The US Federal Reserve cut its policy rate by 50 basis points today, highlighting the serious challenges facing the global economy. Still, we don’t believe investors should cut risk. Very few have an informational edge regarding COVID-19’s market impact, and investors could be left underexposed when and if markets rebound.
Is the emergency rate cut good news or bad news? It’s a bit of both. The good news is that the central bank has aggressively cut borrowing costs to support the economy, even as the spread of COVID-19 within the United States has been limited so far. The bad news is that this first inter-meeting cut since 2008 telegraphs the Fed’s fears of near-term recession risk. Additionally, the Fed has limited capacity to further cut rates and it’s not obvious that even-lower borrowing costs will inoculate the US economy.
The Fed’s preemptive strike may appear aggressive, given that most US economic data still paint the economy as robust. However, US consumer and business activity appears to be changing as the virus spreads beyond China. US consumers are emptying store shelves of hand sanitizer, and businesses are throttling back travel. A significant increase in US cases is likely this month as testing efforts accelerate. Will school closings, postponed meetings, and canceled sporting events follow? Also, what about the global economic impact of China’s shutdown? Chinese purchasing managers’ index (PMI) data released last week revealed a huge hit to the domestic economy, one that dwarfed the US PMI impact in October 2001 following the September 11 attacks. China now accounts for about one-fifth of global economic activity, and over the past five years it has driven more than one-third of real global GDP growth.
Is the United States at an elevated risk of falling into a recession this year? Arguably, yes. Is a recession priced in to US markets? Yes, for the bond market (the ten-year Treasury yield is at historic lows), but probably not for the stock market.
Please see Aaron Costello, Pandemic Risks and Reactions, CA Minute, February 28, 2020.
Investors that believe recession risk is elevated and stock markets aren’t fully baking in a recession may wonder whether they should decrease equity exposure. We argued against that in the February 28 edition of CA Minute and continue to do so today. Why? Very few investors have an informational advantage in assessing COVID-19’s future economic impact. Investors who follow a disciplined rebalancing process during stress periods don’t always make the “correct” decision in hindsight, but they reset their market exposure back to target levels with a long-term focus, and they avoid missing out on the eventual rebound.
Sean McLaughlin, Head of Cambridge Associates’ Capital Markets Research