I don’t pretend to have all the answers. But the questions are certainly worth thinking about.
— Arthur C. Clarke
One of the more interesting aspects of what we do is that our clients will often ask us questions on just about anything. In addition to the capital markets, we will receive questions on politics, demographics, investor behaviour, household balance sheets, government debt, disruptive technologies, and so on. And while we endeavour to do as much research on as many topics as we can, the heart of our work revolves around answering the question, “Where do we make money?” While some topics strike a passionate tone with investors, they are not always relevant to an investment strategy. And with other questions, we simply don’t have the answers, but as the quote above suggests the questions are certainly worth thinking about.
We have been fielding a number of questions around the current coronavirus and its potential impact on the Chinese economy, global economy, equity and fixed income markets, and we have been doing a lot of work on what it may mean. The hard truth though is that while there are some similarities to viral outbreaks in the past, there are no good parallels to what we are experiencing today. In most reports I have read, the immediate comparison to this coronavirus is the SARS outbreak of 2003. Yet, we would argue the economic and market comparisons are far from perfect and therefore, we need to look to a collection of similar disruptive events in the past in order to put together a plausible expectation.
At the time of SARS in 2003 we would suggest the characteristics of the US equity market were quite different than today. Recall that in 2003 the S&P 500 Index was forming a double-bottom off the teck-wreck bear market and at the same time investors were focused on the potential military action in Iraq. Additionally, the S&P 500 was trading at approximately 18.5 times trailing earnings with accelerating earnings growth. Today, the S&P 500 Index is a couple of percentage points off the all-time high, trading near 22 times trailing earnings with negative earnings growth on a year-over-year basis. Back in 2003 given the smaller weight of China to the global economy, SARS may not have had much of an impact on the US equity market as it might today. Therefore, trying to compare the potential impact on the S&P 500 Index today against SARS would be apples and oranges. What we should do is look at the potential impact a disruption in China will have to global exports.
In 2003, China was not as important to the global economy as it is today. In 2003 the Chinese economy ranked 6th in the world, just behind Italy representing 8.7% of the global economy. Today it is the second largest economy in the world representing 19.3%. The United States, Japan and India import more goods from China than any other country while the EU and Brazil export more to China than any other country. Looking at it from an export perspective, China represented 4.2% of global exports in 2003. Today, China represents 10.5% of global exports. Exports as a percentage of China’s GDP however, is roughly the same today as it was in 2003. While a disruption in exports today may have a similar impact to the Chinese economy as it was in 2003 given its similar proportion of GDP, a disruption in export volumes would be far more impactful to the global supply chain and therefore global economy today. As a result, the global economy is likely to feel the impact of a Chinese economic disruption to a greater degree than 2003. We would suggest the earnings recovery that investors have been pricing in to markets in the United States and around the world may be delayed by a quarter or two.
Our belief is that the impact from the coronavirus today will be disruptive to economic growth rather than destructive. The difference being a temporary vs permanent impairment of economic activity. If we believe 2003 is not a perfect reflection of what might happen today then we need to look to other past disruptive events for a clue. One such comparison that we may draw upon is the Polar Vortex of 2014. While the Polar Vortex was not a health issue, the extreme cold and record snowfall that paralyzed much of the United States affected an estimated 200 million people. In the first quarter of 2014 many states suffered record low temperatures and record snowfall. The extreme weather forced tens of thousands of flight cancellations across the United States, along with multiple road closures and state-wide school closures. In a consumption based economy, restricting consumption, in this case weather-related, carries and economic consequence. While 2014’s winter was a different event than what is occurring now (weather vs health scare), some parallels towards cancellation of air travel, and the impact to consumption, services and manufacturing industries may be worth noting.
The extreme weather conditions of 2014 contributed to weaker than expected GDP growth for the first quarter of 2014. We would suggest that the Chinese economy could see a similar drop in economic activity. We believe negative economic growth for the first quarter on a quarter over quarter basis for China, which would represent a significant deceleration of activity for Q1, is a realistic outcome. More importantly however, is what followed in the US after Q1 2014. Once the season passed, the economic rebound in the following quarter was pronounced. We would suggest that once contained and as the virus runs its course (assuming no greater adverse effects) China could see a similar economic rebound driven by a recovery and pent-up demand.
It is an unfortunate turn of events given the economic improvements that were just starting to take hold. Any reacceleration in the Chinese manufacturing economy is likely delayed for a quarter or two. Two measures that we pay attention to are the regional Purchasing Managers’ Indices and what copper prices tell us about Chinese imports. The Chinese manufacturing sector as measured by the Caixin PMI had been above 50 in each of the last six months to its January level of 51.1 (a reading above 50 indicates expansion). It is likely to stall out if not retreat in the coming couple of months. Additionally, our work would show that the change in copper prices tend to lead Chinese imports. We would take an improvement in each of these as a sign of a strengthening Chinese economy. Copper prices had been increasing on a year-over-year basis in the fourth quarter of 2019 indicating a coming improvement in Chinese imports. Indeed, Chinese imports rebounded with a 16.5% yoy growth rate in December. Given the recent retreat of copper prices, again we believe the economic recovery will be delayed a quarter or two.
Overall, we would suggest that from an economic perspective the coronavirus is likely to be disruptive to growth, but not destructive to growth. As such, the economic impact may likely lead to weaker earnings growth in Asian markets, with some spillover to US equities through the first half of 2020. We expect this to be followed by an economic and earnings rebound as we have seen in the past. We would not suggest a shift in one’s asset allocation merely in response to the current epidemic as we believe a recovery will follow in short order. For the time being, we continue to focus on the fundamentals and remain mindful of current equity valuations while looking for signals of a more meaningful earnings rebound in equities.
Philip Petursson, CIM
Chief Investment Strategist
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