Manufacturing new orders bounced back last month, but the ClearBridge Recession Risk Dashboard's signal remains a cautious yellow.
- The increased spread of the coronavirus outside of China rattled global equity markets, with U.S. stocks declining over 12% in the past 10 days.
- Prior to the wider outbreak, the ClearBridge Recession Dashboard was improving with Money Supply and Commodities moving to green from yellow. However, Profit Margins changed to red from yellow and Job Sentiment to yellow from green.
- The overall signal remains yellow and is likely to remain so in the near term given the increased risk and uncertainty emanating from the coronavirus outbreak.
Rising Coronavirus Fears Spook Financial Markets
While the coronavirus has been on the radar for many investors prior to the selloff that began in mid-February, initially the disease was largely contained within China (specifically the Hubei province). Equity markets sold off only after the virus began to spread in a more significant fashion outside of China, with meaningful numbers of cases reported more recently in South Korea, Japan, Iran and Italy. As fear of a global outbreak has risen, investors have fled equities in favor of safer assets like fixed income and gold. U.S. and international stocks, as represented by the S&P 500 Index and the MSCI All Country World Ex-U.S. Index, are down 12.7% and 11.8%, respectively, from their recent peaks and 10-year U.S. Treasury yields have plunged to a record low of 1.15%, as of February 28. While the ultimate trajectory of the disease is unknowable, some have begun to question if this could be the straw that breaks the camel’s back for the current market run and period of economic expansion.
Exhibit 1: Reported Cases Have Increased Outside Mainland China
Data as of March 2, 2020. Source: Bloomberg.
Efforts to contain the spread of coronavirus will curb economic growth in the short term. These include shutting down factories in affected areas, imposing travel restrictions/limits and canceling public events. China’s manufacturing PMI for February came in at 35.7, a level worse than what was seen in 2008 (Exhibit 2). Financial markets have become increasingly concerned about the spread of the virus and the potential for associated disruptions to business and consumer activity. For example, the remainder of the Japanese baseball preseason will be played in empty stadiums, as have several Series A soccer games in northern Italy. Beyond sports, the shift by many businesses to more global supply chains and just-in-time inventory management increases the risk of production challenges. Some businesses that are closed or operating at reduced output may come under financial pressure if these limits persist.
Exhibit 2: China Manufacturing Takes a Dive
Data as of Feb. 29, 2020. Source: China Federation of Logistics and Purchasing, Bloomberg. Past performance is no guarantee of future results. Indexes are unmanaged, and not available for direct investment. Index returns do not include fees or sales charges. This information is provided for illustrative purposes only and does not reflect the performance of an actual investment.
Consumers around the globe could pull back if they see their hours reduced or even go unpaid, to say nothing of being unable to go out and shop. The economy could also come under pressure if a confidence crisis emerges, a scenario where actions to limit the coronavirus cause consumers to pull back even if the virus does not impact them directly. The good news is policymakers are well aware of these risks and are taking steps to aid both consumers and businesses during this challenging period.
Most economic models are not designed to capture the impacts of a previously unknown global pandemic and the ClearBridge Recession Risk Dashboard is not unique in this sense. However, we continue to believe the Dashboard and its underlying signals can be illustrative for those seeking to contextualize risks in times like this. Perhaps the most important question for equity investors is if the foundation of the economy is strong enough to withstand the negative growth impulse from the coronavirus.
Exhibit 3: ClearBridge Recession Risk Dashboard
As of Feb. 29, 2020. Source: ClearBridge Investments. Sources: ClearBridge Investments, Bureau of Labor Statistics (BLS), Federal Reserve, Census Bureau, Institute for Supply Management (ISM), Bureau of Economic Analysis (BEA), American Chemistry Council, American Trucking Association, Conference Board, and Bloomberg. The ClearBridge Recession Risk Dashboard was created in January 2016
Evaluating Coronavirus Risk Using the ClearBridge Recession Risk Dashboard
The dashboard had been trending healthier over the past several months, and in recent weeks the overall signal was nearing a return to green or expansionary territory. The ISM New Orders signal improved from red to yellow last month on the back of the trade deal, and several variables, such as Wage Growth and Housing Permits, saw improvement but not signal changes. Two signals are also changing from yellow to green this month: Money Supply and Commodities. The expansion of the Federal Reserve’s (Fed) balance sheet has been helping to boost Money Supply: the Fed acted in order to stave off issues in the repo market, the effect has been to add liquidity to the financial system, which decreases the risk of recession. Commodities have been helped by falling oil prices as well as positive trends in chemicals and lumber prices, while industrial inputs such as copper and steel remain relatively stable.
However, as the picture regarding the severity of the outbreak has become clearer in recent weeks, the dashboard has modestly deteriorated, and the overall signal remains in yellow cautionary territory. Three indicators worsened but did not change, reflecting increased economic risk from the coronavirus: ISM New Orders, Credit Spreads and the Yield Curve. Despite improvements to Money Supply and Commodities, two non-virus-related signal changes helped keep the overall signal yellow: Profit Margins and Job Sentiment. Profit Margins have continued to deteriorate and are now red (previously yellow) for the NIPA universe we monitor, and margins worsened for S&P 500 Index companies for the second consecutive earnings season. While improving trends in both wages and commodities should dampen margin pressure over time, corporate profits remain vulnerable at present. Job Sentiment has also worsened, to yellow from green. While the labor market remains healthy, early warning signs of stress are beginning to go off. These include the sharp decline in job openings in the JOLTs report as well as the jobs sentiment data. This month saw a large drop-off in “jobs are plentiful” responses and an uptick in “jobs are hard to get” responses. This measure has clearly stalled, suggesting increased caution is warranted (Exhibit 4).
