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by  Eric Lascelles Jan 27, 2020

What's in this article:

  • Wuhan virus
  • US election update
  • Central bank mandates and actions
  • Brexit next steps

I’ve had a complicated week. In addition to the usual trials of life on the road, one of my flights was cancelled on short notice such that I missed a presentation altogether (sorry, Kelowna!), I have learned that my name is being used as part of some sort of German scam (don’t ask), and I am now nursing a mild cold at a time when concern about the Wuhan virus means that sniffles are viewed as highly alarming! On that last subject…

Wuhan virus:

  • As flagged in last week’s #MacroMemo, the Wuhan coronavirus continues to spread, spooking markets and becoming increasingly relevant from an economic perspective.
  • Having entered the public consciousness less than a month ago, there are now more than 30,000 Chinese citizens under observation, nearly 3,000 confirmed cases and 80 deaths. These figures are rising quickly – there are more than 10 times as many cases as there were just a week ago, and some days have experienced an outright doubling in confirmed cases. That said, the number of infections outside of mainland China remains limited.
  • It is unlikely the virus has already peaked given what is known about the incubation period and also possible under-reporting of cases.
  • The epicentre of the illness is in the city of Wuhan, China’s largest central city with a population of 11 million. The city also plays an outsized role in transportation, sitting roughly equidistant between Beijing, Shanghai and Hong Kong.
  • This new disease surfaces memories of the SARS epidemic of 17 years ago, and also of more recent outbreaks of Ebola, the Zika virus and MERS.
  • It is notable that none of those illnesses ultimately exerted a lasting influence on economies or financial markets. In turn, the default stance with regard to the Wuhan virus must surely be to view the market decline with skepticism, or at a minimum to acknowledge its likely impermanence.
  • SARS is the most common disease to which the Wuhan virus is compared. Among commonalities, both are coronaviruses and both emerged from China. Relative to SARS, there are several reasons to feel more optimistic about the world’s ability to handle this new illness:
    • The fatality rate – albeit still very much subject to debate – appears to be approximately 3%. While enormously higher than for the flu (below 0.1%), this is less than a third of the 10% fatality rate for SARS. Furthermore, the disease appears to fell the old and infirm more readily than the young and healthy.
    • The World Health Organization has not (yet) declared this a public health emergency, unlike with SARS.
    • Science has advanced such that the Wuhan virus that new cases can already be identified with confidence. This took months with SARS.
    • Most countries have better protocols in place today to screen, treat and limit the spread of serious outbreaks. Many of these protocols were inspired by the mishandling of SARS.
    • China – where the disease originated – has made particular strides in its transparency and efforts to limit the spread of the disease. As examples, China has limited the movement of people in the Wuhan area and will soon complete two brand new hospitals in the region.
    • As emerging markets such as China have grown wealthier, their hygiene standards have also improved. This should further limit transmission relative to 17 years ago.
    • Scientists believe they may be able to develop a vaccine more quickly than they managed for SARS. In fact, SARS was eliminated before the vaccine had a chance to be widely distributed. It is possible that a vaccine could arrive quickly enough to make a difference in this disease’s progression.
    • The increased ability to shop electronically and work remotely should further reduce the economic dislocation should a significant fraction of the population choose to isolate themselves in their homes.
  • However, on the pessimistic side of the ledger, the Wuhan virus transmission rate may be higher/faster than with SARS. Three pieces of evidence bear this out.
    1. The Wuhan virus has already risen to nearly 3,000 cases and is still rising by 40% to 100% per day. By comparison, SARS only ever infected 8,000 people. The Wuhan virus will likely have spread more broadly than SARS ever did within the next few days.
    2. Some scientists believe the new virus is mutating more quickly than SARS did. SARS took several months to transition from an illness that had bridged the species gap to one that could leap from human to human. The Wuhan virus has done this in no more than a month. This could make it difficult to pin down.
    3. Whereas the SARS incubation period was just 2 to 7 days, the Wuhan incubation period appears to be longer – from 2 to 14 days. To the extent the virus may be capable of infecting others before symptoms appear, this makes it harder to quarantine people before they have had a chance to infect others. It also hints that we have probably not come close to the maximum level of infection yet.
  • Other challenges include:
    • A world that has grown increasingly connected by air travel over the intervening 17 years, with far more Chinese citizens in particular now hop-scotching the world;
    • The timing of the outbreak during Chinese New Year, when people are travelling home for the holiday; and
    • Its positioning during the Northern Hemisphere winter, when the simultaneous presence of colds and flus (and their similar symptoms) makes first-blush diagnosis of the Wuhan virus more difficult.
    • All of this said, a point of comparison provides some calming context. The U.S. alone expects roughly 18 million cases of the flu this season. Even with a tiny fatality rate, this adds up to 14,000 anticipated deaths. Last year was unusually bad, with roughly 80,000 deaths in the U.S. alone. It would take a remarkable surge for the Wuhan virus to induce death on that scale, and yet we accept the annual culling associated with the flu with barely a remark.
  • Economic implications:
    • From this point on, everything is highly speculative. The economic damage so far is likely nil outside of China, and limited within China. However, the damage can only grow.
    • The economic damage theoretically arrives in a variety of forms: fewer workers due to illness and for precautionary reasons; and fewer shoppers and travelers due to concerns about being infected in public spaces.
    • Looking back to SARS, Chinese GDP growth briefly slowed by 2ppt on an annual basis, while Hong Kong suffered a temporary decline in output.
    • Canada was disproportionately hit by SARS among developed-world nations, with the economy actually shrinking in Q2 2003 during the worst of the epidemic. In contrast, the U.S. economy continued trucking along as the country suffered fewer cases.
    • However, all of these economies managed to rebound briskly as soon as SARS was resolved, and none suffered any obvious lasting damage. This episode will likely follow a similar trajectory. There will likely be a palpable hit to China’s economy but this should prove short-lived, in part because China will likely deliver more economic stimulus, in part because conditions should almost immediately normalize as soon as the disease abates.
    • One complicating factor this time for China is that, to the extent many migrant workers made it home to their ancestral villages, they may be reluctant to return to the big cities until the disease is under greater control. This could limit Chinese manufacturing production for a period of time.
    • While we cannot speak with any confidence as to how long the Wuhan virus will remain problematic, the aforementioned prominent diseases – SARS, Zika, MERS and Ebola – have generally been resolved in a matter of months rather than lingering for years.
    • For the moment, we have not adjusted out global growth outlook. In fairness, whereas we had contemplated a growth upgrade for China, that may now be sidelined.
  • Market implications:
    • The market implications of the Wuhan virus are already visible – a pivot toward a risk-off trade in which government bonds are rallying and the stock market is retreating.
    • The virus interacts with the market via weaker economic growth, but also directly through certain sectors in that tourism could be particularly impeded and service-sector activities such as retail could also be damaged. To the extent that air travel may fall in response to concerns about transmission, the price of oil has also declined.
    • Whether the market recoil continues will depend entirely on whether the situation continues to deteriorate to a greater extent than currently imagined. To the extent the incubation period really is two weeks long and transmission truly is possible asymptomatically, we flag the risk that the outbreak proves worse than currently imagined. But no less relevant is the observation that in every prior episode, those lows have ultimately represented buying opportunities.

