Three issues that could keep global markets reeling

by Kristina Hooper, Global Market Strategist, Invesco Ltd., Invesco Canada

Last week was a momentous one for markets, with coronavirus fears gripping markets and creating a risk-off environment. Stocks sold off while yields on government bonds also fell. Over the course of less than two weeks, the yield on the 10-year U.S. Treasury fell from over 1.8% to 1.51%, and the yield on the 10-year German bund dropped from -0.22% to -0.44%.¹

This week, I see potential for continued market volatility, both to the upside and the downside. Here are three key issues I’m watching:

1. Iowa caucus. Voters in Iowa will be determining their choice for the Democratic nominee for president. The most recent polling indicates Bernie Sanders is likely to win this race, which is causing some market observers to worry that there could be a market sell-off. It is important to note that one primary does not a nominee make, and it will take many more contests before the nominee is determined. I expect a lack of visibility on the nominee to persist for some time. And so, I can’t stress enough that investors should be prepared for some volatility this winter and spring, as the primary season is likely to provide some twists, turns, and surprises. I believe investors should not panic – even if a more progressive candidate were to receive the nomination and ultimately win the presidency. The U.S. government provides a powerful set of checks and balances to any leader, so any initiative perceived to jeopardize economic growth would likely face serious opposition.
2. Post-Brexit trade negotiations. On Friday night, UK Prime Minister Boris Johnson pronounced “the dawn of a new era” as Brexit officially occurred and the UK’s “transition period” began. He celebrated the event as “a moment of real national renewal and change.” However, that was the relatively easy part. Now begins a period of intense negotiations between the UK and the EU to not only define their trade relationship, but also to determine issues around security, energy, fishing, and data – all within 11 months.Recall that Boris Johnson has insisted the transition period will not extend beyond Dec. 31, 2020, which provides a very short time frame in order to accomplish many lofty goals. Negotiations will not be easy between the UK and EU, as the EU is insisting the UK agree to heavy requirements to ensure fair competition with European counterparts; the European Commission president Ursula Von Der Leyen explained, “Without a level playing field on environment, labour, taxation, and state aid, you cannot have the highest-quality access to the world’s largest single market.” Boris Johnson has already struck an aggressive tone, threatening to leave the EU with no deal.

   If the UK were to “crash out” of the EU with no deal, that means that the post-2020 relationship between the UK and the EU would be dictated by the terms of the World Trade Organization, and that of course means higher tariffs and other restrictions that would not be positive for either entity. The UK government is coming under pressure – particularly from UK manufacturers’ lobbying groups – to provide more clarity on its trade relationship with the EU sooner rather than later.

   I expect that this pressure will only grow as each day passes, given that companies want to avoid economic policy uncertainty – and it’s hard to imagine a bigger source of economic policy uncertainty than this. We will want to follow this evolving situation closely.

3. Coronavirus. China’s financial markets resumed trading today after an extended Chinese New Year break, with the markets initially selling off -9% in Shenzhen and -8.7% in Shanghai during early trading.² Before the markets opened, the Chinese government was very proactive, as I expected, with numerous Chinese regulators, ministries, and local governments announcing policy measures to contain the downward impact from the coronavirus on the economy.

   In all, the Chinese government announced 30 measures across five ministries and regulators to provide economic support. The People’s Bank of China announced large-scale open market operations by injecting 1.2 trillion yuan worth of liquidity into the markets via reverse repo operations, as well as lowering the seven-day reverse repo rate to 2.4% from 2.5% and cutting the 14-day tenor to 2.55% from 2.65%.³The novel coronavirus has spread quickly, with the number infected far surpassing the total number infected during the SARS (Severe Acute Respiratory Syndrome) outbreak of 2003. However, on the positive side, the mortality rate appears to be far lower for the novel coronavirus than for SARS or MERS (Middle East Respiratory Syndrome).

   Containment measures appear to be working in a number of countries, but only time will tell the exact trajectory of this contagion. Based on what we know today, we expect the coronavirus to have the greatest impact on China and Asia’s GDP in the first quarter of 2020, with a slight improvement in the second quarter.

   Compared to SARS in 2003, expectations this time are for a stronger, more negative impact toward the beginning stages, as new cases should peak in this quarter. We currently expect the number of new infections will moderate starting sometime in the second quarter as China’s and other government’s remediation responses have been swifter and much more transparent than in 2003.

   As the number of new infections moderates – and as consumption returns and positive impacts of the Phase 1 trade deal work their way through positive corporate and consumer sentiment – we think that a rebound in economic activity will start to occur by the end of the second quarter, which should continue into a more powerful recovery in the third quarter.

   While more stock market volatility is likely, we expect the market to rebound in advance of an improvement in economic activity, especially given that both China and the Federal Reserve (Fed) stand ready to provide stimulus as necessary.

In addition to these concerns, we will also want to follow economic data closely this week. For the first time in a number of months, market participants are beginning to worry again about global economic growth, especially in light of the coronavirus contagion. Even the U.S. saw some disappointing economic data recently. The Chicago Purchasing Managers’ Index (PMI) released last Friday was abysmal, dropping to 42.9 from 48.9 in December. In addition, data released last week indicated that U.S. farm bankruptcies rose 20% in 2019 despite very significant amounts of government aid.⁴

In the coming week, we will want to follow upcoming data releases closely, especially leading indicators. I’ll be paying particular attention to the ISM Index prints, as well as the U.S. and Canada jobs reports. I will also be interested to see the European Commission economic growth forecasts.  But what I will be following most closely is the Federal Reserve’s (Fed) Monetary Policy Report to be released this Friday. This is the Fed’s required report to Congress, covering economic and financial developments, monetary policy, and projections in significant detail. The Fed often chooses to focus on one or more special topics in the Monetary Policy Report, which can clue us into what is currently on its mind. Given that monetary policy is arguably the most powerful force affecting markets today, this will be important reading.

This post was first published at the official blog of Invesco Canada.