Editor’s Note: Sven Henrich is founder and lead market strategist at NorthmanTrader. The opinions expressed in this commentary are his own.
Recent history suggests that when a disease outbreak occurs, it will soon be contained, the economic impact will be minor and the markets will eventually ignore the whole thing. The SARS virus, for example, broke out in China in 2003 and killed 774 people, but it was largely contained and the S&P 500 rose by more than 20% that year.
But things are looking to be much different with the coronavirus. The global economy remains fragile and an extended outbreak could tip the current aging business cycle into a global recession, right when US markets are seeing some of their highest valuations in history.
The coronavirus is still spreading rapidly and has now reached over 25 countries, with the number of infections reaching over 28,000 and causing 560 fatalities (as of February 6). For investors to get the all clear, these numbers will need to show significant slowing.
Investors have so far taken the coronavirus outbreak in stride, with only a minor drop at first and then a rally on containment hopes. There hasn’t been any real damage done to markets yet. But there are several factors to consider that suggest the risk to global markets may currently be masked mainly due to large liquidity injections by central banks, such as the People’s Bank of China and the US Federal Reserve.
Bad timing for China’s economy
China is now the second-largest global economy. And what happens to its economy has global repercussions.
Before the outbreak, China reported its weakest annual growth in 29 years, in part due to its trade war with the United States, mounting debt, slowing birth rates, aging population and deflation. China cannot afford another major setback like the coronavirus.
Yet, with a number of businesses including Nike, Adidas, Starbucks and Apple, temporarily closing stores due to empty streets and close to two dozen airlines cutting off service to the mainland as a result of the coronavirus, it appears China’s economy is being dealt another blow.
Bad timing for the US economy, too
During the SARS virus in 2003, the US economy had just come out of a recession. Markets had bottomed in 2002, and 2003 saw an economic recovery bringing about massive new growth. SARS didn’t really matter to markets.
Now it’s different. Last summer, the US economy officially entered its longest growth expansion in history and many fear that an economy this late in its growth cycle can’t handle a larger outside shock. Recessions typically occur on a regular basis and are useful to refresh growth and weed out inefficiencies and excess in the market. But constant central bank intervention has bolstered our economic growth and allowed for excesses and inefficiencies to keep building up in the economy.
Already we had a yield curve scare last summer, and we have seen three rate cuts by the Federal Reserve and a Treasury bills buying program that have been credited with easing recession fears.
In recent weeks, despite record highs in the markets and hopes for a rebound in economic growth in 2020, the bond market has not confirmed the reflation trade. The yield curve has once again flattened and is at risk of inverting again, repeating a pattern last seen just before the 2008 financial crisis and subsequent recession.
The stock market was already overvalued
The recent market rally has produced some of the largest market valuations in history. US markets have (until last week) been trading at a total market valuation of 157% compared to gross domestic product, or GDP — a record figure, higher than numbers seen during the 2000 market bubble.
There is no history that suggests that such high market valuations, that are so disconnected from the underlying size of the economy, are sustainable. In 2000, when market capitalization to GDP reached nearly 150%, the subsequent recession resulted in a valuation reversion to 75% market cap to GDP. In 2007, the market cap to GDP peak reached 110% before reverting to 57% during the following recession. Historically speaking, this is an extremely overvalued market.
This outbreak only adds uncertainty to the global economic outlook. While the coronavirus may play out like the SARS crisis, the risk to investors may be much higher than markets are letting on at this time.
While markets rallied this week on hopes that the virus will be contained in short order, the Word Health Organization threw cold water on prospects of a quick fix announcing there’s no known cure at this stage. Uncertainty remains. This is not over. And as long as this remains the case so does the prospect for slowing growth.