Coronavirus: a tale
of two shocks
The coronavirus is poised to materially disrupt the global economy in the near-term. This shock should abate along with the virus, but is creating major disruption in the meantime.
The coronavirus has created a major shock to the Chinese economy in the near-term, and as the virus has spread East to West the size and duration of the shock on both China and the global economy has risen. Disentangling the shock between the manufacturing and services sectors helps to illustrate the impact. It also reveals the potential for sharper than normal spillovers between countries. Overall, while the near-term corona shock may be very large, we expect that it will not derail the global economy; however, risks of a worse outcome remain high, even with supportive measures by policy makers.
The size and persistence of the shock created by the coronavirus is uncertain
Activity is expected to drop sharply in the near-term
The size and persistence of the shock created by the coronavirus is uncertain. Ultimately, it will hinge on the scale (numbers and countries affected) and the duration. The longer this goes on, the greater the chance that negative effects are amplified, perhaps via supply chain disruptions.
China was the first to be affected, and we believe that official Chinese GDP growth is likely to drop to around 0.0% quarter on quarter (q/q). However, we expect our China Activity Indicator will drop much more sharply, perhaps more consistent with a quarterly growth rate of -1% q/q or lower. Overall, we believe that a contraction is plausible given the extension of holidays and what appears to be a slow return to business in February – both necessary steps to contain the spread of the virus.
Uncertainty about the duration and impact is very high and we shall be updating these views as the data develops. The shock to supply chains is one area we will pay close attention to. For now, we assume some disruption to manufacturing (particularly at company level) is inevitable. We believe that this is captured within our forecast assumptions for the hit to Chinese manufacturing and the shocks to the rest of the globe. But supply chain risk could move from the company level to the macro-level. This risk is likely to rise in a non-linear manner with the duration of the outbreak. Data on production, inventories, trade and PMI surveys - both inside and outside of China - are key metrics to watch, as are signs that a whole industry (autos or technology, for example) is grinding to a halt.
Policy should step in to help growth recover
Policy has already become more accommodative and is likely to loosen further. This should help limit the damage caused by the coronavirus and help the global economy to recovery more quickly as the virus abates.
In China, monetary policy has been easing marginally. For example, the medium-term lending facility (MLF) was recently cut by 10bp. Further steps to help maintain credit growth are likely, but we do not expect the authorities to meaningfully roll back their financial de-risking campaign.
Steps to encourage forbearance in the banking system are more significant, and should prevent the financial system from amplifying the shock to the real economy.
Gauging the combined effect of the smorgasbord of announced fiscal policies is hard. The most significant appear to be: measures to shore up small & medium sized enterprises (SMEs), such as cutting employer contributions to social security; and bringing forward local government special bond issuance, which typically supports infrastructure spending.
Chart 1: Chinese manufacturing recovery delayed as virus spreads to WestSource: Aberdeen Standard Investments (as at 12/03/2020).
For illustrative purposes only. Projections are offered as opinion and are not reflective of potential performance. Actual events or results may differ materially.
Chinese monetary policy may now ease more decisively, reflecting additional headwinds from the West which prolong the shock. Overall, the most significant shift in Chinese policy is still likely to be via fiscal policy, which we expect will move more conclusively over the course of Q2.
A tale of two shocks
Disentangling the shock as it affects manufacturing and services sectors helps to illustrate the key channels by which the virus impacts an economy and spills over to other countries. The same dynamics which we illustrate here for China are likely to affect other countries who suffer outbreaks in a similar manner.
Assuming there are signs of the virus coming under control in March, we expect that Chinese manufacturing should be able to resume production. Before the virus showed signs of taking hold in the euro zone and US we had thought that Chinese manufacturing would be able to make up lost production by the middle of the year. But the corona-shocks in the West now suggest that Chinese manufacturing will be slower to recover, perhaps not doing so until Q4.
Measures to contain the virus and ensure it does not resurface – combined with a cautious approach by households – may result in a more protracted drag on the services sector. Therefore, it may remain depressed for longer and then not catch up until next year.
The overall shock to China is skewed towards the services sector. This would normally suggest a relatively smaller spillover to other countries compared with the hit to China. But in this instance, normal modelling approaches may fall short. The disruption to global manufacturing may go through supply chains quickly, while the impact on travel and tourism is also more immediate.
