Coronavirus – new “Black Swan” or buying opportunity?

Darius Svidleras
Investment Portfolio Manager

• Rapid spread of novel Coronavirus in China may shut down 2nd largest global economy from the rest of the world for weeks, if not months, potentially leading to another round of global economic slowdown
• Actions of central banks may prevent significant sell-off in equity markets, and if situation with virus stabilizes, strong rally may follow
• The recent correction has helped reduce excessive optimism in the market and investor sentiment is no more a headwind for the global equities

Black Swan – is the name given to extremely rare unforeseen events, leading to severe negative consequences. Examples of such events include September 11, 2001 terrorist attacks, 2008 collapse of Lehman Brothers, 2011 Japanese earthquake and Fukushima nuclear accident and some other observations. With the onset of new decade, we are potentially witnessing another black swan in the making – novel coronavirus (2019-nCoV¹) from China.

There are several reasons why situation with the new virus is so serious. First of all, so far virus is spreading almost exponentially. If there were only 282 confirmed cases of infected patients on 20th January, after about two weeks there were already more than 20000 registered cases of disease. Secondly, so far there is no vaccine against the virus, and death rate remains high, especially if measured as a proportion to recovered patients. Thirdly, it may take up to 14 days for the first symptoms of virus to emerge in patients, thus there may be significant delay in how fast the illness is detected. In addition, due to shortages of medical infrastructure in China, potentially not all cases of disease are being reported by the population. Finally, apart from China, first cases of coronavirus were already registered in 27 other countries, including USA, Germany and Australia. As a result, World Health Organization had to announce global health emergency on 30^th January 2020.

Number of coronavirus cases by date

Source: WHO

Therefore, in order to contain spread of coronavirus further, as situation is becoming exceedingly dangerous, rather significant measures are being taken in China and worldwide. Chinese officials have already closed on quarantine more than 15 cities with more than 50 million of population. According to CNBC, in at least 24 provinces that account for around 80% of Chinese GDP businesses will not be resuming work until at least 10th of February. In addition, heavy restrictions are put on travel inside the country, while many global airlines cancel flights to and out of China. Global companies are also temporarily closing their operations inside the country, for example, Apple has closed all its stores in the country until at least 9^th of February.

Thus, with cautionary measures being taken there are good odds that spread of disease would be limited only to certain areas inside China. However, for global economy and financial markets, even such outcome possesses major risks. China is responsible for around third of global economic growth and its GDP constitutes 16% of the global GDP, making it second largest economy after USA. In addition, China consumes more than half of global industrial metals, including copper, steel, aluminum and iron ore, and around one third of global vehicles and smartphones. Majority of global corporations has one or the other link to China – with country being either one of the largest markets for sales, or one of the largest places were production facilities are located. If we again take Apple as an example, majority of iPhones are being assembled at their factories in China. And if these factories would need to be closed due to threat of virus, negative impact on the financial performance of the company may turn out to be quite significant.

Performance of selected assets since 1^st January 2020

Source: Bloomberg

It is clear already now that recent events should slow down both Chinese and global GDP growth in Q1 2020, but it is still too early to say how strong would be the impact. This is rather unfortunate development as epidemic of coronavirus is happening right after we started to witness long awaited signs of recovery in global economic activity as measured by PMIs and OECD leading indicators. And unless situation in China is not stabilized during the upcoming weeks, recovery in global economic data may become only temporary and risks of global recession that we observed during late 2018 and 2019 would again reemerge.  

Global PMIs vs performance of  global equities

Source: Bloomberg

OECD total composite leading indicators vs global equities

Source: Bloomberg

However, for now there is probably still no need to panic. In best case scenario, if Chinese would manage to contain or at least significantly reduce spread of the virus in the upcoming month, strong relief rally in global equities is likely to ensue, as risks for future economic growth would be significantly reduced once again. Alternatively, if business activity in China would continue to remain paralyzed also in spring, impact on the global economy would be negative, of course, but it does not necessarily mean that prices of equities would significantly drop in price. Key reason is that global central banks would continue to inject liquidity in the financial system, and provide significant support and demand for asset prices.  

People’s Bank of China already poured record high $173 billion of funds into financial system after Chinese market was reopened from public holidays on February 3rd, and it is certain that more funds would be provided by monetary authorities, if there would be need to stabilize financial markets further. At the same time FED in USA also indicated that they plan to continue running their repurchase operations, buying treasuries from market participants, and thus providing extra liquidity to US banking system at least until April. So just as in 2019 when global macroeconomic indicators were deteriorating, but equity markets continued to increase in price, same situation might again be observed in the first half of 2020.

People's Bank of China Repo injection

Source: Bloomberg

And only in scenario, when coronavirus will get out of control in China and become a global pandemic, shutting down global trade and putting significant hurdles on business operations around the world, major crash in the markets can be expected. So far, risk of such scenario is rather low, and unless news from China would not worsen, any sell-off in equities should be considered more as a buying opportunity than as a motive for additional fear.

The impact of coronavirus on financial markets has so far been fairly moderate. Emerging market equities took the biggest hit and are down around 7% from their highs. World equity market (as measured by MSCI ACWI), however, is just about 3% lower than its all-time high. Actually, one can say that such correction was already well overdue, as ACWI has marched higher without at least 3% drop since the beginning of October 2019. Moreover, the correction has helped to clear excessive investor optimism that was prevailing in the market, and it is not a headwind to the equity markets anymore, but on the contrary should provide support going forward. For example, according to the American Association of Individual Investors (AAII) latest survey, the number of bullish investors dropped by almost 14 percentage points in one week to 32%. At the same time the number of bearish investors grew 12 p.p. to 36,9%. Still, investors have to be prepared to increased volatility in the near to medium term as many uncertainties remain.

¹Formal designation of virus according to World Health Organization