The coronavirus outbreak has replaced trade wars as the dark storm bearing on markets, sending jitters across global financial markets amid fears of a hit to the global economy.
Despite some sharp moves in China, stocks surged earlier in February on hopes of a containment of the virus. However, record breaking equities appeared at odds with the gloomy message from bonds and sharply lower industrial metal and oil prices. Two assumptions were largely being made, first, the coronavirus would be contained shortly, and pent-up demand would be released and therefore its impact transitory. Second, and the most likely reason for stock markets’ initial muted response was that while the virus is a threat to global growth, global central banks stand ready to support the global economy if needed. This implies that the low rate environment will continue and investors were willing to use lower bond yields as a reason to push up risk asset valuations.
However, global markets tumbled sharply in the last week of February alongside the US 10-year Treasury yield which neared record lows, as a surge of new coronavirus cases outside China shook investor hopes that the outbreak had been contained. This is no longer just an Asia issue (even though the number of reported cases in mainland China has declined), the virus has spread to Italy, South Korea and Iran and there are fears this could develop into a global pandemic. Markets are starting to consider what this means for global trade and travel, while bond markets are worried about recessionary risks. With the coronavirus now in Europe, the region is particularly exposed to trade and the virus poses a threat to its fragile recovery. Indeed, we saw the first signs of the economic fallout last week, with various Asian PMI surveys showing sharp losses.
With stock markets at record levels and elevated valuations, markets are more vulnerable to economic shocks and earnings disappointments. Indeed the virus could cause a delay in corporate earnings improvement, particularly outside of the US.
COVID -19 versus SARS: a more integrated world
Is this just passing turbulence or a global growth scare? It is still too soon to gauge the magnitude and duration of this outbreak as well as its overall impact on the global economy, given the many unknowns. Like politics, it is hard to predict the impact of epidemics on either the economy or markets.
Parallels have been drawn with the SARS breakout of 2002-2003. Following its peak, China’s GDP growth, tourism and retails sales growth bounced back quickly as businesses resumed activity. It took almost four months to brings SARS under control, roughly the time it took for performance to normalise and a V-shape recovery ensued. The temporary hit to economic activity resulted in pent-up demand, which eventually helped fuel the rebound in economic activity.
While government efforts are much more substantial, possibly draconian, than what we saw during SARS, the economic and market impact of coronavirus may be much larger, given China’s economic rise and greater integration in the world economy. China’s share of the MSCI Emerging Markets index has risen to 34.3% from 7.9% in 2003. China is a much bigger part of the global economy than it was 17 years ago – China’s share of global GDP is now 16% (Chinese tourism alone accounts for about 0.4%) compared to 4%, its share of global trade was 11% in 2018 compared to just 5% in 2003.
Supply chain disruption is greater due to increased global dependence on China and more complex supply chains generally. While demand may recover quickly, the supply side could be more problematic. Bottlenecks could develop as production ramps back up. Hubei sits in the global supply chains of autos, healthcare, electronics, aerospace and defence and construction materials. More broadly, disruptions to global value chains from various travel bans, quarantine measures, logistic blockages, plant closures, or suboptimal operations due to workers unable to return to work could pose upward pressure on prices.
As with most market disruptions there will be winners and losers. With consumers reducing spending on travel, hotels and shopping – airlines, tourism and retail have been hit hardest alongside areas most reliant on disrupted supply chains such as semi-conductors, autos, manufacturing and commodities. One positive caveat to supply chain disruption is that unlike services, there is a greater chance that the production disruption is only temporary, and once supply side bottlenecks are relieved, activity can be made up later on. Furthermore, as more people stay at home, consumption of home entertainment and online shopping activities has increased, which is beneficial for gaming, food delivery and e-commerce stocks. Healthcare has also been a gainer.
What to watch for
The short-term impact from the outbreak will likely play out in coming quarters. The general consensus is that China will see a slowdown in economic growth for at least the first quarter, if not the first half of the year. Getting the country’s economy up and running, however, is a top priority for Chinese authorities. While stimulus measures have been enacted, we are likely to see more support and could see tax cuts for sectors hurt as a likely policy response.
The importance of the consumer is why fear of the virus has the potential to do so much economic damage. If fear is contained at current levels, the consumer will continue to support growth. If fear takes hold in the real world, the economic damage could be significant.
It is too early to assess the eventual impact on the global economy, and it will be important to monitor both the spread of the virus and mortality rate. One signal to watch is when newly confirmed cases persistently drops below newly healed cases, and we have reached ‘peak infection’.
As with any sudden sell-off, it is important for investors to maintain a long-term perspective. While headlines are increasingly bearish, in many cases, the equity market sell-off has simply returned valuations to where they were a few months ago, arguably more healthy levels. Recent corporate results have been encouraging, however, some companies are lowering earnings guidance for 2020, so we could see some near-term downward surprises to earnings growth.
At this point, the growth uptick may be delayed rather than derailed. A sustained bear market does not look likely, but be prepared for a volatile few months ahead. It might be worth to wait and see how widespread the situation becomes before making any big decisions, some of the indiscriminate selling could provide selective opportunities. In the worst case scenario, a full-blown global pandemic, growth and markets will be hit much harder than investors are assuming. Diversification across sectors, regions and asset classes including safe havens such as the dollar, gold and US Treasuries will be important to help immunise against volatility and any growth scares.
The value of investments will fluctuate, which will cause prices to fall as well as rise and you may not get back the original amount you invested. Past performance is not a guide to future performance.