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by  Eric Lascelles Mar 2, 2020

What's in this article:

  • COVID-19 update
  • Central banks response
  • U.S. election update

I’ll admit to using a lot of hand sanitizer these days as COVID-19 concerns mount. My state of paranoia is surely not helped by the fact that I’m up to my eyeballs in research material about the disease. The contours of my job – substantial plane travel and meeting new people at every port of call – suddenly seem rather less attractive than before! For that matter, I can only imagine the herculean efforts that would be required to trace back the point of infection if I ever did contract it – “No, doctor, those three cities, five presentations, two sporting engagements, subway ride, music lesson, dental appointment and school pickup were all just yesterday…” Stay healthy everyone!

COVID-19 update:

The COVID-19 virus continues to spread around the world, with 87,137 confirmed cases as of March 1. While more than 90% of these remain within China, the growth rate is faster outside of the country. Nations with particularly prominent outbreaks include South Korea, Iran, Italy and Japan. That said, concern is rising in many markets, and the U.S. has recently suffered its own outbreak, attracting copious market attention and a declaration of emergency in Washington State.

The Chinese situation has become incrementally less severe over time, with fewer new cases per day and the economy midway through the gradual process of restarting after a multi-week shutdown. However, it is slightly worrying that, after a long decline, the number of new daily cases is no longer falling – instead, it has gotten stuck at about 450 new cases per day. The growth rate is still low in percent terms – just +0.7% per day – but suffice it to say that the Chinese part of the story may not be complete just yet, particularly as people return to crowded workplaces.

In the rest of the world, the trend has been of a rapidly rising number of infections, with more than 1,000 new cases reported in each of the past three days (see chart). Intriguingly, the latest day yielded slightly fewer new cases than the one before it, but it seems unlikely that this represents a genuine peak.

Increasing COVID-19 global cases (ex-China)

Increasing COVID-19 global cases (ex-China)

Note: As of 3/2/2020. Source: WHO, RBC GAM

With so many COVID-19 cases in such a variety of places, it will be difficult for governments to contain it from here. Governments face a difficult decision: balancing the health of their economies against the lives of their citizens. The answer likely seems obvious – save lives – but economic damage can be hard to recover from, and any resulting poverty and unemployment are also relevant concerns.

Economic channels

The virus interacts with the economy through a variety of channels. The financial market channel has already been fully triggered, with stocks down sharply and financial conditions accordingly much tighter than they were at the start of the year (see next chart).

Global financial conditions tighten amid risk-asset sell-off

Global financial conditions tighten amid risk-asset sell-off

Note: As of 2/27/2020 for U.S., 2/26/2020 for global. Source: Goldman Sachs, Bloomberg, RBC GAM

The closely-related confidence channel has also triggered. This category spans such matters as diverse as business hiring and cap-ex decisions, and whether to go on vacation, shopping or to a restaurant. The confidence channel even affects the willingness to make big ticket purchases like buying a new car or home. The counterpoint that people may stock up on emergency supplies provides only a partial offset. Our Google search index points to a high level of concern about the virus, though interestingly this has faded slightly from its recent peak (see next chart).

Google search containing ‘coronavirus’ globally

Google search containing ‘coronavirus’ globally

Note: As of 2/29/2020. Interest over time represents search interest relative to the highest point for the time period shown (100=peak interest). Source: Google Trends, RBC GAM

The mortality rate is not yet a binding factor for the economy: the number of deaths so far remain tiny relative to the overall population. However, the temporary loss of workers via quarantine is a very real economic drag and arguably represents the primary constraint on economic growth. Fortunately, it is inherently temporary.

Supply chain issues also become more relevant over time as the inventories of companies that continue to function are depleted, and as companies that attempt to restart their production are stymied by the inaction of others further up the supply chain.

Finally, to the extent a quarantine or uncertainty lasts for a lengthy period of time, more enduring forms of economic damage begin to accumulate. These include businesses failing, banks dealing with delinquent loans and businesses cancelling expansion plans. We are hopeful that China’s quarantine was not long enough to trigger much of this last, most pernicious, form of economic damage.

Chinese economic damage

Actual evidence of the temporary damage done to China’s economy is now starting to roll in. The country’s manufacturing PMI (Purchasing Managers’ Index) plummeted from a neutral reading of 50 to an awful one of 36 in February. The non-manufacturing sector recorded an even larger drop, from 54 to just 30. These will hopefully represent the low water marks, as March is already tentatively somewhat better.

