Principal Global Investors

Economic Insights: Viral headwinds surge across borders
March 2020
Commentary by Robert F. Baur, Ph.D., executive director, chief global economist, andRobin Anderson, Ph.D., senior global economist

The body blows to world growth just keep coming.
New cases of coronavirus in China have fallen by
80-90% from early February, and manufacturers there areresuming operations. But the surge in new cases outside
China suggest the global economy will struggle throughmid-year.
Stock markets tanked the last week of February, taking
only four days to plunge more than 10%--the shortest
time in history. Stocks are more attractive now than in
mid-February, but a sustained rally is unlikely until newcases peak outside of China.

Chinese businesses resuming activity
The Chinese Lunar New Year began January 25. The holiday
ran from January 24-30, then extended to February 2 after theexplosion of coronavirus cases. In Hubei province, location ofWuhan and the center of the epidemic, businesses closed until
at least February 13, according to National Bureau of Statistics(NBS) surveys. The manufacturing gauge collapsed from 50.0
last month, exactly break-even, to a dismal 35.7, showing
significant contraction. For service businesses, the plunge wasto 29.6 from 54.1. Both are record lows.
The good news is that new confirmed coronavirus cases in China
numbered 427 on February 28, down from nearly 4,000 dailya few weeks ago. As total active confirmed cases trend lower,
quarantines are lifting and businesses are resuming operations.
According to Cornerstone Macro, Volkswagen and GM restarted
a portion of production; Airbus will reopen its Tianjin plant; andCaterpillar will have most plants in China running. Starbucks hasreportedly reopened about 85% of its outlets. The NBS notedthat at medium- and large-scale manufacturing enterprises,
the resumption rate as of February 25 was 85.6%, rising to an
expected 94.7% at the end of March.
Large businesses are restarting much faster than small ones, thelatter being more vulnerable to cash-flow problems. Standard
Charter’s survey on small- to medium-sized businesses showed
the worst reading ever, with data history going back to 2014.
According to the Wall Street Journal, citing survey researchers
from Tsinghua and Peking universities, one third of small

Economic summary
After gaining momentum through January, revival from last year’s
world slump has been interrupted. The recent uptick in coronavirus
cases outside China has investors fearing the worst. But it will besome time before we’ll know how far the virus spreads. Disruptions
are already evident in Italy, Japan, the Middle East, and South Korea.
New cases with unknown origin are rising in the U.S. In the worst
case, sizeable, lengthy closures would augur against a sharp reboundnext quarter, as lost wages can’t be recovered. Small businesses withdelayed revenue streams may close, causing defaults and credit
stress. On the plus side, central banks are accommodative and will
become even more so.
If the virus can be contained, there should be enough pent-up
demand to supercharge a revival as the virus subsides. Then, thepickup in world growth that was apparent before the outbreak will
be delayed, not derailed. This is a downside shock, a large negative
event, but, probably, not a long-lasting trend.
In the coronavirus aftermath, a long-term trend for global companies
may be a new awareness of the hazards of far-flung manufacturing
supply chains. When Mother Hubbard opens her cupboard and finds
no goods to sell, producers will reimagine their supply sources. Plant
closures in China may accentuate the move to shift production closer
to the center of final demand. With labor markets tightening in mostdeveloped countries, this would give some impetus to inflation inboth the short- and long-term.

businesses had only a month or less of cash on hand. Beijing
officials are aware of the problems and will make credit available.
Interest rates have already been lowered. Plans for more
infrastructure spending are ramping up. China has allowed banks
to delay recognition of bad loans from small businesses. The sizeof China’s stimulus may rival the surge of 2016.
Real gross domestic product (GDP) in China will surely contract
in the first quarter, given several weeks of closures. It’s likely,
though, that official data will show more optimism. There’s
little question the economy is now improving from a depressing
February. According to Bloomberg, passenger traffic is up tothe highest level since the New Year’s holiday started. Carsales, truck traffic, and coal usage are all up, but from very lowlevels. More than half of China’s migrant workers are back on
the job. Pollution levels are rising, an unfortunate indication ofa recovering economy. There will likely be a sharp rebound inactivity next quarter assuming some normalcy returns.

Expressions of opinions and predictions are accurate as of the date of this communication and are subject to change without notice.
There is no assurance that such events or prospections will occur and actual condition may be significantly different than that shown here.

