Economic update: Downside risks still increasing

The outlook for the U.S. and global economy has deteriorated yet again.  Unsurprisingly, the culprit behind the outlook downgrade has been news of the coronavirus’ continued spread.  To be sure, risk assets sold off this week and financial market volatility increased as concerns about the virus and its potential impact on the global economy dented investors’ up-until-recent euphoric sentiment. 

More importantly, worries about the coronavirus come at a time when economic conditions in the U.S. and around the world remain weak and susceptible to unforeseen shocks.  Our view remains that the coronavirus outbreak is likely to have a material impact on the global economy and financial markets assuming its spread is not quickly stemmed.  Therefore, we believe that households and investors should prepare for economic and market weakness in the coming months, notably as the effects of the coronavirus remain wildly uncertain.

Data pointing to further 2020 weakness

Each month we evaluate a host of quantitative and qualitative factors that help guide our U.S. and global economic and market outlook.   Indeed, we utilize econometric models that rely on developments in the labor market, consumer spending, business and household sentiment and rates, among others, to help frame our U.S and global economic views.  The result of this work includes forecasts on U.S. gross domestic product (GDP) growth, inflation and employment conditions as well as a view on major currencies and commodities.  So, what does our latest work show?

Well, the latest update to our models for February suggests that economic growth in the U.S. is likely to deteriorate further relative to our view in January.  More specifically, our quantitative models show that household spending growth is likely to lag behind 2019 even before accounting for the effects of the coronavirus.  At the same time, our models suggest that business investment could slow further as global manufacturing remains weak, while a rebound in the U.S. housing market largely supports positive U.S. private investment activity. 

Looking abroad, various data releases over the past few weeks have pointed to potentially stabilizing global economic growth.  To be sure, the latest reading of the Organization for Economic Cooperation’s and Development (OECD) Composite Leading Indicators (CLIs) are consistent with a potential growth rebound in both developed and emerging market economies.  And this improving trend has been supported, in part, by some better than mixed global business sentiment and a broad rally in risk assets, especially U.S. stocks, from the start of the year.

Figure 1: Downward revision to 2020 growth outlook

Coronavirus uncertainties intensify

Taken by itself, the data would lead us to believe that the growth outlook for the U.S. and global economy, while sluggish today, could pick up into the tail end of 2020.  This is because broad money printing by the world’s key central banks and a still resilient consumer have underpinned spending activity.  

Nevertheless, as we look into the future, we believe that the hard data will begin to reflect renewed weakness in the global economy as coronavirus concerns take hold.  And, as they do, this will challenge corporate earnings growth and subsequently the stock market’s ability to charge to new weekly highs. 

To be sure, this view was reflected in one of our past writings and comes as the coronavirus is poised to change the way firms do business and the way households spend.  For example, just a few weeks ago, as far as market participants were concerned, the coronavirus was largely a China issue as headlines centered on developments in Wuhan. 

Today however, virus headlines have taken a dourer tone as cities in Italy deal with quickly growing number of infections and more reports reflect the spread of the coronavirus across the European continent.  Adding insult to injury, even leaders from the Centers for Disease Control (CDC) report a heightened risk for a widespread coronavirus outbreak in the U.S.  And what does all this mean for the economy and markets?

Figure 2: Pre-coronavirus tentative signs of global economic stabilization

Source: Broadview Macro Research, OECD, 02/26/2020

Unforeseen disruptions

We expect discretionary spending among households in the U.S. and abroad to decline should cases of the coronavirus continue to increase globally.  This consumption slowdown is likely to come from not only mandatory quarantines, but also from voluntary confinements reflecting a desire among the general public to avoid places where the virus could potentially spread. 

This is important because, while eCommerce has increased notably in recent years, spending at brick and mortar stores still accounts for a large portion of retail sales in the U.S. and many developed and developing economies.  And, with household spending being a key component of GDP growth, a slowdown in spending could put renewed downward pressure on the overall global economy and hence earnings growth. 

