While the safe-haven trade dominated market behavior this week, the decline in interest rates is also sending a message: the U.S. may be holding up better than its neighbors, but it is not immune to the growth-retarding threat posed by the coronavirus. Indeed, with the 2-year Treasury yield at 1.34 percent sitting well below the Federal Reserve's policy rate, currently at range of 1.50-1.75 percent, the market is also harboring growing expectations that the Fed will cut rates again to cushion the economy against the threat. Until recently, expectations of a central bank put gave solace to equity investors. But the market retreat now underway suggest investors are less confident that that a rate cut would be effective in staving off a recession if the disease is not contained soon.
For its part, the Fed officially remains on standby. According to the minutes of the July 28-29 FOMC meeting released this week, most participants were cautiously optimistic about economic conditions, bolstered by recent trade agreements and a strong job market. While Fed officials were comfortable with the current stance of policy, expecting to keep interest rates unchanged for the foreseeable future, there was a palpable sense of concern over the coronavirus and the downside risks it poses to the economy. The key takeaway was that the Fed is poised to act if the negative impact on the economy is greater than expected. Interestingly, while the outbreak has intensified since the meeting. two Fed officials - regional bank presidents Bullard and Bostic - opined that the virus should deliver no more than a short-term shock to the economy. Clearly, the financial markets view that perception with a good deal of skepticism.
That said, the broader picture that depicts diverging trends among nations is holding fast. The virus is exacting the biggest economic and human toll on China, where tens of millions of people are on lockdown, stifling spending, production and overall growth. Asian neighbors whose economic fortunes depend heavily on China and are also experiencing an increase in outbreaks are struggling mightily as well. But the spillover effects extend far and wide, thanks to the interconnectedness of the global economy that links broad swaths of industries with supply chains in a multitude of different countries, with China looming among the largest of the suppliers.
Distance matters, and while the U.S. is vulnerable to supply-chain disruptions (note the travails of Apple and other tech firms) it is less impacted by the plunge in tourism that is taking a big bite out of smaller economies, particularly in Asia. The question for the U.S. is whether the demand disruption will become more of an influence going forward. For sure, spending related to tourism has fallen sharply, hitting airlines and revenues at many leisure and hospitality establishments. To the extent that the global slowdown weakens foreign demand for American goods, exports will suffer as well and impose a further drag on an already-struggling manufacturing sector.
But the U.S. economy derives most of its strength from domestic sources, and the evidence so far is that the virus has not meaningfully impaired domestic demand. That could change, of course, if the disease morphs into a global pandemic stoking fear and uncertainty among households. Another virus-related catalyst that could send consumers into hibernation would be a severe market correction. By itself, the negative wealth effect from a sharp decline in stock prices would not derail consumption: only a small fraction of the population holds the vast majority of stocks, and an abrupt sell-off is not likely to alter the spending habits of these wealthy shareholders.
But a broad swath of households views the stock market as a barometer of the economy's health. Hence, a severe market correction could well unleash a damaging blow to consumer confidence, particularly if it is sustained and undercuts job security. Keep in mind that corporate leaders are highly sensitive to their company's stock prices, and they could well put budgets on hold in response to a sharp market sell-off that appears to be more than a temporary correction. By many measures - and in the eyes of many analysts - the stock market is already overvalued, so it may not take much to trigger a downward spiral in prices.
It is not unusual for external shocks like the one currently roiling the financial markets to generate doomsday scenarios. More often than not perceptions outrun reality, causing markets to overreact to evolving reports. We suspect that a similar situation is unfolding unless the coronavirus goes unchecked and accelerates much beyond previous outbreaks, such as the SARs, Mers and Ebola episodes over the past two decades. By all accounts, the fundamentals underpinning the U.S. economy are still supportive of continued growth. The labor market remains healthy, consumers are still spending, albeit at a slower pace, and even the beleaguered manufacturing sector showed signs of stabilizing prior to the onset of the virus.
What's more, the housing sector has become a pleasant wild card in the economic landscape, providing more of a growth boost than expected a few months ago. Home construction surged to a 13-year high in December and hardly gave back any ground in January, according to this week's report by the Commerce Department. Housing starts in January did slip from December's eye-opening 1.63 million annual rate to a still formidable 1.57 million pace. But the setback was smaller than expected and starts exceeded expectations. Last month, the volatile multifamily sector showed more strength than the much-larger single-family sector. But single-family home construction - which has more of an impact on economic activity - is poised to lead the way in coming months.
