A sudden spike in Coronavirus cases outside China have raised fears of a global epidemic. Global equities suffered their largest one-day loss since June 2016 on Monday, wiping out year-to-date gains.
Our base case remains that the Coronavirus outbreak will be contained sufficiently to avoid a sustained macroeconomic impact into the second half of the year. Even after the news that there are now epidemics in Korea and Italy we still think this is the most likely scenario. However, as we outlined in our first note on the Coronavirus1 there is a substantial tail risk of scenarios which investors should not ignore.
We have been cautious on risky assets over the past year as we move further through the transition market environment. We remain concerned about the medium-term prospects for equities and credit given unsupportive valuations and the vulnerable state of the global economy.
The Coronavirus News
Does the sudden spike in cases outside China mean that it is about to take off globally? What will be the impact on global supply chains? And is there a risk that the virus could turn into an unprecedented global pandemic?
These are all questions that investors are grappling with. Unfortunately, the answers to these questions are largely unknown. In late January we argued that there was a tail risk that the epidemic could turn in to something far worse than previous outbreaks. Unfortunately, no one knows what the path of this virus will be. The sudden outbreak in Italy and Korea has suddenly brought the possibility of a ‘pandemic’ to the attention of investors. What happens now?
Equity markets and the Coronavirus
It is true that markets had looked unruffled for much of the year to date as the Coronavirus newsflow unfolded. On the face of it, this suggested a level of complacency, though based on the information available at the time it did not look unreasonable to assume that this was a contained problem that would be temporary in duration.
It is important to remember that there are many factors driving markets at any given time. It may well be that markets were strengthening in reaction to the improved re-election chances of President Trump. Trump’s re-election is perceived as market friendly as it reduces the threat of higher taxes on companies.
Markets did eventually react to fears of a less contained outbreak, and have at the time of writing, surrendered all earlier gains to show a small negative return in the year to date. As would be expected, Chinese equities has fared relatively badly on a year to date basis, but non-China markets have fared worse in the past week.
The flip side of the recent equity market sell-off has been a big decline in bond yields. Usually this is a sign that investors are nervous about the economy. The U.S. Federal Reserve’s minutes from their January meeting had expressed concern about the virus hitting risk sentiment and being a threat to growth. Whilst tightening this year was never likely, if we do start to see a sustained negative impact on the U.S. economy, it seems likely that there will be not just one but multiple rate cuts. Bond market are currently expecting at least two interest rate cuts in 2020.
What will the global economic impact be?
Just as epidemiologists don’t have any certainty about the number of people who will be infected and will die from the disease, economists do not know what the economic impact will be. There is also not an easy read across between the severity of the epidemic and the economic impact. Where the infection spreads, the types of measures governments introduce to control it, and the levels of fear created amongst consumers and the reaction in terms of their spending behaviour, are all unknowns.
As we argued in our last note, the serious acute respiratory syndrome (SARS) epidemic in 2003 can barely be seen in Chinese economic data at the time, but this epidemic will likely be very different not least because it has spread outside Asia. According to a Reuters poll, the consensus amongst economists is for a deceleration in Chinese growth to around 4.5% YoY in Q1 from 6.0% YoY in Q4 last year. This is almost certainly an underestimate. A more plausible estimate has come from Standard Chartered, an emerging markets focused bank. They forecast that Chinese growth will fall to just 2.8% YoY this quarter, which allows for a contraction in the economy in the first quarter.
What will be the impact on the rest of the world? For the U.S., momentum going into Q1 seemed strong. Manufacturing activity was rebounding, as shown by strong shipments and orders data as well as the ISM purchasing managers’ survey. However, with supply chains being impacted we could see a hit to growth in the coming months. Japan looks set to enter a recession. GDP contracted sharply in the last quarter of 2019 as a consumption tax hike appeared to have a bigger impact than economists had expected. Normally we would have expected a bounce back in the following quarter but the shock to consumer confidence and supply chains from the Coronavirus could mean that Q1 2020 sees a contraction too. Anecdotally, the hit to the Japanese economy seems to be disproportionate relative to the number of cases, with widespread event cancellations, empty shopping centres and factory closures due to a lack of supplies.
Economists were anticipating a bounce back in Q2 2020 in most economies. This bounce will of course be contingent on the number of cases continuing to decline. It is also worth noting how strong the bounce will look will depend on whether it is compared with Q1 2020 or Q2 2019. Even if the virus is controlled, we think that sectors like tourism may take a while to recover and we suspect the year-on-year growth rates will look subdued.
This Coronavirus will most likely be contained, but pandemics are an underestimated risk
Although the fatality rate, the proportion of infected people who die from the infection, is estimated to be around 3%, the number of people infected is already over ten times higher than in the 2003 SARS epidemic and the total number of deaths is over 3 times higher.
This epidemic therefore is already far more serious than SARS. However, markets up until the end of last week had seemed relatively sanguine. This was because as the figure above shows the trend in new cases had been decelerating (the spike on February 12th was the result of Chinese authorities adding clinically diagnosed cases but not lab confirmed cases to the total). However, inferences made from the number of new cases need to be done with care as (i) the total number is still dominated by what is happening in Hubei province and this disguises the take-off in other regions including outside China and (ii) new cases can easily spike again even in regions where the incidences have appeared to stabilize as either authorities start to relax quarantines or if the virus mutates.
