MIKE TOWNSEND: If you look at just a sample of headlines in the last week or two—from “World Stock Markets Tumble on China Coronavirus Fears” and “Global Markets Are on Edge as Coronavirus Spreads” to “Wall Street Shrugs Off Risks Related to Viral Outbreak in China”—it can be hard to know what to make of the latest outbreak and its impact on the markets. Personally, I’m always skeptical when headline writers and financial news analysts try to sum up a given market performance by attributing it to a single factor.
Hi, everybody, I’m Mike Townsend, and this is WashingtonWise Investor, an original podcast from Charles Schwab, where I try to cut through the noise and the nonsense of Washington and help investors figure out what is really worth paying attention to. Coming up, I’m going to explore the investing and policy implications of the rapidly expanding health crisis in China. But first, let’s take a look at other stories at the top of the news.
As was expected, President Trump was acquitted last week by the Senate, ending the impeachment process. And it means that Congress can get back to the regular business of legislating, something that’s been mostly on the back burner since 2020 began.
Despite the bitter atmosphere on Capitol Hill in the wake of the impeachment process, I do think there are some real possibilities for bipartisan compromise in the weeks ahead. Now, one of the myths of politics is that Congress can’t get anything done in an election year. Now, setting aside for a moment the idea that Congress can’t get anything done in any year, election years often prove to be quite productive. In fact, if you look at the re-election years of our past three presidents—Barack Obama, George W. Bush and Bill Clinton—all three signed significantly more bills into law in the election year than they did in the third year of their presidency. Why is that? Because Members of Congress need to run for re-election, and they need to be able to tout their accomplishments in Washington on the campaign trail. That makes them more willing to compromise.
I see two major issues ripe for compromise in the next few months. First, on health care, there is broad bipartisan support for action in two areas: ending so-called surprise medical billing and reducing prescription drug costs. There are bipartisan bills to accomplish both goals, and I think they have a real chance of being approved.
The other issue is infrastructure spending. Now, it seems like Washington talks every year about spending on infrastructure—both Republicans and Democrats are virtually unanimous that the nation needs significant investment in its roads, bridges, and ports and the like. The president specifically said in last week’s State of the Union address that he would sign an infrastructure bill into law when Congress sends him one. But the sticking point has always been how to pay for it.
Earlier this month, House Democrats unveiled a five-year, $760 billion infrastructure spending plan. That plan did not include any mechanism to pay for it. Democratic leaders instead invited Republicans to put their spending plan on the table, and then the two sides could sit down and figure out how to pay for it.
Now, I think it’s unlikely a massive spending plan for infrastructure can be agreed to this year—mostly because paying for it would likely mean raising the gas tax or finding some other tax increase that might be a difficult sell to voters in an election year.
But there is a chance for a smaller, more targeted infrastructure spending package. That’s because the law that currently funds the federal surface transportation program expires in September of this year. That’s the law that allocates dollars to the Highway Trust Fund, which is the source for federal money that can be spent on surface transportation projects—roads and bridges mostly. Every five years, Congress must reauthorize the program, and that time has come again. And that provides an opportunity for lawmakers to inject at least some dollars into road projects. Don’t be surprised if the two sides agree to a modest package—perhaps $50 billion or $75 billion—later this year. It will give lawmakers of both parties something they can point to on the campaign trail, with an eye toward a larger infrastructure spending package in 2021.
Turning now to the Election 2020 update, New Hampshire voters go to the polls today in the first primary of the Democratic presidential campaign. And I think there is no question that New Hampshire’s role has grown even larger in the wake of last week’s chaos in Iowa. Iowa’s first-in-the-nation caucuses became a debacle when technological glitches delayed the reporting of final results for several days.
Here are my four quick takeaways on what happened in Iowa:
First, the “winners” of the Iowa caucuses did not benefit nearly as much as they might have. Former South Bend, Indiana, Mayor Pete Buttigieg and Vermont Senator Bernie Sanders had the best outcome. But they missed out on the victory speech and headlines the next day and carried less momentum into New Hampshire than they otherwise would have.
Second, the flipside of that is also true. Candidates who finished further back, like former Vice President Joe Biden, who was fourth, were not hurt as badly by the result as they might have been.