Satellites show that China emitted drastically less air pollution in February 2020 than in February 2019, a clear indication that the manufacturing sector was effectively shuttered. Turning to higher frequency measures that capture day-to-day changes, the country’s labour migration index is already about three-quarters of the way back to normal and a Freight logistics activity index is back to nearly 70% of normal. However, the IRPP coal consumption index and Urban civil transportation index have only made the slightest of rebounds so far.

Developed-world scenarios

We’d like to think COVID-19 should inflict less damage on the developed world than it has in China, for a variety of reasons:

  • Developed countries have a larger service sector and a greater fraction of white collar jobs that can be done from home during a quarantine.
  • The developed world has enjoyed considerable advance warning from China, and has also been able to observe China’s best practices. Confirming that these are important considerations, it is instructive that other regions of China have not been hit as badly as was the point of origin in Wuhan. This suggests that the transmission and fatality rates are lower in places that have had time to prepare.
  • Developed nations have fewer people living at a subsistence level, such that quarantines can in theory be implemented more comprehensively.
  • Crucially, developed countries have stronger medical care.

Admittedly, the timing is not optimal for this shock to the extent it comes at a time when developed economies are already dealing with “late” business cycle readings. Our yield curve recession model has now upgraded the risk of recession to 34% from a low of 22% at the start of 2020.

Scenario analysis

There are any number of ways this outbreak could play out from here.

Several optimistic outcomes are entirely possible:

  • In concert with the observations above about developed nations, it is conceivable that increased vigilance outside of China manages to take the infection rate below the critical threshold of one, meaning that the virus peters out by itself, without requiring further medical innovations. This is what happened with SARS.
  • Alternately, it could be the case that the true fatality rate –accounting for all of the people who likely had mild infections but were never formally diagnosed, and factoring in improving medical care as the disease is better understood – is significantly lower than the current 3% estimate. If the true fatality rate were just 0.5%, for instance, this would be only moderately higher than the flu and likely not necessitate widespread quarantining.
  • Another best-case scenario reflects the possibility that the virus could cease to spread as readily once the northern hemisphere morphs from winter to spring. That would buy more time for a vaccine.
  • Finally, researchers are hard at work on a vaccine, and may in theory be in a position to deliver one in as little as a few months. Granted, producing the vaccine on a mass scale would take additional time.

At the opposite extreme, a worst-case scenario involves the virus continuing to spread without cease, forcing nearly universal quarantining, resulting in large scale loss of life and imposing a multi-percentage point hit to the global economy. It seems as though many analysts have jumped all the way to this conclusion, though this may be premature.

A medium scenario has certain regions of certain countries imposing limited quarantines and special health measures, but perhaps allowing younger people and those without chronic health problems to remain engaged in the workforce given the substantially lower fatality rate for those groups.

Our stance

To the extent governments are primed to lend a considerable hand (more on that in the next section) and the historical experience with modern pandemics is that they are short-lived and do not ultimately require worldwide quarantining, our best guess is that COVID-19 will play out somewhere between the medium and the best-case scenarios. Accordingly, our forecasts assume nearly a full percentage point is subtracted from Chinese GDP growth in 2020, with 0.4 percentage point subtracted from global GDP growth.

As a result, from a financial market perspective, we tend to view the recent retreat in risk assets opportunistically, looking to take advantage of these cheaper valuations that should deliver superior returns over the long run.

Central bank response:

It will be a busy time for central banks over the coming weeks as they decide what to do about COVID-19. We believe monetary policy will rise to the challenge, cutting interest rates shortly.

Bank of Canada

The Bank of Canada renders its next verdict on March 4, and is now very likely to cut the overnight rate. In a sense, this has been a long time coming. The Bank failed to ease in 2019 when its neighbor to the south was busily delivering stimulus, pushing Canada somewhat offside in a relative sense. The Bank of Canada had then hinted over the past few meetings that it was at least considering a return to easing, albeit mainly for domestic rather than international reasons (the country’s Q4 GDP print was a feeble +0.3% annualized).

