quassem Soleimani which risked triggering an escalation of hostilities with Iran. Iran eventually retaliated with a strike on US facilities in Iraq in which no one was killed. This quelled at least the overt nature of the conflict, although it could resurface at any time, all the more so as Iran has now officially abandoned the Nuclear agreement (the JCPOA) concluded by President Obama.
The second shock was the outbreak of the coronavirus, now known as COVID-19 in Wuhan in China which rapidly spread abroad and has claimed over 900 fatalities at the time writing, more than the SARS epidemic. It is certain to disrupt activity in the world’s second-largest economy and the fallout could spread to the rest of the world through the impact on global trade, on integrated supply chains and through commodity prices.
The market reaction was generally sharp and unequivocal. Inflation-adjusted 10yr yields in the US turned negative, dropping below their 2016 post-Brexit referendum low. The 3m-10yr yield curve, after having normalized during Q4 2019 and early January quickly inverted again. The expectation that world interest rates would stay persistently low drove gold further up, extending the 2019 rally, and making a new seven-year high, while the price of copper marked a precipitous fall to its lowest level since June 2017.
Yet, equity markets maintained their resilience throughout. Following on from the impressive gains over the previous quarter, the S&P500 rallied to new highs until mid-January and even MSCI ACWI gained nearly 5% during the November-January period. Nevertheless, there was a sharp discrepancy between the performance of the US and equities in the rest of the world (and between US Tech stocks and the rest). Naturally, Chinese equities declined the most, with the MSCI China losing 9.6% from peak to trough in January and the CSI 300 down 12.3% from peak to trough during the month. Similarly, the MSCI World with China Exposure underperformed the aggregate index.
Markets thus appear to treat the epidemic as primarily a Chinese event and secondarily one for emerging markets. But not as one for the rest of the world. This may appear complacent at first, all the more as the US rally in particular is very narrow-based and valuations have been stretched for a long time. On the other hand, it may simply reflect the expectation that should the economic impact turn out worse than anticipated, policymakers would step in with counter-cyclical measures. China has already done so, providing liquidity, lowering interest rates, cutting reserve requirements and issuing lending directives to banks.
*The publication reflects asset performance up to 31 January, 2020, and macro events and data releases up to 12 February, 2020, unless indicated otherwise.
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