Taking stock of the coronavirus correction
The end of February saw one of the most rapid market corrections in history as investors confronted the building evidence that the outbreak of the 2019 strain of coronavirus, dubbed Covid-19, had not been contained within China and could become a more global pandemic.
The speed of the sell-off was surprising, however, it comes on the back of a period of very strong equity market performance which had priced a reacceleration in activity from 2019 levels. The contagion of the coronavirus internationally now poses a significant threat to the 2020 growth outlook.
China has borne the brunt of economic impact so far. In trying to contain the outbreak large parts of the economy have been shut down. This has likely resulted in a lost quarter for Chinese economic activity. Recent PMI readings seem to confirm this. Efforts by officials in newly affected countries will likely add further disruption to the global economy as we move from containment to mitigation.
We still expect this to represent a one-off outside shock that economies and markets can recover from. As the seasons change, it is possible we will naturally get some respite in the summer months. In the meantime, we are monitoring to what extent markets may over-estimate the risks as they correct and will look to act on opportunities accordingly.
Stepping back from the economic and financial considerations, our thoughts are with all those already affected by the outbreak and whilst we seek to treat new developments objectively, we do not lose sight of the human cost.
Risk assets have seen indiscriminate sell-off at the end of February
Covid-19 – What we know, and what we don't
"As we know, there are known knowns; there are things we know we know. We also know there are known unknowns; that is to say, we know there are some things we do not know." Donald Rumsfield
Covid-19 – What we know
Coronaviruses are a large family of viruses which infect humans as well as animals. The virus causes respiratory infections such as pneumonia, common cold, etc. The recently discovered COVID-19 belongs to the zoonotic1 family of coronavirus as do Severe Acute Respiratory Syndrome (SARS) and Middle East Respiratory Syndrome (MERS) .
Researchers have indicated that the virus is a chimeric virus, i.e. it is a hybrid of a bat coronavirus and a virus of unknown origin. The virus latches itself on to a specific enzyme receptor site on specialised cells found in the lungs   which results in cell infection and reproduction of more viral particles. However, there are a number of aspects of the virus that are still being actively researched.
Currently, there are a number of research groups across industry and academia working on a vaccine with the aim of producing a workable version within the next few years.
Based on research carried out in China, the median age of the patients was 47 years; 0.9% of the patients were younger than 15 years of age. A total of 41.9% were female. The severity of COVID-19 was categorised as non-severe in the majority of patients and severe in a minority. Patients with severe disease were older than those with non-severe disease by a median of 7 years. Data further indicates that the diseases progresses faster in elderly than in young and it is more fatal in the elderly population than young .
The outbreak of a new strain of coronavirus in China had been well telegraphed and has had some impact on the Asia region but until recently had seen relatively little contagion globally.
What we don't know: Rate and nature of global spread
However, the past few weeks have seen cases develop across 71 countries (as at 2nd March). This has come with an acceptance that the outbreak of the virus has not been contained within China, as some of the new large volume cases emerged as far afield as Iran and Italy.
Countries with confirmed cases as of the beginning of March
Whilst early data on the new strain has been heavily subject to uncertainty and revision, the initial spread of the virus appeared to be faster than experienced with previous known outbreaks such as SARS. Current estimates suggest that the virus has a transmission rate, referred to R0 as, of between 2-3 new infections per existing case, compared with an R0 of 1.3 for seasonal flu.
The scale of response by the Chinese government in shutting down activity and movement in the affected areas had raised hopes that it would curtail contagion, however, reports of new cases across continents in the past weeks have shifted the likelihood of a global pandemic and triggered the market correction.
Estimates of mortality rates shift as more data becomes available. The mortality rate in China has been quite high so far at around 3%, however, this has been reflective of medical services being ill-prepared for the unknown nature of the virus in the early days and weeks as they sought to find potential cures and vaccines. As it becomes better understood, there is a sense that the mortality rate will come down. The estimates may also be overstated due to miscounting of the actual number of cases; given that there is thought to be a two week incubation period and some only exhibit mild symptoms, the number of cases could be vastly underreported at this stage. Currently, expert estimates point to this strain of coronavirus ultimately having a mortality rate in the region of 0.5-1%, elevated when compared with an estimated rate of 0.1% for influenza but significantly lower than the mortality rate of circa 10% estimated for SARS.
