Investors seemed deeply worried this past Friday about the Wuhan coronavirus outbreak, with stock indices around the world tumbling, including a more than 600-point drop for the Dow Jones Industrial Average. As of midday Tuesday, American stock markets, at least, have fully rebounded from that loss.
The volatility in the markets reflect uncertainty about the severity of human effects of the epidemic, which spans a huge range of possibilities: Will the outbreak remain largely limited to China, and begin tapering off there within the next couple of weeks, with modest effects on Chinese economic output and hardly any effect on the U.S.? Or will disruption to business and life in China persist for months, with a pandemic spreading and causing similarly large disruptions in many other countries? Whether we get one of those two outcomes — or something in between — has major implications for financial indicators that have whipsawed in the last few days, including interest rates and stock prices.
Patrick Chovanec, the chief strategist at the investment firm Silvercrest Asset Management and an expert on the Chinese economy, compared the economic effects of the epidemic to those of a natural disaster, where the long-run economic importance depends heavily on the duration of the disruption to business.
“If you have a factory that’s shut down, and it’s shut down for a week because of a cyclone, then next week you’re just going to use more capacity to meet your back orders; the actual amount of economic activity and output isn’t diminished hardly at all,” he said. “If things go on for an extended period of time, you actually start to lose orders.”
China’s hope has been to endure a brief shutdown: Many businesses were instructed to extend their Chinese New Year holiday closures by approximately a week. In theory, that means many of them should be reopening around February 10. If that happens, the Chinese economy won’t be unscathed — service businesses like restaurants will have lost business during a holiday when they expected to do especially well, and unlike factories, they won’t be able to make it up with overtime shifts — but the economic damage will be manageable.
Ernie Tedeschi, a former Treasury Department macroeconomist with the investment research firm Evercore ISI, has been watching U.S. financial market expectations of future, short-term Treasury rates to quantify market participants’ assessments of the risk to the U.S. economy from the epidemic. If investors expect the Fed to cut rates more, that presumably means they expect more economic problems which would necessitate rate-cutting action by the Fed.
Tedeschi pins the start of major worries among market participants at Martin Luther King Jr. Day weekend; the quantity of stories on the Bloomberg terminal about the outbreak was “an order of magnitude” higher on Tuesday, January 21, than Friday, January 17, he says. And from January 17 through January 31, market expectations for short-term interest rates at year-end fell by 0.26 percent, meaning investors had shifted their views to expect the Fed to offer an additional quarter-point cut, right as they were getting more nervous about coronavirus.
It is important to note, market expectations about future interest rates are probabilistic. The shift didn’t mean market participants were sure coronavirus would hurt the U.S. economy enough to require exactly one additional rate cut; rather, it was a measure that incorporated a significant possibility of no major economic effects and no additional rate cuts, and also a possibility of significant economic effects requiring several rate cuts.
But since January 31, the signs that sentiment on Wall Street has improved go beyond rising stock prices. Interest rate expectations have rebounded, too: That expectation of one additional quarter-point rate cut has turned into an expectation about half of an additional quarter-point rate cut. Again, that’s a probabilistic measure — the Fed doesn’t move in eighths of a point — but market participants seem more inclined than they were on Friday to believe that coronavirus will have more limited effects on the U.S. economy, and therefore, on future interest rates.
For comparison, the suite of economic troubles that led the Fed to implement a “mid-cycle adjustment” of interest rates last year — largely, these had to do with weak economic growth in China and Europe and the president’s trade-war actions — ended up requiring, in the Fed’s view, 0.75 percentage points in interest rate cuts. If you attribute moves in interest rate expectations over the last three weeks to coronavirus worries, you might say the market is assessing coronavirus as likely to be about one-sixth as bad for the U.S. economy as those problems were — so, not huge.
One problem with assessing the economic outlook for coronavirus has been great uncertainty about the epidemiological outlook. People are skeptical about the completeness and accuracy of Chinese data on its spread, and estimates of both contagiousness and mortality rates have varied widely. That’s a reason Chovanec will be watching whether those planned factory openings in China happen on schedule: If they do, that will be a sign the Chinese government is truly confident it is getting a handle on the epidemic and its economy will normalize.
“We’ll find out within a week or two whether they meet their objectives of going back to work and lifting the restrictions,” Chovanec says. That added clarity should show up in financial markets — in one direction or the other.