U.S. election update:

  • Let us start on the Republican side of the aisle. President Trump’s impeachment trial in the Senate is now underway, but extremely unlikely to go far. The Republican-majority Senate, the extreme partisanship of U.S. Congress and the onerous requirement of a 67/100 vote majority necessary to convict combine to make it virtually impossible that Trump will be removed from office. He is thus the presumptive Republican candidate come the November presidential election.
  • On the Democrat side, the nomination race is starting to truly heat up. The field is down to 12 candidates, and if history is any guide, should be down to no more than two or three within the next two weeks. No one has ever captured the nomination without finishing in the top two in the New Hampshire primary, which will be held on February 11, just after the Iowa kick-off on February 3.
  • We are inherently skeptical that two tiny and mostly homogenous states provide the same window into the intentions of a highly heterogeneous America that they once did, and the importance of the endorsements and fundraising advantage that come with early wins – while still significant – have surely diminished in an era of online fundraising and the readier flow of information (and dis-information). Nevertheless, most political pundits continue to believe it is crucial to get off to a strong start, and so it is highly significant that far-left candidate Bernie Sanders has now taken the lead in those first two states, with a market-assigned 60% chance of victory in Iowa and 70% in New Hampshire. Accordingly, betting markets now put Sanders at the top of the charts with a 37% chance of capturing the Democratic nomination (see chart).
  • Sanders’ far-left advance represents something of a reversal relative to the trend of the past several months, when moderate candidates such as Joe Biden and Michael Bloomberg had come to the fore at the expense of the now diminished far-left darling, Elizabeth Warren.
  • While Sanders will likely emerge from the first two states with the lead, this is not yet certain. Furthermore, former Vice President Joe Biden is likely to benefit from a more diverse voter base in later primaries, such that betting markets assign him a nearly one in three chance of capturing the final nomination, and professional forecasters such as fivethirtyeight.com continue to argue that Biden remains the most likely winner. Do not underestimate the desire of the party establishment to have a moderate candidate with a better shot at beating President Trump (in hypothetical head-to-head matchups, polls show Biden leading Trump by 4.5 points versus a 3 point lead for Sanders over Trump).
  • Interestingly, Michael Bloomberg continues to increase his probability of capturing the nomination, now landing in front of Warren, Yang and Buttigieg. He has run an unconventional campaign, entering late, deploying his own massive wealth in a wall of ads and remaining staunchly centrist in his views at a time when the public appears to yearn for far-from-centre ideas.
  • As it stands now, the centrists (Biden and Bloomberg) and the far-left candidates (Sanders and Warren) are now effectively in a dead heat, with each group possessing an identical 44% chance of capturing the nomination. Markets would prefer the centrist candidates, and the recent surge of Bernie Sanders may help to explain the stock market’s recent caution above and beyond coronavirus news.
  • Most betting markets believe the race for the White House is very close, with a slight edge usually accorded to Trump (notwithstanding the earlier figures showing that the two most prominent Democratic candidates would beat Trump in a head-to-head matchup – betting markets are skeptical that it would truly play out like this). Models that use the incumbent’s popularity argue that Trump has a low probability of being re-elected. Conversely, those that incorporate economic variables such as the low unemployment rate and a high stock market argue Trump is a lock. History shows that incumbent presidents win a second term most of the time. We ultimately believe Trump has a better than 50% chance of winning the 2020 election, and perhaps even a higher likelihood than accorded by markets. While this represents a potentially chaotic outcome, it is arguably the market’s first choice, as financial markets arguably prefer the tax cutter they know to what could be much less business-friendly economic policies from the left.