Another impact stemming from the coronavirus spread is that of supply chain disruptions.  China remains a key supplier of manufactured goods and is integrated into global supply chains that span not just the Asia Pacific region, but also across Europe, the U.S. and other parts of the world.  This is important because it only takes the loss of just one critical component to halt the entire production of a key good.  Today, some governments are exploring ways to get around such supply chain disruptions, but the fact is that China remains a key global supplier of critical manufacturing components.  How do these developments affect our forecasts for the year?

The prospect of a widespread coronavirus outbreak in the U.S. is likely to notably alter of our current estimates of economic growth.  That is, assuming a quick resolution to the viral outbreak is not found and coronavirus concerns intensify, economic growth in the U.S. and globally are likely to move from a moderate slowing in 2020 to sharp slowdown with yet to be determined consequences.  How bad could it get? 

At this point the severity of the slowdown will largely depend on the adaptability of businesses and resilience of consumers to deal with host of uncertainties amidst the threat of a global outbreak.  With that said, the virus comes at a time when our quantitative recession risk indicator is pointing to a rising likelihood of an economic downturn in the second half of 2020.  What this means is that a sharp decline in business and household spending as a result of the coronavirus could be enough to tip the U.S. and global economy into a recession sooner rather than later. 

Figure 3: U.S. recession risk indicator reflects rising likelihood of a 2020 downturn

Source: Broadview Macro Research, 02/26/2020

Preparing for the unexpected

What are households and investors to do in an environment that is charged for more market and economic volatility in the weeks and months ahead?  The fact that risk asset prices remain elevated even amidst the coronavirus headlines has given us reason for pause.  As we’ve noted in prior reports, we believe that the current rally in risk assets has more to do with the Fed’s unsustainable easy money policies rather than solid economic fundamentals.  And this could set the stage for more market pullbacks this year. 

While central bank asset purchases have been supportive of lower borrowing rates and a boost to housing market sentiment, we are hard pressed to find positive catalysts that would support a sharp economic rebound this year, particularly as coronavirus risks have yet to be contained and hence challenge the feasibility of a sustained rally in financial markets.

With the economic outlook set to weaken in 2020 and financial market volatility likely to remain elevated, we recommend that households take some constructive steps to prepare for the unexpected.  For instance, one way to increase financial preparedness and resilience in a time of uncertainty is to reevaluate big-ticket spending decisions and divert more cash flows toward emergency savings. 

This can be accomplished by reducing non-essential spending and refinancing high interest debts in today’s low interest rate environment.  We believe that these steps will better prepare households for unexpected life events, particularly as job opportunities have become less plentiful and labor market conditions show signs of continued weakening into the months ahead.

For investors oriented towards asset growth, we recommend maintaining a diversified exposure in investment portfolios.  This means not chasing hot stocks or trying to time a market bottom.  At the same time, we recommend reevaluating exposure to risky investments to ensure that aggregate portfolio holdings across all investment accounts are in line with long-term goals.  This includes rebalancing to target allocations and trimming winning positions to raise cash to keep as dry powder for when market volatility creates favorable buying opportunities. 

Finally, for households taking distributions from investment, we recommend rebalancing accounts to long-term investment objectives and reduce unnecessary risk taking.  Further, we recommend ensuring that cash positions are adequate to meet 6-12 months of living expenses.  This is intended to avoid forced selling at depressed prices, especially as economic and market uncertainties are likely to rise in the coming weeks and months most notably as the overall impacts of the coronavirus remain wildly uncertain.

About the Author

Peter Donisanu
Peter Donisanu is Chief Financial Strategist and President at Franklin Madison Advisors, Inc. Franklin Madison Advisors is a fee-only fiduciary financial planning and investment management firm based out of Pittsburgh, Pennsylvania and serving clients nationally. We exist to serve a generation that has been underwhelmed by traditional paths to financial security and independence.