Economic impact channels
A starting point in getting to grips with risk scenarios is to look to historical experiences for context. This approach led to initial comparisons being drawn with previous respiratory epidemics such as SARS and MERS in an attempt to understand how the outbreak of new cases could evolve and what the economic and financial impact may be, implicitly assuming the outbreak would be brought under control.
However, it has become increasingly clear that the NCovid-2019 outbreak has evolved to be increasingly different from SARS, and in particular, is much more global and widespread in terms of its economic impact. Estimates of economic impact from the SARS outbreak are put at around $50bn; based on the current number of cases and policy response. The current outbreak has likely already far exceeded that amount but it’s difficult to disentangle at this stage due to the complex nature of supply chains.
Aside from the tragic human cost of the outbreak, the immediate economic impact is significant. Economic growth will slow globally, and dramatically in some of the most directly affected regions. How long and deep the slowdown is, depends on how wide the virus spreads and what health countermeasures are enacted. The impact on the economy is less a direct result of the virus and more a by-product of health countermeasures to contain the virus as well as the indirect impact via confidence.
The scale of the shutdown in China has been unprecedented. The travel restrictions and quarantine measures implemented not only brought the Hubei province, which accounts for about 5% of economic activity, to a virtual standstill but also affected the manufacturing and trade hubs along the east coast. Based on roaming usage data, Caixin report, as of the end of February there were still about 10m people waiting to return to industrious Guangdong province.
Figure: China PMI registered worst reading on record in February
Supply chains: The disruptions in China also impact production in other parts of the world through supply chain effects. And the impact is nonlinear. Short disruptions can generally be worked around but the longer the disruption goes on, the larger and more persistent the impact. China’s relative importance and integration of supply chains have increased dramatically over recent decades. In 2002 when the SARS epidemic started China accounted for about 8% of global GDP. Today, China accounts for 18% of global output and an estimated 25% of manufacturing.
With new cases arising in new countries and regions, we have yet to go through the additional disruption that containment efforts in those places may cause. Economic models are limited in their ability to fully capture the unusual nature of such events. To begin with, uncertainty about the potential of the virus to spread and the speed at which it does so remains very high at this point. Additionally, the policy responses and resultant outcomes will be different for each region.
Academic studies have previously attempted to approximately estimate the impact of pandemics on the global economy through various channels such as labour disruptions, cost increases and demand reductions. The next charts show findings taken from a study conducted in 2006. The "severe" scenario, in which 2% of the global population die, leads to an estimated 5.5% impact to global GDP, whilst a "moderate" scenario leads to a 2% hit to growth. A study conducted in 2017 by the World Bank on antimicrobial resistance estimates a similar economic impact under their severe and moderate scenarios. Rough estimates suggest that the impact of the Covid-19 outbreak sits closer to the moderate scenarios characterised in these studies.
Figure: Estimated impact of different degrees of flu pandemic on global economies2
Current estimates suggest that the disruption seen so far is on course to have a 5% annualised impact on the most affected economies such as China, whilst work by Oxford Economics suggests the impact could be a hit of 2% to global GDP. Economists are downgrading their estimates for global growth for 2020 down toward 2%, from around 3.5% coming into the year. Within that aggregate, some economies face recessions that could exacerbate existing vulnerabilities. Given low trend rates of growth, high sensitivity to international trade, policy rates already close to the lower bound and fiscal imbalances within the region, Europe in particular appears vulnerable.
The good news from a pure economic point of view is that the combined supply and demand shock should be of temporary nature. While uncertainty remains about the length of the impact, growth is likely to rebound as the virus becomes more contained and the world adjusts. Lost production will not be fully recouped and lost demand not fully compensated but in most current scenarios, potential growth should not be damaged.
