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Persistent economic contraction even as businesses reopen

Asia Analytica
Asia Analytica • 9 min read
Persistent economic contraction even as businesses reopen
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(May 15): US stocks led global markets to a strong rebound in April and early May. The Dow Jones Industrial Average and Standard & Poor’s 500 index were up by 11.1% and 12.7% respectively last month, the best monthly gains in more than three decades.

Stock price movements for the past few months have been largely driven by news related to the Covid-19, from initial full-blown fears of a global pandemic to relief that the world is not facing imminent apocalypse.

But what of the inexplicable stock market resilience even as the stream of recent data showed severe damage to economies? The world is in the deepest recession since the Great Depression. Yet the S&P 500 is trading at only 16.9% below its all-time high — and the Dow is about 21.4% off its peak while the Nasdaq is just 9.9% lower.

Historically, financial markets had always overreacted on the downside to sudden shocks when uncertainties spiked, whether they were caused by financial system distress, liquidity squeeze, geopolitical risks or, as in the current case, a pandemic.

But given time, with more data and deeper analysis, markets tend to get it right — foreshadowing Main Street recoveries by months. In other words, the market is often an accurate leading indicator of the economy.

We believe the market rebound — despite short-term ugly economic data and dismal corporate earnings — is probably correct this time too. That said, we would still caution investors against being swept up by the current wave of euphoria.

The strong optimism prevailing in markets right now is being driven by positive news flow on the treatment front as well as rising expectations that a vaccine will become available sooner rather than later.

Numerous potential candidates are under development and some have begun human trials. Last week, the US Food and Drug Administration (FDA) approved Phase 2 human trials for the vaccine, which is being developed by Moderna. The company suggested that the final phase of trials could start within the next few months. An effective vaccine would be a game changer in terms of how we are currently containing the risks.

The quick and decisive actions of governments and central bankers, especially the US Federal Reserve, too have prevented more severe damage to economies and businesses. And they will surely hasten the economic recovery process. Interest rates are near zero and would remain so for a long time.

This strong policy response, the willingness to “do whatever it takes”, is a boost to investor confidence — to the extent that it may be fanning unrealistic expectations of how quickly things will bounce back to where they were.

The excitement surrounding the reopening of economies is understandable. Many countries are near or in the process of implementing phased easing of stringent lockdown measures, including the US, those in Europe and, on the home front, Malaysia and Singapore.

However, lifting lockdowns does not mean things will return to normal. It will not be as easy or smooth as markets seem to be presuming. The odds of economic activities rebounding rapidly, back to pre-crisis levels, are low.

Notice that very few companies have been willing to provide earnings guidance. Either they are being exceedingly cautious or this tells us that conditions really are too uncertain to make a call at this point.

In fact, many companies have slashed or halted dividends altogether — a big taboo under normal times — to conserve cash. For example, Royal Dutch Shell shocked investors by cutting dividends, by a hefty two-thirds, for the first time since World War II. Companies are hunkering down — in stark contrast to the prevailing market optimism. Who knows the company better than its own management?

Investors are choosing to ignore expected dismal earnings for the next one to two quarters, and we believe rightly so. But they may be holding unrealistic expectations of the pace and strength of the recovery. We suspect markets will be in for the long slog — one where share prices have to, ultimately, be more reflective of the underlying fundamentals.

The coronavirus originated in Wuhan, China, the first epicentre of the pandemic. It was the first country to implement draconian lockdowns and the first to have them lifted (starting mid-March), mostly. How it fares is, therefore, a useful playbook for the rest of the world.

To be sure, it is still early days yet, and with limited data points available, it is hard to conclude any definitive trend. But China’s official Composite Purchasing Managers’ Index (PMI) — which is made up of manufacturing and non-manufacturing sectors — carries warning signs of an uneven recovery in the coming months. The data shows recovery stalled in April ­after rebounding sharply in March (due to pre-lockdown order backlogs) (see Chart 1).

Notably, the manufacturing PMI is down to 50.8 in April from 52 in March on the back of sharply lower export orders — as the rest of the world shutters its economies — and limited recovery in domestic consumption. The non-manufacturing PMI was shored up by construction activities while services were flattish. The weak outlook demand has some manufacturers laying off workers (see Chart 2).