Third, I think a real beneficiary of the chaos is former New York City Mayor Mike Bloomberg, who did not compete in Iowa and is skipping the next three states—New Hampshire, Nevada and South Carolina, as well. Bloomberg’s focus—and his hundreds of millions of dollars—are going into the 14 states that vote on Super Tuesday on March 3. This is an unconventional strategy that really has no precedent in the modern era of presidential campaigning. The only way it works is if no clear front-runner emerges from the first four states—and, after Iowa, that looks more plausible.
Finally, I’ll join the chorus of pundits and analysts who have said that last week likely ended the long-standing tradition of the Iowa caucuses being up first on the presidential campaign calendar. Iowa was already under lots of pressure from other states that want to be first, and those states had legitimate arguments that Iowa, which is overwhelmingly white and has a heavy concentration of older voters, does not really represent the rest of the country. The embarrassment and confusion of the caucus process last week is likely the final blow for Iowa. Sometime in the next year or two, don’t be surprised if a revamped primary calendar is announced that has some other state leading off the process for the 2024 election.
One other election note: The Democratic National Committee quietly made a change to the qualification rules for its debates going forward by dropping the requirement that candidates have a certain number of donors. Candidates still have to hit certain polling thresholds to qualify for the debate stage. It’s widely assumed that this change was made so that Mike Bloomberg can potentially join future debates, starting with next week’s debate in Nevada. Bloomberg, of course, doesn’t have any donors—he’s self-funding his campaign. Now, Bloomberg still has to hit the polling threshold, and he has not yet done that, so it’s not certain that he will be on the debate stage next week. But other candidates had begun to grow frustrated that they were not having an opportunity to face Bloomberg in a debate format, so the change was made to at least make that possible going forward.
On this week’s Deeper Dive, I want to explore the investing and policy implications of the rapidly expanding health crisis in China. The coronavirus is a new virus that has resulted in unprecedented efforts to contain it from spreading. It’s got everyone anxious, from travelers and business leaders to investors and even policymakers here in Washington.
To discuss the implications for the market—and what lessons we can learn from previous pandemics—I’m joined today by Randy Frederick, vice president of trading and derivatives at the Schwab Center for Financial Research. Welcome back to the program, Randy.
RANDY FREDERICK: Thanks for having me, Mike. It’s great to be back.
MIKE: Well, Randy, let’s begin by talking about how this outbreak is affecting the markets—what have you seen over the past couple of weeks?
RANDY: Well, I’m sure everyone knows the market pulled back a bit, but I think it’s important to put this decline into perspective. First, just prior to the coronavirus outbreak, which hit the news on Tuesday, January 21, the S&P 500® had just hit an all-time high on the previous trading day. At that point, the S&P 500 was up 3.1% YTD; and that came after an impressive return of 28.9% in 2019.
Now, since October 11 of last year, when President Trump first announced that the phase one trade deal with China was imminent, the S&P 500 had risen 13.3%. That means that about 40% of the gains in 2019 came after the trade deal was formally announced on October 11; and the largest pullback in that three-month period was less than 2%.
So from that perspective, this 3.1% decline from peak to trough was relatively small in scale compared to the impressive gains we’ve seen in the market lately—and it only lasted two weeks. And when you consider the last correction greater than 10% happened in Q4 of 2018, the markets were statistically overdue for a correction, and that made them especially vulnerable to this “black swan” event. Black swan events are ones that are impossible to predict and also impossible to hedge against. We never know where, when, if, or how they might occur, and this outbreak definitely qualifies.
For now, though, the market doesn’t really seem too worried about it.
I will say I’m a bit surprised that the rebound has been so quick and so sharp. In just three days, the market gained back all of the loss, even though there hasn’t been much of a slowdown in the outbreak or a lot of progress to contain it.
MIKE: Yeah, Randy, I was also surprised at how quickly the market rebounded after that initial pullback. As you look at historical comparisons, is the market reacting differently to this outbreak than it has to others? I’m thinking about the bird flu in 1997 or SARS in 2003—how much did those events impact the market?
RANDY: I won’t pretend to be an epidemiologist, but I think it’s always useful to take a look at history, because it can be helpful in avoiding an overreaction. Now, our colleague, Jeff Kleintop, has an excellent article, published last week, that discusses how previous epidemics have impacted global markets, and I would encourage everyone to read it.
