1. What are the recent developments?
This week, we have reached a new level in the coronavirus crisis:
- Europe starts to feel the effects: though the number of cases is still very limited (300 declared in Italy), the willingness to avoid the spreading that occurred in China led the Italian authorities to almost close the two regions around Milan and Venice.
- Korea (close to 1000 cases), Japan (170) are also becoming affected as well.
- Globally the number of cases has reached 80’000, of which almost 78’000 in China, and which now grows at a much lower pace (500 new cases per day in China over the last days instead of 3’000 early February). Death counts has reached 2’700 of which almost 2’600 in Hubei region.
- Statistics can move rapidly and the accounting of cases could be more difficult in several countries of South East Asia with less structured health and security systems.
- The WHO has highlighted that this cannot be called a pandemic yet but the most recent declarations created greater anxiety, pointing out that the recent development of the virus internationally was very preoccupying.
2. What are the questions investors have on their mind this week ?
As other observers, investors have more questions than certainties on the situation:
- How far can this epidemic affect populations outside China?
- Do social media and pressure on governments to react promptly in modern politics amplify global reaction?
- Are markets too anxious on the macro-economic implications?
As asset allocators we are not public health experts and will therefore refrain from building a scenario on the coronavirus pace of break down and potential containment in march as experts were hoping for, but rather highlight the macro and market implications of what we know at this stage.
3. What does the market reaction tell us?
As we were writing only a few days ago, there was something wrong in markets, i.e. bond market pricing slowdown and/or monetary response, and equity markets at record levels ignoring bottom effects and buying the goldilocks effects of central banks.
Here is a summary view on market effects:
- Equity markets have erased the last 3 months gains, with 7.5% lost in a week on the S&P 500
- Government bond yields compressed by 30 bps in 2 weeks.
- Volatility is back to the levels recorded in December 2018.
- Spreads are widening in credit markets (Itraxx crossover Europe widening by 40 bps).
- Rotation from value to defensive stocks continues and amplifies.
- Commodities reflect a lower oil demand from China with WTI closing at USD 50 per barrel.
- Gold has reached record levels at around USD 1650/oz.
Globally, this tells us that equity markets have quickly reversed their stance from denial to anxiety, while immediate communication and social media tend to amplify the stress and transmit it to economics trough preventive measure or through the impact psychology: this is what we call viral economics.
4. What are the macro-economic implications that we can anticipate?
- We have already been highlighting that China Q1 GDP will be significantly affected; if the epidemic does not diminish rapidly and any sectors are still in a frozen mode in Q2, the effect on FY 2020 numbers could be more important than the 1 to 2% initially indicated.
- We have also said that the bottom-up signals from various industries suggest that global growth could be affected up to 0.5% this year.
- Concerning Europe, the effects are both direct and indirect: direct through lower exports, lower trade and lower tourism from China to Europe; indirect through the disruption effects on value chains and through a hit on confidence impact corporate behaviour. We anticipated that European manufacturing PMIs released last Friday would weaken in February, which was not the case so far, but it could be the case next month.
- We highlighted that the hit on Q1 or H1 GDP could be partially offset in the new quarters and that the policy mix response from governments and central banks could play the role of a backstop and prevent us from a more recessive scenario.
5. What can we anticipate for corporate earnings and equity markets?
- Several industries are highly affected by the measures taken (such as travel, tourism, physical retail in China) and directly depending on Chinese consumers such as luxury goods on consumer discretionary sector.
- Several industries depend largely on China on the supply side such as technology, consumer goods or pharmaceutical companies incorporating many components manufactured in China.
- As an example, some large names in the Staples sector (views as defensive and composed of food & beverage companies for example) generate 10 to 20% of their sales in China (and some of which could suffer from up to 30% decrease of sales in Q1, which represent on a global basis up to 1% of global turnover lost on an annual basis, assuming not offset effect in the next quarters; this means lower earnings growth but not earnings recession at this stage.
- Some sectors suffer more from the bond market or commodities reaction; though we cannot easily identify the impact of the situation on European banks earnings for instance, this sector suffers from lower rates and style rotation.
- On the contrary bond proxies such as utilities, domestic players in US and Europe are more defensive whilst Chinese companies gaining market share thanks to their digital model (in retail or in education for example) could attract investor interest.
- Clearly this highlights that bottom-up signals are so far more severe than macro assumptions and the paradox was that so far equity markets were not reflecting that.
- We have not updated yet our earnings scenario for 2020 but believe that this situation could lower earnings growth up to several % points on Q1 earnings.
We think that the tendency of equity markets is structurally to amplify optimism and pessimism and therefore could soon offer opportunities given volatility levels reached.
February 26, 2020