International Equities

Is this the “Black Swan” event that stock markets fear?

As “Black Swans” are, by definition, unpredictable, it cannot be ruled out - it is still early days.
March 2020

It seems extraordinary to us that the investment world took so long to recognize the threat that coronavirus (COVID-19) posed to the world economy. China, the epicenter of the virus, makes up approximately 16% of world GDP but accounts for a much higher proportion of its annual growth (around one-third).

Global supply chains are now so important (and increasingly complex) that a disruption anywhere can cause alarm, but when the disruption occurs in the world’s second largest economy and the center of production for a vast array of consumer and other goods it can cause far more than alarm. Latest data indicates that manufacturing activity in China plunged in February following wide-scale factory closures.

The virus has now been found in many countries but the disturbing feature is the rate of increase in cases outside China that began in earnest early in the third week of February. The latest countries to cause serious concern include South Korea, Italy, Japan and Iran although that list is being added to on a daily basis. Most countries in Europe have now reported infections. Virtually every day a fresh batch of airline and shipping suspensions are announced.

It will take time to analyse exactly what has occurred and to determine if the initial steps taken to contain the spread of the virus were inadequate or tardy. President Xi Jinping has rigorously defended China’s actions but censorship and obfuscation, which have blossomed under his leadership, make judgement difficult. Reading the China Daily, the English language mouthpiece of the communist party, has never been a reliable guide to the facts, despite heroic efforts by its English-language journalists to smuggle the truth out in plain sight.

The countries most exposed to loss of revenue from collapsing expenditures by inbound Chinese tourists (as a share of domestic GDP) are: Thailand, Hong Kong, Malaysia and Singapore. In terms of export exposure to China the most vulnerable are: Hong Kong, Australia, Taiwan and South Korea.

What is undeniable is that a slice will be taken off world growth in the first quarter and, inevitably, the second – and probably further ahead. Corporate profits were already struggling in many parts of the world so this is far from an ideal scenario. Is this the “Black Swan” event that stock markets fear? As “Black Swans” are, by definition, unpredictable, it cannot be ruled out – it is still early days.

Untangling the UK from the EU

We have now completed one month with the UK technically out of the embrace of the European Union but we have until the end of the year to wait for the transition period to end and the “deal”, if there is to be one, to be clarified. We doubt that Prime Minister Boris Johnson will agree to anything that leaves the UK with any of the EU bureaucratic interference or control that he is so anxious to leave behind but there is many a slip twixt cup and lip. The EU still seems determined to make life difficult for the UK. Now that is what we call short-sighted.

In the meantime, Boris has announced that his government plans to ban sales of any new passenger vehicles in the UK that are anything but fully electric by 2035. In 15 years! We wonder what sort of Kool-Aid he had been drinking when he made that announcement. Has his government thought through the implications for country-wide charging points as well as the impact on the electricity grid? Or the amount of copper, nickel, lithium, manganese and cobalt required to manufacture all of those batteries? Or the CO2 emitted in digging the stuff up? The UK registers more than 2 million new passenger cars every year. Electric vehicles made up only 1.6% of new registrations in 2019. Even new hybrids will be banned by 2035. The implied take-up of fully electric passenger vehicles assumes an average annual compound growth rate of comfortably more than 30%. Boris obviously likes challenges.

Australia's power problem

In a similar climate-related theme the opposition party in Australia (the Labour Party) has joined many others by announcing that if it were in office it would aim for net-zero emissions by 2050. They have not announced how that will be achieved or how much it might cost the economy. That’s the beauty of being in opposition – you can announce what you like if the measurement date is so far in the future that none of the incumbents will then be in a position to be much bothered.

Interestingly, Australia is already experiencing the problems that can occur with a rapid take-up of wind and solar power generation. Australia has probably the fastest rate of rooftop solar panel installation in the world. Recently the government’s Energy Security Board warned of “critical” instability of the power grid because of the intermittent nature of wind and solar generation. Coal-fired power stations typically provide the base load power when sun and wind generation ebbs but they cannot be ramped up and down at will. And, of course, coal-fired power stations are now a political kiss of death so that the chances of any new installations are ranked from slim to nothing. In the meantime, the existing crop of power stations soldier on to old age and ultimate closure. Nuclear would make sense but that is yet another political kiss of death in Australia.

Bumpy political situations in Malaysia...

Malaysia bounced into the political headlines with the resignation of its 94-year-old leader, Dr Mahathir Mohamad. Mahathir had, seemingly, been due (overdue) to hand power to his long-suffering rival, Anwar Ibrahim, but this latest tactic was designed to frustrate Anwar’s ambitions. Mahathir’s political party, (the Bersatu Party) quit the four-party ruling alliance to coincide with his resignation. Dr Mahathir and Anwar have fallen out more times than is healthy and those with long memories will recall politically motivated charges that put Anwar in jail (twice) and away from power. From 1993 to 1998 he served as Deputy Prime Minister to Mahathir.

In a week which provided more twists and turns than any fictional thriller, Mahathir, who was maneuvering to once again resume the Prime Ministership (for the third time), was outfoxed when the Malaysian King swore in Muhyiddin Yassin as the new Prime Minister on March 1. Muhyiddin is a former interior minister and also deputy Prime Minister in the United Malays National Organisation (UMNO) government which was led by Najib Razak but ousted by Mahathir in the 2018 elections. Razak is facing 42 charges in relation to the multi-billion-dollar 1MDB scandal.