The Caixin PMI, which is representative of smaller businesses as opposed to large state-owned enterprises surveyed for the official PMI, should raise even more caution. The index remained below 50 for both months, which signifies contraction. Services, in particular, were very weak even as factories reopened (see Chart 3).

It is not only countries that implemented lockdowns that are suffering, underscoring how interdependent the world really is. For example, Taiwan and South Korea, countries that did not implement stringent lockdown measures, reported manufacturing and non-manufacturing PMI in contractionary territories in April — attributed largely to weakening global demand as well as domestic consumption weakness (see Charts 4 and 5).

Retail sales in both countries reported negative y-o-y growth in February and March, suggestive of a lower “new normal” in consumer spending with social distancing and safety measures (see Chart 6).

The pandemic caused severe supply disruptions owing to restrictive movement measures around the world. It may take some months for complicated global supply chains to normalise as businesses reopen and people go back to work. But they will normalise relatively quickly. Demand, on the other hand, we suspect, will take far longer to recover.

We are seeing globally, job losses of unprecedented scale. For instance, the number of first-time claims for unemployment benefits in the US totalled more than 33.5 million in a mere seven weeks.

The April employment report saw a staggering job loss of 20.5 million. Add this to the 870,000 loss in March, and that means it took only two months to wipe out nearly all of the 22.8 million jobs created in the past 10 years.

The unemployment rate soared past 14.7%, the highest since record-keeping started in 1948, and a sharp reversal from lows of 3.5% before the outbreak. The number would have been about 5% higher if workers unable to look for jobs were not classified as out-of-the-labour force.

Yes, many of these jobs will return once economies reopen. But a good percentage — quite likely larger than most currently expect — may not, at least not for some time, and some permanently. The Congressional Budget Office predicts unemployment will remain at 9% by end-2021.

The services sector, which accounts for a large part of GDP, will be hard hit. Demand for travel and tourism — and therefore jobs in these sectors — could take years to recover to pre-crisis levels, and will have spillover impact on related industries such as hotels, restaurants and entertainment businesses, bricks-and-mortar retailers and others. Coupled with high unemployment, consumer behavioural changes, protracted social distancing and safety measures, these would all translate into subpar sales and higher operating costs for awhile yet.

As job losses mount, lenders — wary of defaults — are also tightening credit standards, including for credit cards and mortgages. All these have to affect consumer confidence and spending, especially for discretionary and big-ticket items such as homes and cars.

Consumers are also likely to spend less and save more, given uncertain jobs prospects.

Weakness in consumer spending will, in turn, affect company profits and create a negative feedback loop. Temporary furloughs could turn into permanent job cuts. Investments and future expansions could also be hurt when businesses are forced to take on more debt to cover short-term cash shortfalls. That will have spillover impact on new jobs creation and wages growth going forward.

There is still much that is unknown with regard to the coronavirus and the pace of restarting economies. Renewed tensions between the US and China in recent days will further add to the uncertainties.

Against this backdrop, it is imperative that investors stress-test companies they are invested in or planning to invest in. Do the companies have sufficient liquidity to tide over extended periods of subpar sales and margins? We discussed this subject two weeks back and published simulations for how long companies listed on Bursa Malaysia and the Singapore Exchange can withstand sustained lower sales, based on their existing balance sheets.

Many small and medium-sized businesses, which typically have limited cash buffers, are likely already in financial distress. Even large businesses cannot escape unscathed. In the US, retailers J.Crew and Neiman Marcus have filed for bankruptcy within the past two weeks — victims of the shift from offline to online commerce, a secular trend now hastened by pandemic-driven behavioural changes.

We expect to hear of more business closures and bankruptcies over the coming months. The world has changed. Businesses will have to adapt to survive. Some business models may no longer be viable and some jobs will be lost forever. But economies will eventually recover, new business models will emerge and new jobs will be created — just not in the next quarter or two.

Global Portfolio

The Global Portfolio fell marginally, by 0.2% for the week ended May 14. Shares in Alibaba Group Holding, Home Depot, Apple and Starbucks were among the notable gainers while homebuilder Lennar and building materials companies BMC Stock Holdings and Builders FirstSource were the bigger losers for the week.

Total portfolio returns now stand at 4.5% since inception. By comparison, the benchmark MSCI World Net Return Index is down by 0.5% over the same period.

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