Meanwhile, outside China …

Investment conjectures

Manufacturing may finally have turned the corner in the UnitedStates, as output (ex aircraft) picked up nicely in January andregional Fed business surveys are clearly better. Housing activity
has been vigorous, with building permits at the highest level since2007. New home sales soared in January. Consumer confidence
stays high as job growth and income gains have been robust.

The 12.8%, seven-day rout from the mid-February all-time highon the S&P 500 Index was ugly, agonizing, and swift. But markets
had become complacent and valuations pricey after the huge
returns last year and the straight-up rally since October fromrecord high to record high. Some downdraft was likely, whatever
the cause.

But cracks are showing beneath the surface. Retail sales
decelerated in recent months, despite labor market strength andlofty confidence. A key survey of service businesses weakened
in February, driven by falloffs in tourism and other travel-relatedindustries associated with coronavirus.

For investors, the situation is extremely fluid. If the virus can becontained, the news flow could quickly turn positive and a sharp
stock market rally would ensue. Long-term interest rates would
also jump. Or: the news could turn even more negative if newcases spike further and fear of recession spreads. That would
accelerate the collapse that took 11.5% off the S&P 500 Index
the last week of February. The velocity of risk keeps getting faster.

If the virus doesn’t spread meaningfully, there could still be
problems with supply chain issues, plus travel and trade fromcountries harder hit by the virus. For example, a Forbes article
noted that auto companies have only from 2-12 weeks supply ofparts on hand. If the virus is contained, those impacts may remain
muted; if not, the risk is serious disruption. Last week’s stock
market collapse could hit consumer confidence and spending. Ifthe U.S. experiences anything like the closures in China, a mild
recession could easily result.
In the Eurozone, tepid fourth quarter GDP led to improving data
early this year. Business surveys upgraded further in February
from the lows of late last year, even in Germany. Most measuresof economic confidence rose, too. That strength will be neededas the coronavirus starts to take a toll.
The virus outbreak in Italy penetrated the industrial heartland.
Italy’s economy was already vulnerable after the fourth quarter
contraction in GDP. Business closures in Lombardy likely meana first quarter contraction, too. Germany, a key part of global
supply chains, is also at serious risk, as trade is a large share of
their GDP. The Wall Street Journal, citing International Monetary
Fund statistics, showed that products from Germany may besignificantly harder to replace in supply chains than thosefrom China.
Japan is still struggling after a sizeable fourth quarter GDP
contraction and is extremely vulnerable to another downdraft.
Early business surveys fell in February, with a sharp drop in theservices sector. Japan is a hub for Chinese tourism; about 27%of visitors to Japan come from China, and those sojourners arestaying home. The second largest tourist source is South Korea,at 24%; they’re also not touring. Japan closed its schools for amonth, disrupting life for working families. Japan also has large
trade exposures to China and South Korea, as about 20% ofexports go to China and 8% to South Korea. If the virus spreads
much further, the risk is that the Summer Olympics in Japan
could be cancelled.

Central banks will do what they can. The Federal Reserve (Fed)will surely cut the fed funds rate in March by 0.25% to 0.5%.
The People’s Bank of China will likely lower official interest rates
further and drop banks’ reserve requirements to pour morecredit into the system. A boost in fiscal stimulus is surely goingto happen in the Eurozone, the United Kingdom, and Japan. It’s
already been announced in Malaysia and is expanding in China.
What to do? Our confidence, while shaky, as well as our financial
market projections, are undergirded by the view that the worstcase scenario of a moderate U.S. recession will probably notoccur, and that China will see a significant economic reboundstarting late in the second quarter. This suggests that the growth
revival that was underway in January may return in the second
half of the year. If that happens, there should be some upside forstock prices and long-term interest rates later this year.
In the meantime, though, a further downdraft in stock prices islikely. No equity rally can be sustained until there’s a peak in thenumber of new virus cases. That’s not yet apparent with the big
jump in new cases in Italy and Iran. That will also keep long-term
interest rates under pressure and likely widen the spread between
U.S. treasury yields and those on similar maturity corporate
bonds. Those spreads widened dramatically in the final daysof February.
The appropriate attitude is to hope for the best but prepare forthe worst.

Expressions of opinions and predictions are accurate as of the date of this communication and are subject to change without notice.
There is no assurance that such events or prospections will occur and actual condition may be significantly different than that shown here.

Disclosures
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