Muhyiddin will lead a coalition backed by parties dominated by the country’s ethnic Malay Muslim majority. Mahathir immediately criticized the appointment as being “illegal” stating that “we are going to see a man who does not have majority support become Prime Minister.” He has vowed to fight on as he claims he has majority parliamentary support. This soap opera could run and run.

It is disappointing that Malaysia, a country with much potential, suffers whilst politicians do their very best to make the road ahead as bumpy as possible.

...and in Germany, too

Germany is also suffering its share of political disarray. In early February Angela Merkel’s anointed successor, Annegret Kramp-Karrenbauer, abruptly quit her position as leader of Merkel’s Christian Democratic Union (CDU) party. Within 12 months a general election is to be held by which time Ms Merkel will have retired as Chancellor after 15 years in charge. The centre-right CDU is the key cog in a “grand coalition” with the centre-left Social Democratic Party (SPD) but that arrangement now looks as though it could disintegrate. In a regional election in Hamburg on 23 February Merkel’s party struggled in at third place with just 11% of the vote behind the Greens and the Social Democrats. This was the CDU’s worst ever result in Hamburg. The Greens were the key disrupters as they doubled their share of the vote to 24%.

The successor to Annegret Kramp-Karrenbauer will be elected at a special party conference on 25 April. There appear to be at least four potential candidates but the jostling is in its early stages. Whether the CDU’s fortunes can be revived in time for next year’s general election remains to be seen. Speculation that Ms Merkel may be the CDU’s last Chancellor has begun.

Global economic challenges around the world

The Japanese economy has hit a sizable air-pocket. The economy shrank in the 4th quarter of 2019 following the impact of an increase in the consumption tax from 8% to 10% (on 1 October) and then on 12 October Typhoon Hagibis slammed Japan’s main Island causing widespread damage and costing at least 90 lives. Hagibis is rated as the strongest typhoon in decades to strike the mainland. The economy was already suffering from the ripple effects of the China/US trade war. And now, like many other countries, Japan is battling the economic impact of the coronavirus. China is Japan’s largest trading partner and also its biggest source of international visitors so the country is suffering from a four-fold whammy. It seems inevitable that the economy will shrink again in the current quarter, taking it into a technical recession. There is even speculation that the Tokyo Olympics (July/August this year) may be cancelled if the coronavirus is not brought under control soon. That will be at least one whammy too many.

We noted during February that record low yields were being attained on US corporate bonds. Our nervous system immediately went into overdrive. The spreads on “sub-investment grade” corporate bonds as well as “investment grade” fell below the levels reached in the 2007 mania – immediately prior to the financial crisis. Not only have spreads collapsed but they have done so on a far greater volume of sub-investment grade bonds than existed at the time of the crisis. Morgan Stanley has opined that if companies were rated on leverage alone “over a quarter of the investment grade [bond] market would have a high yield [or junk] rating.” Simple math suggests that even a relatively low default rate of 10% would generate corporate debts in the US several times larger than the sub-prime catastrophe of 2007-8.

The IMF has weighed in with disconcerting comments on the leveraged loan market: “There is a growing segment of the financial world that involves loans…to companies that are heavily indebted or have weak credit ratings. These loans are called “leveraged” because the ratio of the borrower’s debt to assets or earnings significantly exceeds industry norms. The global market for such loans now stands at $1.4 trillion…Most of these loans involve weak underwriting standards and less investor protection, and they are less transparent.”

None of the above can be regarded as music to the ears. It seems that the pursuit of return has pushed investors and speculators into exactly the same trap they fell into in the period leading up to the financial crisis. Institutional memories are getting dangerously short.

Market movements in February were dramatic. Turning firstly to equities we saw the following index falls (MSCI local currency price indices – developed markets): Belgium: -16.0%; UK: -9.8%; Japan: -9.6%; Norway: -9.2%; Germany: -8.6%; USA: -8.3%; Australia: -8.1%; France: -8.1%; Switzerland: -7.6%; Netherlands: -7.3%; Spain: – 6.5%; Ireland: -6.4%; Canada: -6.1%; Italy: -5.9%; Portugal: -5.9%; Sweden: -5.7%; Singapore: -5.0%; Hong Kong: -1.1%; New Zealand: -1.0%. New Zealand is the only developed market in the world to have clung on to year-to-date gains (+2.5%).

The place to be in February was high quality government bonds. The flight to safety was ramped into high gear and yields at the benchmark 10-year end fell dramatically – in several cases to record lows. Here are some of the yield movements over the month: USA: 1.52% to 1.15%; UK: 0.52% to 0.44%; Germany -0.47% to -0.58%; Japan: -0.06% to -0.11%; Australia: 0.96% to 0.84% and Canada: 1.27% to 1.16% (Source: Datastream).

In an effort to finish on an uplifting note (not easy) we can report that in late February a 2½ year-old collie dog called Megan, reared in Northumberland, UK, fetched a record price for a sheep dog of £18,900. It was purchased by a Wagyu beef cattle farmer from Oklahoma. Wagyu beef cattle fetch very fancy prices but now it seems that the gentleman from Oklahoma who purchased Megan will be using another animal with a fancy price to supervise his herd. We trust that Megan can satisfactorily make the switch from sheep to cattle.

And with that doggy tail we leave you for another month.


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