Epidemiologists typically use the term ‘mortality rate’ to refer to the total proportion of a population that dies from the disease. Our base case is that the global mortality rate will be substantially lower than 0.01%: i.e. total deaths will be a fraction of the 650,000 people globally that die from seasonal flu each year2. However, because the fatality rate is far worse and hence the potential for catastrophe far greater if nothing is done, the public health and consumer response will be far stronger than for seasonal flu. It is this that is causing the economic damage.
The latest outbreaks in South Korea, Iran, Japan and Italy, show the potential for this virus to ‘go global’, especially given the global reach of the disease in an age of mass travel. In this sense, it is already technically a pandemic, even though this nomenclature has yet to be used by the World Health Organisation.
However, we don’t know that governments will be successful in controlling the disease. As our illustrative figure below tries to show, when there is a long ‘fat’ right tail of increasingly bad scenarios, the most likely scenario (or modal scenario) can be very different from the probability weighted outcome (the mean), which could be higher. We think this applies to both this Coronavirus and other future pandemics simply because the possibilities of far worse outcomes cannot be ruled out.
Why do we think there is a long ‘right hand tail’ for mortality? History has seen some truly devastating pandemics. The Spanish Flu epidemic of 1918 to 1920, is estimated to have killed up to 2% to 5% of the global population3, whilst the first European outbreak in the 6th Century plague has a wide range of mortality rate estimates, some as high as 40%4.
Pandemics of this size seem inconceivable today given better nutrition, the triumphs of modern medicine and improved sanitation. But in some ways our vulnerabilities have increased in recent years. Globalisation means the world is ever more interconnected. Our cities are getting ever bigger. Climate change is making the world hotter. This not only increases the prevalence of insect spread diseases, but may assist the transmission of new coronaviruses from animals to humans, even if coronaviruses tend to spread more easily between humans when it is cold. The chances of any one pandemic, including this one, rivalling historical episodes is, extremely low, but that doesn’t mean it cannot and will not happen.
What is the situation in Korea and Italy?
Until late last week, the outbreak appeared to have been mostly contained within China. Even within China, the number of new confirmed cases outside of Hubei province (where the disease originated) has been dwindling. We think this has been why equity markets have previously been relatively sanguine about the economic impacts of the outbreak.
Since then, over 1,000 cases have been recorded in South Korea, the second most affected country outside of China. South Korea has raised its infectious disease alert to the highest level, and Daegu, home to 2.5 million people, have been placed in a “special care zone”.
Elsewhere, Italian authorities have quarantined a number of towns across the northern regions of Lombardy and Veneto, home to regional capitals of Milan and Venice. Meanwhile, neighbouring countries have closed their borders with Iran as the number of cases there spiked. The emergence of these disease clusters outside East Asia, with no confirmed links to China so far, raised fears of potential unknown clusters around the world.
The World Health Organization warned that the window of opportunity to contain the outbreak is narrowing rapidly and experts feared that we may have reached a “tipping point” for a global outbreak. Even if no further clusters emerged, potential disease control measures in Europe and the Middle East will pose a further drag on the global economy.
How should portfolios react?
We think that this episode is a crucial reminder of the importance of unanticipated shocks that seem to come from nowhere. If a shock is sufficiently big, it risks destabilising the economic environment we have been in, where ultra-stimulative monetary policy has led to very low rates and reaching for yield behaviours. Yield-seeking investors and corporate leveraging to finance buybacks has driven equity markets to record highs.
It is true that the most likely scenario is that the Coronavirus will only hurt profits temporarily. The virus and its impact may, therefore, not be sufficiently bad (as things appear at present) to fully expose the vulnerabilities in the global financial system. However, we believe it is a useful reminder that the outlook for markets has now become much more asymmetric. The prospect for significant upsides look increasingly limited. Taking a slightly longer term time frame into account, we feel it is likely that a significant setback to risk assets is due.
How has the virus affected our views? Not directly as a result of the virus outbreak, but overall, it reinforces our medium-term caution on risk assets. As we keep noting, the global economy has looked fragile for most of the past two years. Even if the impact of the virus is temporary economically, it is still bad news and will impact corporate cash flows. The magnitude and duration of any economic shock is still uncertain at this stage. This is therefore an opportune time to build shock absorbency through diversification and focus on conservative and quality-focused approaches which will provide at least some protection from the tail risks of the virus that we have noted above.
An easing of bad newsflow on the virus should see some relief on the trend towards ever-lower bond yields, but this is more likely a short-term bounce rather than a sustained rise. Even with yields where they are today, it remains true that they could go lower still, at least for a time.
1 “Coronavirus: What will the economic impact be?”
2 https://www.who.int/mediacentre/news/statements/2017/flu/en/ *
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3 “Updating the Accounts: Global Mortality of the 1918-1920 Spanish Influenza Pandemic”. Niall P. A. S. Johnson and Juergen Mueller. Bulletin of the History of Medicine. Vol. 76, No. 1 (Spring 2002), pp. 105-115
4 “Yersinia pestis and the Plague of Justinian 541-543 AD: a genomic analysis”. DM Wagner, J Klunk, M Harbeck, A Devault - The Lancet 2014 - Elsevier
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