Emerging markets in Asia will be heavily affected by the coronavirus shock. Not only are they deeply embedded in regional supply chains, they also benefit from large numbers of Chinese tourists. Thailand, Malaysia and Vietnam stand out as being particularly exposed on both metrics. And similar to China, even if the engines of manufacturing restart, services may be somewhat slower. With the spread of the coronavirus to the West, global travel & tourism may be even slower to return to normal.
Commodity prices have now fallen very sharply, reflecting the impact and uncertainties of the coronavirus on the global economy, plus changing dynamics in the oil market.
This means the coronavirus shock has a longer reach across developed and emerging markets. For oil importers this provides an offset which will help cushion the blow slightly, but commodity exporting economies, such as the Saudi Arabia, Russia and Brazil will see a correspondingly larger drag. The rise of shale in the US suggests that the US economy is more neutral with respect to oil: the gains to households may be offset by lower business investment, for example.
As this supply shock fades, demand should return and the tailwind from policy easing should help growth momentum to accelerate. The ‘phase one’ trade deal between the US and China had looked likely to come under pressure. But the coronavirus shock may allow China’s purchase commitments to be pushed back, moving any flash point in US-China trading relations beyond the US elections. However, the corona-shock has highlighted potential fragilities in global supply chains, which could further weigh on capital spending and in an era when globalisation was already under pressure.
Chart 2: Emerging Asia is particularly exposed to ChinaSource: Aberdeen Standard Investments, Refinitiv (as at 12/03/2020).
Markets have reacted violently but consensus may still be too optimistic
As China and the rest of the world escalated their responses to the spread of the virus from mid-January, a cascade of significant market impacts became evident.
Oil prices fell sharply and this has been further exacerbated by the price war announced by Russia and Saudi Arabia. Oil was already declining after US/Iran tensions receded in early January, but expectations of demand destruction and a supply increase have renewed the weakness and taken oil back to 20-yr lows. Prices are now well below where shale producers are considered to be profitable and it is likely there are energy sector defaults in the coming quarters.
Because the bulk of the immediate risk aversion and economic effect was in Asia, equity indices there fell sharply first - led by energy companies, airlines, transportation companies and industrials. As the China-led shock was processed into forecasts, it became more evident that the disruption would be amplified through tight knit global manufacturing supply chains and because the virus was not contained to China. Steadily, international companies with Chinese supply chain exposure or production facilities began to warn of the impact. As global business travel and tourism have now been curtailed aggressively, extreme weakness globally in the equities of related sectors has ensued. Many companies have withdrawn profit guidance altogether.
We and other investors are assessing the cumulative and compounding effect of multiple and simultaneous global shocks. However, these come at a time of extraordinary monetary looseness and the likelihood of additional monetary and fiscal easing albeit not as fast as the market would like. This slowdown or recession comes at a time of extra-ordinary liquidity but where the availability and price of that liquidity is highly bifurcated between companies of varying quality and business models. We are seeing this already with sector and quality dispersion very high across credit and equity markets.
Our multi-asset portfolio managers use a range of behavioural, scenario and survey tools that have helped guide decision-making. Equity markets were technically overbought before virus concerns escalated and so, at least now, we are reassured that this headwind has reversed with many metrics now signalling the market is deeply oversold. However, profit expectations in the short-term are moving sharply lower as the severity, duration and cascading consequences of the downturn are being assessed. This period is increasingly likely to include some permanent value destruction through defaults or equity capital raisings of the viable, but more indebted companies and we must judge how widespread this value destruction becomes.
If the pandemic passes in Q2 and permanent value destruction is contained to some companies or smaller sectors, great value and asymmetry is already available – we think more in credit markets than equities. With equities valued on profits and growth, the same quality bifurcation is likely but with much more volatility until virus and recession risks are clearly receding. We have a list of positive waymarks we would like to see before we become more positive on equities globally. We are not there yet.
Activity is very slowly resuming in China now and the worst of the global economic impact of the virus hopefully passes in the coming quarters. The focus now moves to Europe and the West facing its own crisis. Our baseline scenario is for a sharp slowdown but a steady recovery back to trend in the coming two years. However, we worry of the potential for a cascade of negative consequences from the growth shock (through credit and employment). With consensus still somewhat optimistic of a sharp V-shaped recovery, we think they may still end up disappointed by the severity and length of the slowdown and consequently, the potential for lower valuations and losses on capital that are not recovered quickly.
The size and persistence of the shock created by the coronavirus is uncertain