Focusing primarily on the domestic markets, I compiled information on the impact to the S&P 500 caused by the 16 largest outbreaks, only eight of which were significant in the U.S., going all the way back to the polio epidemic of 1952.
Now, this was quite a challenge because even reliable sources often had contradictory information on the initial dates of the outbreak, the total number of cases, and how long the outbreak lasted.
Based on what I could gather from sources like the World Health Organization and the Centers for Disease Control and Prevention, if the information we are getting is accurate, the total number of cases for this new virus is now greater than 28,000, as of this recording, which far exceeds the 2003 SARS outbreak, which was around 8,400. But that’s not the whole story. While this new coronavirus outbreak appears to be much more contagious, it also seems to be much less deadly. Only about 2% of those contracting the disease have died so far, whereas it was about 10% with SARS. And there’ve been only two confirmed deaths outside mainland China.
As you mentioned previously, we should always be skeptical when we try to blame the movement in the markets on just one cause, especially when the data is a bit fuzzy.
Case in point, it might be easy to correlate the sharp drop in January of 2016 to the Zika outbreak, when in reality, it was much more likely caused by a sharp drop in crude oil prices to a 13-year low. And that drop started about 6 months before Zika, so it wasn’t caused by travel restrictions.
When I looked at how the S&P 500 moved during these previous outbreaks, the current reaction is not atypical. In most cases, the market’s reaction was moderately negative initially, but also rather short-lived. Over the first 30 days, the largest downturn in any of these cases was less than 7%, and over 90 days, it was less than 8%.
MIKE: Well, that’s great data, Randy. You mentioned Jeff Kleintop’s article. Jeff is Schwab’s chief global strategist, and I agree that his article is a must-read if you’re interested in more information about how the market has reacted to previous outbreaks. I’ll put a link to that article in the show notes.
But I want to follow up on your point about the accuracy of the information. There’s a serious concern that accurate information and data is not coming out of China, and there’ve been a lot of reports that the outbreak is even more serious than is being reported. Yet we live in an incredibly interconnected time, a time of 24/7 news coverage of just about everything. So are you worried that we are not getting an accurate picture of what is happening? And is the market worried about that?
RANDY: Virtually all data coming out of China—whether it’s economic, geopolitical, or something like this virus—should be viewed with some skepticism. Now, I say that not because China is intentionally trying to mislead us, as some people assert. But simply because China is a very large place. Not the physical size of the country, which is actually about the same size as the United States, but rather the population, which at 1.4 billion is more than four times the population of the U.S. That means gathering and aggregating data is significantly more complex than doing so in the U.S.
Some of the research I’ve read also indicates that there are likely many cases of this virus being reported as pneumonia or regular flu. So even if we assume that the Chinese government is being completely forthcoming on this issue, it’s likely that the actual number of cases is still being underreported.
MIKE: Well, what do you make of China’s efforts to control the spread of the disease? They have basically isolated a city of 11 million people, one of the 20 largest cities on the planet, a city much larger than any city in America. And one of the most amazing things was watching China build a new hospital for coronavirus patients in Wuhan in just ten days—if you haven’t seen it, there is a fantastic time-lapse video of the construction that you can watch online. But China seems now to be putting the full resources of its government behind the effort to combat the virus, right?
RANDY: What we do know is that the virus was first discovered sometime in December, though the Chinese government kept quiet about it for at least a month. That was probably a mistake. But I agree—now they seem to be making significant effort to control it. China is an authoritarian government, and some human rights groups say some of the restrictions are a bit extreme.
I do think that a temporary ban on live animal sales at these so-called “wet markets” is a good plan, and it might even be something that should be made permanent, assuming, of course, that they can enforce it. Like SARS and MERS before it, many experts believe this virus may have come from bats and may have been transmitted to humans through an animal called a civet, both of which are sold at some of these markets.
MIKE: Well, Randy, let’s discuss what the market is concerned about with this outbreak—it’s the potential impact on China’s economy and the ripple effect that could have across the globe. China’s the second largest economy in the world—so what’s the potential risk here for China’s economy? We’re already hearing that this is having a dramatic effect on consumer spending and the manufacturing sector in China.
