Low Interests Rates Are Propping Up The Global Economy
With central bankers cutting their prime interest rates to 0.0% or near 0.0%, investors are right to worry. The main concern is that the economic outlook is getting worse and the central banks may not be able to do anything about it.
The problem is that the major world powers already had low-interest rates. The U.S., the EU, Japan, the UK, and Australia are only the tip of the iceberg, low-interest rates were a common theme among most of the world’s central banks.
The central banks have been holding their key rates at or near historic lows for the last decade in an effort to spur global recovery. The reason is simple, the global economy took a long time to get back on its feet after the 2008 Global Financial Crisis and the footing was shaky.
The U.S. led the charge when it came to normalizing interest rates. After holding rates steady at 0%-to-0.25% for eight years the FOMC began hiking rates in 2015. After 9 incremental 0.25% adjustments, the rate topped out at 2.5%.
Since then, the FOMC made three “mid-cycle” adjustments in response to the trade war that put the benchmark at 1.75%. To put that in perspective, the high rate leading into the 2008 financial crisis was 5.25%. Since then, rates haven’t recovered half that ground leaving the FOMC without much ammo to fight future battles.
Other central banks were in the same boat or worse. The Bank of England was one of the last to cut rates to zero following the 2008 financial crisis, holding out until 2016, but in the end, did so. Since then, due to signs of economic recovery, they too have been hiking rates. The BoE’s top rate hit 0.75% in 2018 and was held at that rate into 2019. The Bank of Japan and European Central Bank were the worst off. Both of these institutions have held their rates at negative levels for several years.
The Best Medicine For Coronavirus? Fiscal Stimulus
The biggest risk to the world from the coronavirus is its impact on the economy. The virus is a threat to health, I’m not discounting its danger, but it’s little more than a cold in most cases. The problem is that everyone is going to get sick, sooner or later, and world governments are trying to slow the spread. This means disruptions to activity, hiccups in supply chains, business closures, loss of revenue, and a growing potential for a deep, worldwide financial recession.
The central bankers’ best means of fighting economic weakness is with monetary stimulus. Monetary stimulus means, in virtually all cases, lower interest rates. Lower interest rates make it easier for businesses to borrow money they need to get through periods of crisis. The trouble now is that the only central banks with ammo to fire used it up in a preemptive attack.
The FOMC made two emergency cuts, the BoE, Bank of Korea, Reserve Bank of Australia, and others at least one putting the world’s benchmark lending rates at 0%. If the economic fallout from the virus worsens there is little left for the central banks to do.
These Sectors Are Hurt The Worst
While all S&P 500 sectors are feeling pain from the coronavirus, there are several taking the direct force of the blow. The worst sectors are travel, leisure, and hospitality. The spreading virus has shut down travel and recreation on a global scale. The flights that are still allowed are virtually empty because no one wants to put themselves at risk. Likewise, casinos, resorts, and amusement parks are shutting down to prevent large crowds from gathering.
Most businesses have yet to quantify the amount of damages they will incur because the virus outcome is still an unknown quantity. Travel and leisure may be shut down for a month or they may be shut down for the rest of the year, we just don’t know and the potential for spillover into other sectors is huge. That said, a few companies have issued guidance that helps put the potential for loss in perspective.
Apple was the first major company to issue a guidance revision. The consumer tech giant is heavily dependent on China for its supply chain and said the epidemic would impact revenue as much as 10%, and that was before it spread globally. Since then, the company has had to close all stores outside of China which is another big blow to Q1 revenue.
Airliner United Airlines has come out with its own dire prediction. United Airlines executives see March revenue falling and that is just the beginning. Because of an expected downtick in traffic, they are cutting capacity by 50% for the next two months. They expect, assuming there is no flying ban, for capacity cuts to linger into the summer months. Basically, the economic impact will be severe and could last four to six months if not longer.
The Economic Impact Could Be Huge
With the world preparing to shut-down in an effort to stop the spread of the virus it is certain activity is slowing. The question is how much? Some industries are hurting, and badly, but others are not.
While shoppers shun public places, avoid large gatherings, and cancel plans for travel they are gearing up for an extended stay at home. This means increased spending on staples and health items that have retailers scrambling to fill shelves. Kroger and Amazon have both announced hiring plans to meet the demand and they are not the only ones.
Bloomberg did a study on the potential impact of the virus using four models. The worst-case scenario has a total impact on global economies at $2.7 trillion or roughly the annual output of the United Kingdom. This scenario is when the virus causes more than just localized disruptions, a point the world is on the verge of crossing.
Some sources estimate the impact has already caused world GDP to contract although the data is limited. The news we get from China is the most current there is and it isn’t promising. The PMI figures show a severe contraction in manufacturing and services activity that is scary if it becomes the global norm. GDP estimates vary widely but include the chance of 0% growth for China in the 1st quarter.
Contrary to China, data from the U.S. shows the economy not only expanding but accelerating in the first two months of the year. The Atlanta Fed’s GDPNow Tool is tracking at 2.9% for the first quarter and only fell 0.10% since peaking in late February. It is clear the U.S. economy was on solid footing before the virus, so the shock might not be as bad as feared for China. If the economic stimulus provided by the world’s central banks can sustain consumer spending the economy should rebound quickly.
The risk for most countries and the U.S. is not immune, it is not acting quickly enough. Delayed response or one not coordinated on a national scale will test the healthcare system and economic resilience of any nation. Prevention and slowing the spread is the key to ending the epidemic and paving the way for an economic rebound.
Low Rates Won’t Make Much Difference By Themselves
Lower interest rates won’t make much difference by themselves. Because most economic activity is driven by consumption and the consumers are home hiding from the virus, it’s them, the consumers, that need to be stimulated.
Low-interest rates will make it easier to borrow, many homeowners will get lower mortgage payments with a refi, but the positive impact will be small and long in coming. Low rates are good, they will help when the economy starts to rebound, but there are other fiscal weapons lawmakers can use with quicker results.
You can see proof of this in the charts. The FOMC lowered rates not once but twice and dramatically both times and was unable to stop the equity market from selling off. Even a $1 trillion spending package from Congress wasn’t enough to curb the selling.
How The Market Should Handle This Outbreak And Prepare For Future Outbreaks
This outbreak is the worst we’ve seen that I can remember but even so, we will get through it and with lessons learned. The first is that action needs to be taken quicker. No matter how innocuous a new sickness may seem it can’t be stopped after it’s let loose on the world.
Travel restrictions may have seemed like an overreaction two months ago but look where we are now. Cruise ships can’t operate, travel is severely curtailed, schools are closed, and I write this article with a kitchen stocked for a month-long stay at home.
Investors should prepare for future outbreaks like this by hoarding cash. Stocks are trading at their cheapest levels in over a decade and ripe for the taking but you can’t buy any if you don’t have cash.
Eventually, the virus will pass and the economy will get back on its feet. When that happens all these cheap stocks will become valuable again and make millionaires out of anyone brave enough to buy.