In recent weeks we have highlighted the limited response of equities to the coronavirus outbreak, contrasting with commodity, bond and FX markets, which all showed significant signs of concern. The S&P 500 reached a record high just 9 days ago.
This was the week when equity complacency was finally punctured, as profit warnings multiplied and the virus spread rapidly outside China. US health officials warned that it was only a matter of time before person to person transmission of the virus occurred in the US and that the public might have to prepare for disruptions to daily life.
Fed officials remain watchful of the virus but confident. Fed Vice Chair Clarida said it is “still too soon” to say whether the outbreak would cause a material change to the US outlook.
But interest rate markets are not waiting – the implied rate on Fed funds by end-2020 has tumbled from 1.20% as stocks peaked last week to 0.84% today. In its December update, the FOMC projected that the funds rate would be held steady at 1.50-1.75% throughout 2020.
Westpac’s base case remains for 3 rate cuts this year, mostly premised on US growth and inflation falling short of consensus.
The market rethink on the Fed has halted this year’s sharp US dollar upswing which was arguably premised on US insulation from Covid-19. The dollar is down against the Japanese yen and major European currencies over the past week.
But the Aussie continues to underperform, sliding as far as 0.6543, its weakest level since March 2009. The jitters over the US economy may be growing, but Australia will surely suffer greater economic pain from what Prime Minister Morrison declares is likely a global pandemic.
While the coronavirus has dominated market attention this week, Australia’s domestic data calendar is picking up pace. Fourth quarter construction work slumped 3% as falls in private sector residential, commercial and engineering construction outweighed a rise in public infrastructure.
This posed downside risks for GDP growth but there was a glimmer of hope in the Q4 business investment survey, with a small rise in capital expenditure on plant and equipment. Australian business investment plans for the financial year starting in July also improved.
It’s a very busy week ahead too. The RBA Board meeting takes place Tuesday. Westpac expects the cash rate to be held at 0.75%. Given the sharp increase in concern over the impact of Covid-19, market pricing for a shock rate cut has ticked up to a 15% chance.
A rate cut is now fully priced by June and the terminal cash rate is projected at a record low 0.28% by February 2021, not far from Westpac’s view.
Most likely the RBA will retain a wait and see approach on the virus, with its monthly meetings providing plenty of scope to respond if the growth outlook deteriorates further.
The RBA will also be keen to see Wednesday’s Q4 national accounts. Westpac looks for growth of 0.5% in the quarter, 2.1% over the year. This is a pretty lukewarm pace but unfortunately Q1 is shaping up as much worse given the bushfires and coronavirus, with our current estimate for zero percent quarterly growth, just 1.5% over the year.
Meanwhile, Australia’s government has extended its travel restrictions on arrivals from China for another week. This is a very challenging outlook for the Aussie dollar.