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Coronavirus, the Fed, and the steady 2020 that wasn’t

Eric Compton  |  04 Mar 2020Text size  Decrease  Increase  |  
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2020 started off as another seemingly normal year for the economy. There were, of course, the quotidian worries about slowing manufacturing output in certain parts of the world, a generalized but moderate slowdown in global GDP, and if we could ever get inflation trending higher again.

These really weren’t new concerns; these were the normal, daily economic apprehensions of a formerly placid 2020. This has all changed quite dramatically due to the global outbreak of the coronavirus.

Officially recognising these evolving risks, the Federal Reserve has cut its target rate by 50 basis points, to the 1-1.25 percent range. The Fed released a statement on 28 February, stating that it was closely monitoring the situation and that it would “act as appropriate to support the economy.”

people walking with face masks on

2020 started off as another seemingly normal year for the economy but has transformed due to the coronavirus outbreak

The markets interpreted this statement as a direct signal that the Fed would imminently cut rates, and the markets have been proved right, as the Fed released another brief statement the morning of 3 March stating that the Fed was lowering its target rate by 50 basis points. The vote was unanimous.

The Fed’s rate cut was not part of our original rate outlook for our banking coverage. Originally, before the outbreak of the coronavirus, we had been predicting that rates would remain flat for 2020. With this new development, banks are in a tough place.

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The average USD LIBOR had already dropped roughly 60 basis points since January, and 10-year US treasury yields have dropped roughly 80 basis points since the start of the year. Regardless of the ultimate effect of the coronavirus on the economy, lower rates today will be a negative for bank profits.

If the coronavirus has a materially negative impact on the economy, this will be another negative. There is no way for the banks to escape this unscathed. We will incorporate the new rate outlook into our traditional bank coverage and estimate that our current fair value estimates may drop by a low-single-digit percentage, on average.

This was the first official act of monetary policy in response to the coronavirus. Other governments have taken similar measures, and some governments have even begun to implement fiscal policy responses to the coronavirus, such as Hong Kong and Italy. The US has not yet responded with any fiscal policy measures.

We emphasize that there is still much uncertainty. We don’t know how long rates will stay low, or if the Fed will cut rates even further. We also don’t know how impactful the coronavirus will be on the global economy in general, or the US economy specifically.

In a worst-case scenario, supply chains could freeze up, consumers could stop spending, and a recession could begin imminently. Lower rates, lower activity, and higher credit costs could all hit the banks.

However, there are other, less severe outcomes that are also possible. Predicting the ultimate rate and range of the spread of coronavirus is a difficult task, and predicting how people will react is also difficult. The banks are getting cheaper, but we don’t have any 5-star calls yet. Investors should understand the risks within banks.

The worst-case scenario is not yet fully priced in, in our opinion, but if the virus is eventually contained, the economic impact could be limited, and today’s prices will have been good entry points.

is an equity analyst for Morningstar.

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