The Novel Coronavirus is the black swan no one saw coming – one that has made investment markets exceedingly volatile in recent weeks. George Lin, Senior Investment Manager at Colonial First State, explores the potential impacts of the epidemic on economies and financial markets.
- China effectively locked down the city of Wuhan (population 11.1 million) and much of the province of Hubei (population of 58.5 million) on 25 January due to the spread of the 2019 Novel Coronavirus (or 2019-nCov). How effective is the lockdown? Frankly, no one has the answer – simply because there is no precedent of a city of more than 10 million residents being quarantined.
- At the time of writing, the number of confirmed cases has risen dramatically in recent days to more than 14,500. There have also been roughly 300 deaths – one of which has occurred outside China. The vast majority of cases are inside China alone, but about 150 cases have been confirmed abroad, including in Japan, the Philippines, South Korea, Thailand, Germany, the United States and here in Australia1.
- The Chinese government has imposed a number of additional, drastic measures to control the spread of coronavirus – including the extension of the Chinese New Year holiday by two days until 2 February, the suspension of all outward tours from China, the cancellation of major cultural and sporting events and the postponement of public transport between a number of Chinese cities.
The nature of the Wuhan Coronavirus makes precise forecasting exceedingly difficult. The only certainty here is that the level of uncertainty will likely result in a significantly higher level of volatility in financial markets, especially for equities. We explore below:
- Coronavirus has already impacted the level of economic activity in China and will likely result in significantly lower economic activity for the region in the March and June quarters. Other economies will also be impacted, with the East Asian economies (especially Hong Kong and Taiwan) being most at risk due to their close proximity to China and the number of Chinese visitors to these places.
- We think financial markets will draw comfort from the comparison with the Severe Acute Respiratory Syndrome outbreak in 2002-03 when the epidemic stabilises four to six months after the initial outbreak. Overall, the impact on financial markets will likely be transitory and concentrate on certain regions or industry sectors. For example, Chinese and Asian equities will be most affected, while some technology stocks will also be negatively impacted due to China and East Asia’s central role in the global high technology supply chain. In Australia, the first negative impact will be the flow-on effects of fewer Chinese tourists. However, demand for Australia’s commodity exports to China should remain relatively intact over the medium term, assuming that the epidemic stabilises as expected.
- However, based on previous experience with SARS in 2002-03, we expect the health situation in China to deteriorate further – with a continued rise in reported cases. The SARS episode suggests that stabilisation, as measured by the number of cumulative cases, will not occur until some time around May or June.
- Equity markets have been volatile. The S&P 500 Index fell 1.7% on 27 January and then rose by 0.6% a day later. The Nikkei Index fell by 0.6% and the ASX 300 Index fell by 1.5% on 28 January. And the Hang Seng Index has fallen by around 2.4% so far in its first trading day since the Chinese New Year holiday.
- Safe-haven assets rallied. The US 10-year bond yield was at 1.66% at the end of trading on 28 January – the lowest level since early October. Australia’s 10-year bond yield closed at 0.99% the same day.
- The Australian Dollar (AUD) is currently trading at around 0.68 US Dollars (USD), down from 0.70 USD at the beginning of 2020.
The outbreak of the Novel Coronavirus in China is the first Black Swan of 2020, and a very big swan indeed. This is an epidemic that is difficult to quantify due to the nature of the virus as well as the relative lack of transparency in China. However, we offer some insight below:
- Events so far have a somewhat disturbing resemblance to the SARS outbreak in 2002-03 – initial reports of mysterious cases of respiratory illness linked to exotic eating habits, official claims that everything is under control, more cases and then deaths reported, and confirmation that the virus can be transmitted from human to human which culminated in drastic measures imposed by the central government in Beijing. The only thing missing now is the dismissal of senior leaders due to the poor handling of the epidemic.
- In the case of SARS, the first case was traced to a farmer in Guangdong on 16 November 2002, but Chinese authorities did not officially notify the World Health Organisation (WHO) until February of 2003. The number of cumulative cases in China did not peak until mid-May that year. History therefore suggests that the health situation in China will deteriorate further before stabilising sometime in May or June.
- The main uncertainty is the scale of infection. The positives, however, include the quicker response from the Chinese government (compared to SARS) and the scientific progress made in epidemic science since 2003. Within a week of reporting the Wuhan outbreak to the WHO, Chinese scientists were able to identify and isolate this new type of coronavirus. They also shared the genetic sequencing by 12 January, where they found the 2019-nCov to have at least 70% similarity to the genetic sequence of SARS and 40% similarity to the Middle East Respiratory Syndrome. By mid-January, the first diagnostic test for the virus was developed. Despite positives, there are still some levels of uncertainty as to how the virus will develop, and the economic implications cannot be certain.
- A serious disease outbreak is both a negative shock to aggregate demand and supply, leading to lower output. The primary shock on aggregate demand is driven by policies which seek to control the spread of the disease by prohibiting certain economic activities. The cancellation of cultural and sporting events and the banning of outbound travel are prime examples. Consumers also display risk avoidance behaviour which negatively impacts demand. They curtail shopping, travelling, eating out or other non-essential activity requiring human contact. The supply shock should be less severe and is primarily caused by loss of work days as workers are forced to take leave – either because they are sick or as a precautionary measure.
- We expect the Chinese economy to be the most impacted given that the reported cases concentrated in that region. While the SARS outbreak provides some high level comparisons, we believe the economic impact of the Novel Coronavirus on China will likely be more severe than SARS, where Chinese economic growth only slowed marginally for a number of reasons:
- Firstly, the Chinese economy started 2020 in a weaker position having just recorded the lowest annual economic growth in 20 years and limping out of a damaging trade war with the US.
- Secondly, much of the province of Hubei, including the city of Wuhan, is effectively locked down indefinitely. While one can argue that Hubei accounts only for 4.3% of Chinese GDP, the supply side disruption is more significant due to Wuhan’s status as an important national transport hub. Wuhan is also an important logistics hub, accounting for 1.2% of national freight traffic by weight in 2018.
- Thirdly, while the extraordinary measures introduced by the Chinese government are necessary to control the spread of the virus, they are likely to lead to significant risk-avoidance behaviour by Chinese consumers and will curtail economic activity. Anecdotal evidence suggests that this is already happening – for example, the aggregate box office for the top ten Chinese movies on 25 January was just $1.12 million. On Sunday, the trickle of business halved again to a total of just $510,000.
The negative economic impact of the Wuhan coronavirus means that equities will be affected most. During SARS, MSCI Asia ex-Japan lost 7.7% (versus the 5.5% gain for MSCI World) from when deaths were first reported until the bottom. We should expect underperformance from Asian equities again. The extent of underperformance will be industry and country-driven – China and Hong Kong will likely fare the worst and discretionary consumer stocks (e.g. airlines, high-end retailers, casino operators and hotels), particularly in Asia, will be the worst affected.
- Timing the trough of the equity market is always a challenge. Using the Hang Seng Index during SARS as a rough guide (Hong Kong was the most affected city), the index bottomed out at about the same time as the number of new reported cases stabilised. We doubt that anyone can forecast the peak of new cases but the consensus seems to be around four months away.
In our view, the saving grace here is that the negative economic impact is likely to be short term and transitory in nature. Once the public is convinced that the epidemic is under control and various restrictions are lifted, we think economic activities could return to their normal levels.
1 Source: New York Times as at the morning of 2 February 2020, Sydney time.