By Scotia Wealth Management - The Zukiwsky Group

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MARKET WATCH: Feb. 28, 2020

Feb 28, 2020 | 12:04 PM

Investment Strategy

China’s slowdown threatens global economic growth. Risk assets gapped lower to begin the week and remained under pressure as new cases of the coronavirus (COVID-19) were announced in Asia and Europe. The outbreak has already caused considerable disruption in and around China. An epidemic-induced slowdown in China’s economy, which approximates 16% of global GDP, could have a more significant and lasting impact on the global economy than the SARS outbreak did in 2003, when China represented a mere 4% of global GDP. Notwithstanding its short-term effects, COVID-19 will act as a transitory drag on the economy if evidence and history are any guide. Any deceleration in growth will likely dissipate as the outbreak is contained, resulting in an extension of the business cycle beyond the second half of 2020 amid accommodative monetary and fiscal policy. In the near-term, sentiment will likely remain depressed, and deteriorating investor confidence may continue to weigh on government bond yields, lift demand for U.S. dollar-denominated assets and support capital flows into haven currencies and investments.

The outbreak has disrupted industries that rely on Chinese manufacturers for final and intermediate goods, and domestic demand in China has been impaired by quarantines and a material decline in business operations. Global inventories, which had been drawn down in 2019 on the back of trade policy uncertainties, will likely be depleted and subsequently restocked when the outbreak subsides. In recent weeks, earnings estimates have been revised modestly lower. Given lingering concerns about the virus and the potential for supply chains to be further burdened, we expect further negative revisions in the coming quarter. At the moment, however, U.S. corporate earnings are still expected to rebound meaningfully in 2020, with consensus estimates implying YOY growth of ~11% by the fourth quarter. We expect financial market volatility will remain elevated in the near-term, underscoring the benefits of a disciplined and patient investment philosophy that prioritizes diversification and risk-adjusted returns.

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The spread of the coronavirus (COVID-19) has shaken investor sentiment and pushed many major equity benchmarks into negative territory YTD. So far, only a handful of companies have made special announcements regarding the outbreak’s potential impact on their businesses. Unless the epidemic abates, we expect this number to rise, depressing Street expectations. Thus far, companies that have commented on virus-related setbacks have, for the most part, been concentrated in the travel, hospitality, and discretionary sectors. Market participants have begun marking down expectations beyond 1H20 and extending EPS stagnation, signalling expectations for a U-shaped recovery in S&P 500 profit forecasts (Figure 2). Consensus forecasts for YOY EPS growth in the first quarter of 2020 have fallen to 0.5% from 1.6% in mid-January. Estimates for consumer discretionary, materials and industrials companies have taken the biggest 1Q haircuts, with all but the utilities and technology sectors experiencing negative revisions. Estimates for 2Q and 3Q have edged modestly lower but still imply respectable YOY growth.

Fixed Income

U.S. municipal bond yields tumble to 38-year lows as investors flock to the asset class’s perceived stability. The US$4 trillion U.S. municipal bond market is experiencing significant inflows this week, with funds tied to the S&P Municipal Bond Index logging their largest aggregate one-day inflow in more than twenty months on Monday. The index itself returned ~0.3%, a result matched or exceeded only five times in the past three years. Yields on high-grade tax-exempt 30-year municipal bonds fell to 1.63% Monday, 46% lower than in February of last year. Municipal bond prices (which are inversely related to yields) had been climbing steadily even before the coronavirus outbreak occurred. This was prompted by late-2017 changes to the U.S. tax code, which, by capping the federal deduction for state and local taxes, made tax-exempt bonds more attractive in high-tax states. Municipal bond holdings in exchange-traded funds (ETFs) and mutual funds now top US$850bn, according to data collected by the U.S. Federal Reserve. Municipal bond funds reported net inflows of US$96.5bn in 2019, a 28-year record, and US$1.8bn in inflows last week, according to Refinitiv.

Economics

Flash PMI surveys show European business shrugging off virus concerns – for now. The Eurozone economy grew at its fastest rate in six months in February as the Composite Purchasing Managers’ Index (PMI) rose to 51.6 from 51.3 previously. New activity was concentrated in the services sector. The manufacturing sector remained in decline, though it contracted at the slowest pace in twelve months. New business rose at a rate equal to January’s seven-month high, but this was insufficient to offset a slight decline in backlogs, suggesting excess capacity still exists. With respect to new orders in the manufacturing sector, inflows of work fell for a seventeenth consecutive month. That said, the decline in factory orders was the smallest in fifteen months, as firming demand from domestic customers helped to offset a more substantial decline in export orders.

While the continued improvement in PMI is encouraging, softening sentiment in both the manufacturing and services sectors poses some downside risk to future readings. The potential for supply chain disruptions and further delivery delays owing to the impact of the COVID-19 outbreak could reverse some of the year’s early gains.

Geopolitics

Three states down, forty-seven to go in the race for 1,991. Vermont Senator Bernie Sanders won the New Hampshire primary to jump out to a twenty-delegate lead in the early voting as former New York City Mayor Mike Bloomberg enters the fray next week for Super Tuesday. On March 3rd, fourteen states and one territory will award a total of 1,357 delegates (34% of total delegates), including California (415), Texas (228), and North Carolina (110). National polling data continue to suggest that Mr. Sanders will be the Democratic Party’s nominee for president. He is now favoured by more than 10 points, on average, over former U.S. Vice President Joe Biden. Candidates took to the stage on Tuesday for the tenth debate of the primary process. Mr. Sanders was on the defensive all night, as the six other participants tried to slow his campaign’s momentum. Mr. Sanders was forced to fend off challenges to his voting record, stance on guns, and alleged sympathy for socialist regimes. Mr. Biden turned in a strong debate performance, seeking to contrast himself with his opponents as someone with the political experience to get things done. South Carolina is a must-win state for Mr. Biden. After next week, it should be clearer who will face-off against President Trump in the general election on November 3rd. 1,991 delegates are required to win the Democratic nomination for president on the first ballot at this July’s Democratic National Convention in Milwaukee.

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