RANDY: Well, as I mentioned a moment ago, equity markets seem to have already put the issue aside. But despite all of China’s efforts, we really haven’t seen major progress in slowing the spread of the virus, and we don’t know when or if a vaccine will be developed. I do think the markets will be watching for how long this drags on and continues to pull down the Chinese economy.
I’ve seen several forecasts that say this outbreak could subtract as much as two full percentage points from Chinese GDP in Q1. And since China was targeting 6% growth, that puts them in the range of 4%-5%. Even if those numbers are accurate, if the outbreak is brought under control before the end of Q1, there still could be a substantial rebound in Q2—enough to get them back to a 6% average.
Historically, previous viral outbreaks have not had a significant or lasting impact on the U.S. economy, though some Wall Street estimates say it could subtract as much as 0.4% from U.S. GDP in Q1. Government economists, however, are forecasting a more modest 0.2% impact initially, but I would say that ultimately depends on how long it lasts.
MIKE: Well, there’s certainly some impact, potentially, down the road, for the U.S. economy. But I think there’s already growing implications for U.S. companies. The travel industry, particularly airlines, is already being impacted by the travel restrictions in and out of China. And supply chains for countless American companies are being impacted. So what types of businesses are potentially most affected?
RANDY: Well, you know, China really stepped onto the world stage when it joined the World Trade Organization at the end of 2001. And when the SARS outbreak happened a little more than a year later, China was only about 4% of global GDP. But now, 18 years later, China is the second largest economy in the world as you said, and it represents about 15% of global GDP.
We’ve already heard from Hyundai that they can’t get parts out of China—they’re having to suspend production at some of their South Korean factories. Depending on how long the outage lasts, it could start to impact U.S. manufacturers. Think of all the automobiles, smartphones, computers—and the list goes on and on and on—that use parts produced in China.
And as the Chinese consumer has become wealthier, not only is China a significant component of global supply chains, they’re also a large consumer of manufactured goods. So Apple and Nike for example, two companies that are known for manufacturing a lot of goods in China, also get about 11% and 17%, respectively, of their sales revenue from China.
Now when the news first broke, the immediate impact was felt in the most obvious places. There was a 6% drop in transportation stocks as travel restrictions were implemented, which in turn spilled over into an 11% drop in energy stocks, and crude oil, which was already in about a 4% downturn, dropped another 16% and dipped into bear market territory briefly.
If the travel restrictions last long enough, there’s little doubt it will be felt in global restaurant, hotel, and retail chains—especially those that have a presence in China.
MIKE: Randy, if the crisis drags on for a while, do you think the U.S. has a role to play in helping China—not just in battling the disease but in helping economically?
RANDY: While the U.S. has pledged to help China fight the virus, it could certainly offer some economic help, too, by temporarily lifting some of the tariffs on Chinese exports. The phase one trade deal calls for China to purchase $200B more in U.S. goods and services over the next two years, including more than $30B in agricultural products. These targets equate to over a 90% increase in U.S. imports over the 2017 levels, which is where they peaked, and the U.S. would need to boost total exports by as much as 18%. Both of these are substantial increases that might have been impossible for either side to meet, even under ideal circumstances. So this virus only adds to the difficulty.
And since China is offering a 50% cut in tariffs on about $75 billion in U.S. goods, a reciprocal gesture could be in the offing.
So Mike, let me turn this around and ask you a question. When this virus first broke, the U.S. quickly formed a task force, and it implemented a comprehensive travel ban. Now President Trump’s economic team has acknowledged that the virus will likely delay some of the exports; but they expect the impact to be minimal. Is that realistic at this point?
MIKE: Well, I think it’s really too early to tell. It really depends on how severe the impact on China’s economy turns out to be. The U.S. and China signed that phase one trade deal less than a month ago, and as you mentioned, there’s already concern that China won’t be able to hit the targets that were set for its increased purchases of agricultural products and other U.S.-produced goods, mostly due to the sharp decrease in consumer spending in China that has resulted from the outbreak. But there’s really nothing for the U.S. to do. There’s a provision in the China trade deal that specifically addresses natural disasters or other unforeseen events, which this certainly qualifies. We’ll have to see how it all plays out.