Central bank mandate reviews:

  • The central banks of the U.S. and the European Union are both conducting major mandate reviews. These don’t come along very often.
  • In plain English, this means they are reviewing whether to change how they communicate, what tools they use, and even what their objectives are.
  • Most of the time, little changes after a policy review. The Bank of Canada goes through a rigorous process every five years, surfacing new ideas and then – usually – shooting them down as impractical or not obviously superior to the existing framework.
  • Here are some of the more prominent options for the Fed and ECB:
    • Higher inflation target: This is theoretically attractive in that it provides more room for monetary stimulus in the event of a downturn, but with the side-effect of undermining economic growth the rest of the time (and imposing an even higher real tax rate on investors). The ECB could technically pursue a slightly higher inflation target, but only in that it could pivot from its current ludicrous objective of “below, but close to, 2%” to a simple 2% target.
    • Price-level targeting: This is the more serious policy option on the table. Instead of pursuing a 2% inflation rate every year regardless of what happened in prior years, central bankers could try to course-correct. That is to say, a year of 1% inflation would mean the central bank would try to deliver 3% inflation the next year (or spread over the subsequent few years).  This has highly attractive theoretical properties in that, so long as the commitment were credible, inflation expectations should rise whenever inflation is surprisingly low. In turn, this means that the real interest rate actively falls even after bumping into the zero lower nominal bound. Thus, central banks can’t run out of stimulus. However, for this to work, economic actors need to be credulous. If, as seems to be the case in the real world, many people would be skeptical as to the central bank’s ability to deliver high inflation in the future when it is struggling to even manage normal inflation at present, then the whole approach fails. This is why the Bank of Canada ultimately rejected the idea. The Fed may yet manage to transition to a more qualitative form of price-level targeting by allowing inflation to run a bit hot after having been unusually cool for a long period of time. But we have long felt that this was already implicitly the approach of many central banks.
    • Single/dual/triple mandate: The ECB currently has a single mandate – inflation. It is possible it could add the unemployment rate as a second mandate. In practice, the ECB already manages policy with an eye to this variable, but such a move might improve the central bank’s image with the public and politicians while changing little of its actual conduct. For the same reason, the U.S. is unlikely to abandon its pre-existing dual mandate. The idea of adding a third mandate, financial stability, is reasonable but unlikely to be formally implemented. It is already effectively in place thanks to central banks paying heed to the long-run inflation and economic outlook (which gets hurt when financial crises occur), and it would arguably be folly to add a third variable to optimize when central banks only have one lever to pull.
    • Communication: With only a few exceptions, central banks have become ever more transparent over time, setting fixed meeting dates, publishing statements, minutes and transcripts, releasing forecasts and dot plots, hosting press conferences and communicating views via speeches. While it is hard to see how they could become much more transparent, that certainly represents the ongoing trend.
    • The environment: The ECB is also debating whether the environment should be factored more centrally into its conduct of monetary policy. The Bank of England has also mused on this subject. While the environment is certainly a critical consideration for the world’s well-being and for central banks indirectly via its effect on the state of the economy, it is not clear how interest rate policy could play a direct role in ameliorating the environment. This seems to be more the domain of fiscal policy.
    • Negative rates: The ECB maintains a negative deposit rate. We continue to argue that negative rates have probably been a mistake, creating distortions and failing to truly stimulate growth beyond what a 0% rate could achieve. Sweden has already recognized this, opting to abandon its negative rate policy. We are not sure that the ECB will admit any error in judgement so quickly, but it is possible that the central bank could stage a retreat back to 0% after the mandate review.
  • While there are more items on the table than usual, do not forget that it is fairly rare for central banks to significantly shift their policy framework. The best bet is that little will fundamentally change, though a few issues are not completely locked down.