With the arrival of COVID-19, markets now view a cut as a foregone conclusion, and are instead debating whether a 25bps or 50bps move is most likely. One could certainly make the case for a 50bps shift given the abruptness and potential depth of the economic shock. That said, Canada opted to move in mere 25bps increments during the oil shock of 2015, suggesting a preference not to use all of its ammunition at once. It really could go either way, and a further cut or two is entirely conceivable later in the year. For comparison, markets now price in more than 75bps of easing by the end of 2020.

U.S. Federal Reserve

In contrast to the Bank of Canada, the Fed does not have a meeting on its calendar for this week, but it does later this month, on March 18. It is also likely to cut rates, conceivably by 50bps in one fell swoop.

The Fed had initially set a fairly high bar against further easing, arguing that a “material change” to the outlook would be necessary to justify additional cuts. But COVID-19 is an indisputably “material” development, and tighter financial conditions present a strong argument (see earlier chart). Furthermore, Fed Chair Powell recently promised to “act as appropriate” in the context of the virus, hinting at imminent action.

Financial markets price in a total of three to four rate cuts by year end. This is quite a contrast to the beginning of 2020, when less than one cut was assumed. We concur with the market that substantial further easing is now likely.

Other central banks

Emphasizing that this prospective monetary policy response is hardly constrained to North America, China has already eased significantly in response to its own economic woes. aThe Reserve Bank of Australia (RBA) is also widely expected to ease on March 3. Australia will provide useful insight into the thinking of central bankers, though it should be conceded that the RBA has occasionally marched to its own drummer.

The European Central Bank and Bank of Japan have less obvious room for major monetary stimulus, but they should at a minimum address possible liquidity needs or make a symbolic gesture.

Special considerations

It is possible that central banks will opt to ease before their fixed decision date. The COVID-19 shock is such that the sooner monetary stimulus can be delivered, the better. But it is a balancing act between this and spooking markets by overreacting with an urgency not demonstrated since the dark days of the global financial crisis.

Another possibility is that rate cutting could be done in a coordinated fashion. Whether that means all would act on the same day or simply that central banks collectively acknowledge the need and value for everyone to return to easing, but on their own schedule, is unclear.

For all of this potential action, it is an open question whether lower interest rates would actually help very much if economies are forced to temporarily close. No amount of monetary stimulus will bring workers back into the office if the government tells them to stay away, though the subsequent journey back to normal output would be somewhat smoother.

U.S. Democratic race:

The Democratic race was starting to look like a foregone conclusion as far-left candidate Bernie Sanders excelled in the first three states. But it now a race again after South Carolina yielded a triumph for moderate Joe Biden. He picked up 48% of the support, more than twice Sanders’ 20% figure. While this was just one state, it could prove a bellwether for other ethnically diverse states. And with that, we have ourselves a race (see next chart).

Several lesser lights announced their exit from the race, including brief frontrunner Pete Buttigieg, Amy Klobuchar and Tom Steyer. In turn, betting markets now assign a 57% chance that Sanders will capture the nomination this summer, down from 62% a week ago. Conversely, Biden has surged to a 31% chance, up from just 12% last week. Centrist Mike Bloomberg remains the other semi-viable name still in the race, with a 10% chance of winning. Elizabeth Warren’s prospects have shrunk to just 2%.

Who will win the Democratic presidential nomination?

Who will win the Democratic presidential nomination?

Note: As of 3/1/2020. Based on prediction markets data and RBC GAM calculations. Source: PredictIt, RBC GAM

Next up is “Super Tuesday”, a cavalcade of 14 states voting on Tuesday March 3. These include giant states such as California and Texas. To provide some context, the three states so far have furnished just 155 delegates. In contrast, an eye-watering 1,344 will be awarded on Super Tuesday, more than a third of the total available in the entire race.

Sanders is expected to pick up such giant states as California and Texas, but this does not necessarily seal the deal for him as the Democratic process allocates delegates roughly proportionally to vote count rather than in the all-or-nothing format of the general election.

The possibility of a contested convention is non-trivial, though the risk is arguably shrinking as contestants drop out. Moreover, a contested convention is inherently rare, not having occurred in nearly 70 years. A contested convention would probably be to Biden’s advantage, to the extent that party-insider “superdelegates” would be unleashed in the second round and likely favour him.

Just as President Trump’s odds of securing a second term were rising while Sanders was ascendant, Trump’s probability advantage over the Democratic nominee has now fallen from 12 points last week to 9 points today, presumably in response to Biden’s surge.

-With contributions from Vivien Lee and Graeme Saunders


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