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The coronavirus knocked our 2020 outlook off track. But maybe not for long.

It wasn’t long ago that the ink was drying on our 2020 outlook, entitled “Getting Back on Track.” In it, we touted the conclusion of the third major policy-driven growth scare (along with 2012’s European debt crisis and 2015’s Federal Reserve [Fed] rate hike) of the elongated business and credit cycle. Stable growth and supportive policy were to be the theme of 2020. The Fed had already overturned the 2018 rate hikes and had successfully eased financial conditions, while the Trump administration had inked a Phase 1 trade deal with China. China, for its part, was working to stimulate its economy. The January reading of the Institute of Supply Management Manufacturing Purchasing Managers Index, as good of a leading indicator of economic activity as any other, would have traditionally been viewed by us as a resounding affirmation that the growth scare had passed. “Risk on!” we would have rejoiced. 

The ISM Manufacturing PMI bounced back into
expansion territory in January

Sources: Institute for Supply Management, Bloomberg

The coronavirus detoured the economic growth
path

Alas, “the normal times” were not to be. The rise of the coronavirus
and the ensuing quarantines and ongoing lost production will ultimately
represent a severe growth drawdown at an inopportune time for the global
economy. No sooner was the third major growth scare of this cycle abating than the
fourth significant scare was now upon us. In my view, that blue line in the
chart above will no doubt be back below 50 in no time.

I am not going to attempt to quantify the expected loss in
economic activity. (Other than to note that my colleague Paul Jackson, Head of
Global Asset Allocation Research, is hopeful for a short, sharp downward shock
to the Chinese economy during the first quarter, with recovery during the
second quarter and second half — a path that is dependent on how long daily
cases and deaths continue to rise.)

Instead, I will address the growth scare from the
perspective of a market strategist, using frameworks to A) assess whether the business
cycle is ending and B) determine potential market leadership based on the
direction of economic activity and the policy response.

What
does the ‘end-of-cycle dashboard’ show us?

It would be rare, if not unprecedented, for an infectious
disease outbreak to lead to a global economic recession. Then again, global
growth was already in a precarious state, the result of the uncertainty
stemming from the US-China trade war. Rather than simply speculate on the
prospect of a technical recession, I instead deploy an end-of-cycle dashboard comprised
of telltale market indicators. Among them:

  • The shape of the US Treasury yield curve: As I
    pen this commentary, the spread between the 10-year US Treasury rate and the
    2-year US Treasury rate is 11 basis points.1 Call it modestly steep
    or stubbornly flat but importantly, it is not inverted. Each of the past half
    century’s recessions have been proceeded by a prolonged inversion
    of the yield curve
    .2 Yes, the federal funds rate is above
    that of the 10-year US Treasury rate, as of this writing, but the relatively
    benign inflation environment provides cover for the Federal Reserve to cut
    rates, if necessary.
  • The strength of the US dollar: The
    US dollar has been strengthening once again and may break out against a
    trade-weighted basket of currencies. Watch the dollar closely, as capital
    flight to US-dollar assets would weigh on international activity and provide a
    headwind to the earnings of US multinational corporations. If the dollar gets
    too strong and deflationary impulses emerge, the Federal Reserve would once
    again be forced to act to stabilize the currency. 
  • The spread of US corporate bonds to
    Treasuries:
    Corporate bond spreads have thus far been behaving,
    remaining very tight from a historical perspective. In fact, high yield bond
    spreads tightened in the first half of February.

Pulling it all together, financial conditions thus far
remain exceedingly easy compared to the starts of each of the past three
recessions, as illustrated in the chart below. The picture does not seem to be
suggesting that a recession is in the offing.  

The Goldman Sachs Financial Conditions Index
does not suggest that a recession is imminent

Sources: Goldman Sachs, Bloomberg, L.P.

Where
do we expect to see market leadership?

To determine market leadership, we ask ourselves three
primary questions:

  1. What
    direction is the global economy trending?
  2. How
    will policymakers react to existing conditions?
  3. What
    will the impact of economic growth and policy be on capital flows?

To answer Question 1: There
is no doubt that global economic activity is decelerating, with many of the
usual trappings — lower rates, stronger dollar, weaker industrial commodity
prices, bonds and bond proxies performing well even as the broader market has
thus far held up well (don’t be surprised however if economic volatility leads
to some near-term market volatility). However, in my view, the time to get
defensive may have passed or prove short-lived. The optimist in me is hopeful
that the virus can be contained, the Chinese labor force will gradually get
back to work, and pent-up demand will support growth in the latter half of the
year.

Regarding Question 2: I
would also expect US and Chinese policymakers to act quickly, if necessary, to
support growth and reflate the global economy.

As for Question 3: I
believe that stabilizing growth and supportive policy would help support stocks
over bonds, growth assets over value-oriented assets, and credit over
Treasuries. This was my view at the start of the year and has been for most of
this cycle.  

These three questions, and our thought process around them,
are detailed
in this infographic
.

 And so, while I
already used this title back in December, maybe I’ll recycle it for our midyear
outlook — “Getting Back on Track.”

1 Source: Bloomberg, L.P., as of Feb. 24, 2020

2 Bloomberg L.P., as of Feb. 19, 2020. Recessions are
defined by the National Bureau of Economic Research (NBER).

Important
information

Blog header
image: D3sign / Getty

All investing involves risk, including
the risk of loss.

The ISM Manufacturing PMI, which
is based on Institute of Supply Management surveys of manufacturing firms in
the US, monitors employment, production, inventories, new orders and supplier
deliveries.

The Goldman Sachs Financial Conditions
Index is a weighted average of riskless interest rates, the exchange rate,
equity valuations, and credit spreads, with weights that correspond to the
direct impact of each variable on gross domestic product. An investment cannot
be made into an index.

The opinions
referenced above are those of the author as of Feb. 24, 2020. These comments should not be
construed as recommendations, but as an illustration of broader themes.
Forward-looking statements are not guarantees of future results. They involve
risks, uncertainties and assumptions; there can be no assurance that actual
results will not differ materially from expectations.

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