Central bank actions:

  • Bank of Canada: The Bank of Canada left its policy rate unchanged, but now appears to be positioned such that a rate cut could be delivered fairly easily. As the Bank acknowledged, Canadian GDP barely grew in the final quarter of 2019 and is set for muted growth in the first quarter of 2020. The labour market is also running more slowly than before. While far from certain, we continue to believe that the Bank of Canada is more likely to deliver rate cuts than most other central banks, in part because of the country’s idiosyncratic challenges, in part because it neglected to ease while others were cutting in 2019, and in part because the currency was the strongest among major developed-world currencies in 2019.
  • Federal Reserve: The Fed’s meeting this week is likely to be a sleepy affair, with no rate change, no forecast update and no updated dot plots. The central bank has already indicated there is a fairly high bar before it would be willing to cut or hike. The accompanying press conference could unveil some comments about the Fed slowing the rate at which it is buying bonds, but this is more of a technical matter relating to the functioning of the repo market than a question of monetary policy. While rate cuts are far from assured, we continue to believe the Fed is notably more likely to ease than to hike, especially in an election year.
  • Bank of England: The BoE meeting could be an interesting one. Markets believe there is a very real chance of a rate cut. These odds had initially faded but have again risen, in part as risk assets have declined and in part as concerns about the Wuhan virus have dimmed global growth expectations. But the meeting is a peculiar one, in that it represents Mark Carney’s last as governor. Whether that means the BoE should be more willing to act as a parting gift from Carney, or instead that they are less likely to move in deference to the imminent arrival of a new governor, is unclear. To the extent the BOE was another central bank that failed to ease in 2019, we believe the bar is fairly low for a cut at this or subsequent meetings.

Brexit update:

  • The U.K. withdrawal agreement from the EU has received royal assent. This means that the U.K. is on track to exit the EU as of midnight Friday January 31. EU parliament is scheduled to approve the proposal on Wednesday and EU nations should provide assent on Thursday.
  • That said, recall that the U.K. will continue to abide by (and enjoy the benefits of) EU regulations through the end of 2020. As such, the U.K. economy shouldn’t be too different as of this Saturday, February 1.
  • Over the transition period, the U.K. and EU will negotiate feverishly in an effort to arrive at a new permanent deal (as opposed to the temporary transition arrangement that they spent much of the past few years haggling over).
  • A pessimistic stance on the matter goes as follows:
    • Eleven months isn’t much time to negotiate a sophisticated agreement, particularly given that much shallower trade agreements between the EU and the likes of Canada and Japan have taken many years.
    • Furthermore, all 27 EU parliaments (not just leaders) will also have to ratify any deal by the end of the year.
    • While there is the possibility of an extension, the U.K. has indicated it doesn’t want one and logistically an extension would have to be requested by the middle of 2020 whereas it is unlikely to be apparent until the end of 2020 whether one is actually needed.
    • Recent negotiations have demonstrated there continues to be a divide in terms of what the U.K. wants and what the EU will provide.
  • That said, not all hope is lost:
    • By virtue of the tight deadline, the two parties are unlikely to procrastinate and should be highly motivated to reach a deal.
    • Both parties have known these negotiations would eventually arrive for more than three and a half years – surely some advance planning has already occurred.
    • The EU is something of a pro when it comes to trade negotiations, having penned several large deals recently, the contents of which could be repurposed toward the U.K.
    • Negotiations over the interim deal have already laid bare what each side wants. While they remain apart on some matters, the positions at least are known.
  • For the moment, we have three main thoughts.
    1. The risk of a No Deal Brexit is significantly diminished since last fall. It certainly isn’t down to 0% to the extent that negotiations could well fail and the new deadline is fairly tight. But whereas the risk of a No Deal Brexit was perhaps 40-60% last September, it is more like 15% today.
    2. We expect some form of free-trade agreement (FTA). We’d certainly prefer a deep FTA, but this may be difficult to achieve unless the U.K. acquiesces to an extension. If the existing deadline sticks, a shallower FTA is perhaps more likely, and ideally built upon at a later date. The latter situation would do more economic damage than the former, but both are much superior to a No Deal Brexit.
    3. To the extent that a lot of uncertainty and bad news has already been priced into the U.K., we are feeling somewhat better about U.K. prospects going forward. The economy has already suffered its lumps; uncertainty is somewhat diminished; we don’t expect the pound to depreciate any further; and U.K. equities look distinctly cheap.

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