Exhibit 4: Job Sentiment
As of Feb. 29, 2020. Source: Conference Board, Bloomberg, NBER.
Overall Yellow Signal Likely to Persist Amid Uncertainty
Looking ahead, the macro backdrop remains mixed. While the underlying trend in the pre-coronavirus economy appeared to be improving (absent several one-off items such as the Boeing shutdown), this new unknown has introduced a new set of risks to the global economy. Fed Funds futures have fallen substantially, and that market is now pricing an additional interest rate cut at the upcoming March meeting. While the effectiveness of lower interest rates in dampening the initial, more supply-side impacts of coronavirus may be limited, this could be an important signal to help boost sentiment and stabilize financial markets. In our view, the Fed could achieve a similar result through a combination of other policy tools, such as coordinated liquidity swap lines which were utilized during the global financial crisis. These would allow central bankers to send a message that they are working together to stave off lasting damage from coronavirus by providing sufficient funding to ensure the smooth operations of global markets.
The evolving nature of the spread of the virus makes its demand-side economic impact difficult to forecast with precision, however there is likely to be some drag on U.S. GDP. In the coming months, we believe Credit Spreads, Retail Sales, ISM New Orders, Commodities and Truck Shipments are the most likely indicators to reflect the impacts of the coronavirus. Additionally, this exogenous event will likely extend the length of the yellow overall dashboard signal, and a “V” shaped economic rebound from the effects of the virus appears increasingly unlikely. Given this, we believe caution is prudent at the current juncture given the potential for heightened volatility such as that experienced by equities in recent weeks.
A credit spread is the difference in yield between two different types of fixed income securities with similar maturities, where the spread is due to a difference in creditworthiness.
The Bureau of Economic Analysis (BEA) is an agency within the Department of Commerce's Economic and Statistics Administration, responsible for collecting and publishing economic data, research and analysis, and estimation methodologies.
The Bureau of Labor Statistics (BLS) is an American government agency tasked with collecting and disseminating a range of economic and employment data.
The United States Census Bureau (USCB) is a principal agency of the U.S. Federal Statistical System, responsible for producing data about the American people and economy.
The Conference Board is a US-based business membership and research association.
Fed funds futures are financial contracts that represent the market opinion of where the daily official federal funds rate will be at the time of the contract expiry. The futures contracts are traded on the Chicago Mercantile Exchange (CME) and are cash settled on the last business day of every month.
The Federal Reserve Board ("Fed") is responsible for the formulation of U.S. policies designed to promote economic growth, full employment, stable prices, and a sustainable pattern of international trade and payments.
Gross Domestic Product (“GDP”) is an economic statistic which measures the market value of all final goods and services produced within a country in a given period of time.
The ISM New Orders Index is the new orders component of the ISM PMI.
The Institute for Supply Management (ISM) is an association of purchasing and supply management professionals, which conducts regular surveys of its membership to determine industry trends.
The Job Openings and Labor Turnover Survey (JOLTS) is conducted by the US Department of Labor, producing data on job openings, hires, and separations.
Liquidity swap lines are designed to improve liquidity conditions in dollar funding markets in the United States and abroad by providing foreign central banks with the capacity to deliver U.S. dollar funding to institutions in their jurisdictions during times of market stress.
The MSCI All Country World Index (ACWI) ex USA captures large and mid cap representation across 22 of 23 Developed Markets (DM) countries (excluding the US) and 24 Emerging Markets (EM) countries
The National Bureau of Economic Research (NBER) is an American private nonprofit research organization "committed to undertaking and disseminating unbiased economic research among public policymakers, business professionals, and the academic community.
The national income and product accounts (NIPA) are part of the national accounts of the United States. They are produced by the Bureau of Economic Analysis of the Department of Commerce. They are one of the main sources of data on general economic activity in the United States.
Purchasing Managers Indexes (PMI) measure the manufacturing and services sectors in an economy, based on survey data collected from a representative panel of manufacturing and services firms. PMI greater than 50 indicated economic expansion; below 50, contraction.
The S&P 500 Index is an unmanaged index of 500 stocks that is generally representative of the performance of larger companies in the U.S.
U.S. Treasuries are direct debt obligations issued and backed by the "full faith and credit" of the U.S. government. The U.S. government guarantees the principal and interest payments on U.S. Treasuries when the securities are held to maturity. Unlike U.S. Treasury securities, debt securities issued by the federal agencies and instrumentalities and related investments may or may not be backed by the full faith and credit of the U.S. government. Even when the U.S. government guarantees principal and interest payments on securities, this guarantee does not apply to losses resulting from declines in the market value of these securities.
The yield curve is the graphical depiction of the relationship between the yield on bonds of the same credit quality but different maturities.
Weathering The Storm:
Perspectives on Volatility Now
Turmoil in oil prices, uncertainty about COVID-19 and rapid moves by central banks have shaken the markets. What do our managers see as the likeliest outcomes in the short and long term?
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