I do think that the administration is taking the crisis seriously. As you mentioned, the government quickly formed a 12-person senior leadership task force that brings together agencies across the government—the Defense Department, the State Department, Homeland Security, the Centers for Disease Control, National Institutes of Health, among others. The State Department’s travel advisory is at the highest level—it’s the same advisory that the government has for Americans traveling to places like Afghanistan and Syria. And the mandatory 14-day quarantine for any travelers returning from the most affected parts of China is pretty dramatic.
But it’s hard to know what comes next. The key is going to be how much time it takes to get the virus under control. For now, I think official Washington remains mostly in a wait-and-see mode.
Well, Randy, this has been a great discussion, but my final question is perhaps the most important: What should investors be doing about all of this? Should investors be in a more defensive posture? Or is this something to just ride out?
RANDY: Well, as I mentioned previously, during past virus outbreaks, equity markets usually react in a moderately negative fashion at first, but those downturns tend to fade fairly quickly. Of the eight U.S. outbreaks I looked at, five of them had a small decline that lasted less than 30 days, and only during the AIDS outbreak in mid-1981 was there still a material downturn, about 7.4%, after 90 days.
As we talked about earlier, there’s little doubt it will have some sort of negative impact on Q1 GDP, especially in China. How much though, it all depends upon how long it lasts. For now, patience may be the best course of action.
However, if this virus turns out to be different, and there’s always that risk, then the domestic markets could be vulnerable to another, even more significant, downturn. At the moment, though, they’re acting as if it’s already over.
MIKE: Well, I think that’s the right advice, Randy. Probably no need right now to act hastily, but keep an eye on the outbreak in the coming days and weeks to see whether it is brought under control or threatens to impact the U.S. markets more than it already has.
Well, Randy Frederick is vice president for trading and derivatives at Schwab and you can follow him on Twitter: @RandyAFrederick. Well, thanks so much for joining me, Randy.
RANDY: You’re welcome, Mike. It was great to be with you, Mike.
MIKE: Well, time now for the Why It Matters segment. Each episode, I take a look at a story you might have missed and tell you why I think it’s important. This week, I thought I’d have a little fun by looking at the Super Bowl Indicator. Now, this is the idea that if the winner of the Super Bowl is from the NFC, a bull market follows, while if the winner is from the AFC, a bear market follows. It’s been correct 40 out of 53 years—a 75% accuracy rate, though it’s been incorrect the last three years. This year, of course, the Kansas City Chiefs of the AFC won, so the tradition says it will be a down market year.
But there’s another way of looking at the outcome. History also says that if the teams combine for 46 or more points in the Super Bowl, the market goes up by an average of 16%, as compared to an increase of just 6% when the teams combine for fewer than 46 points. This year, 51 points total were scored—so that bodes well. Of course, none of this really matters—you can find interesting correlations between stock market performance and just about anything, if you look. But congratulations to Chiefs fans everywhere.
Finally, I want to wrap up by just mentioning what I am watching for in this week ahead. It’s an interesting week for the Federal Reserve. Today and tomorrow, Fed Chair Jerome Powell delivers his semi-annual testimony on monetary policy and the state of the economy to Congress. He’ll appear before the House Financial Services Committee today and the Senate Banking Committee tomorrow. Expect a lot of questions from lawmakers about whether the Fed has enough tools at its disposal to respond if the economy slows, especially in the face of an unpredictable event like the coronavirus outbreak.
And on Thursday, the Fed will remain in the spotlight when the Senate Banking Committee holds a confirmation hearing for the two nominees to fill the open seats on the seven-member Federal Reserve Board of Governors. Economists Judy Shelton and Christopher Waller will make statements and respond to questions as the Senate begins the confirmation process. Waller, a long-time official at the St. Louis Fed, is widely expected to be easily confirmed. But Shelton, who most recently was the U.S. director of the European Bank for Reconstruction and Development, has more controversial views in her background, so expect her to get the bulk of the tough questions at Thursday’s hearing. If the two are approved by the committee in a vote that will likely come later this month, that would set them up for a final confirmation vote in the full Senate sometime in March. Now, the Fed has not had a full complement of seven governors in more than six years—now it seems possible that streak could come to an end.
Well that’s it for this edition of WashingtonWise Investor.
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For important disclosures and a transcript, see the show notes at schwab.com/washingtonwise.
I’m Mike Townsend, and this has been WashingtonWise Investor. Until next time, keep investing wisely.