The Chinese Central Bank (PBoC) has already acted by lowering policy rates and injecting liquidity measures to ease credit and cash flow disruptions for businesses and consumers. The widely anticipated emergency 50bps US Federal Reserve rate cut was announced last Tuesday. After an initial surge, markets began to tumble on fears the Fed had moved too early and the economic impact might be larger than first feared. One market participant quipped, “To pull that bullet out so fast and so furiously leaves us with not that much ammo”, and, to make matters worse Donald Trump tweeted urging “…more Easing and cutting!”. Central bank action may ease market fears, smoothen credit and ease liquidity constraints to avoid a disorderly tightening of financial conditions but risks exacerbating the economic shock. Fiscal policy, if applied efficiently would be a much more effective tool for such a shock.
Our research suggests the world preparedness for a pandemic outbreak is poor. Preparedness is generally more effective and less costly than an outbreak response but represents a cost with invisible benefits when it is successful and as such has received little funding. An incremental cost of $4bn per year is estimated to be necessary in order to improve preparedness.
Capital market impacts
During periods of high market volatility, it is useful to think through what the fundamental impacts could be in order to ascertain whether markets are beginning to over-exaggerate negative developments. We often lean on hypothetical scenario analysis, including worst-case scenarios but also what we believe is the most likely path and how outcomes could be better than expected.
Covid-19 outbreaks were first documented before the turn of the year in China and as the number of new cases spiked, Chinese equities sold-off heavily. Global markets were generally resilient to these moves as the outbreak was treated as an epidemic that would likely be contained within China. It is now clear the containment efforts were failing, and this uncomfortable truth became most stark with news of a surge of new cases in countries such as Italy and Iran.
Once this reality was confronted, market participants moved quickly to reprice the risk of the outbreak becoming a pandemic. Global equity markets have seen significant sell-offs, whilst safe-haven assets such as US treasuries and gold have rallied. The speed of moves has been particularly severe and, anecdotally, this has likely been made worse by market microstructures and automatic trading.
The strength of equity markets in recent months had also made them vulnerable to a shock. Coming into 2020 they had performed strongly and in our opinion were discounting a solid rebound in activity following the slowdown seen in the second half of last year. Looking at recent move through the lens of our activity indicators and cross-asset growth factor, that sentiment has changed and a renewed slowdown now discounted.
Rate expectations have fallen significantly over the past week and further easing is now priced for many central banks across the developed and emerging world. Reflecting this further flattening of the expected path for policy rates, long-end government bond yields have fallen further this year, with US 10-year yields reaching record lows.
The rally in government bonds contrasts with the downturn in global equity markets, which have fallen between 10-20% in terms of excess return relative to bonds. Depending on the assumptions you apply in terms of what proportion of this move has been driven by increased risk premium, it points to earnings declining somewhere between 10-20% this year, from expectations of a 10% increase previously.
Whilst this may seem extreme relative to current estimates of economic growth impacts, earnings are extremely pro-cyclical and a useful rule of thumb for earnings cycles is to amplify economic swings by a factor of 10. Thus, a full year hit to economic growth of 2% could well translate into a 20% reduction in earnings.
The challenge for us is to what degree this constitutes a one-off level shock to this year’s earnings that can be recovered over time and mitigated with policy response, versus a more fundamental shift to the required risk premium for risk assets.
The channels through which we would think the shock could spread more meaningfully would be firstly via the credit channel, with overextended borrowers defaulting during a longer period of economic disruption. Within credit markets, high yield segments of the market have joined the sell-off, with the energy sector in particular signaling significant risk of default. A deterioration in credit markets would require a redoubling of efforts from policymakers to provide support. A second more lasting impact could be a further move toward dismantling global supply chains, a notion already given credence by the continued uncertainty of the trade dispute between the US and China. Under this scenario, we could see profit margins to come under threat and economic volatility and inflation risks increase.
On balance, we remain of the opinion that whilst the full scale of the impact is impossible to know at this stage the nature of the shock is exogenous and not driven by internal fragilities within the global economic and financial system. It is plausible that not all of the lost activity will be recovered – we generally don’t make up for missed restaurants meals or holidays by having twice as many in the future, whilst workers’ lost earnings due to closures will not be recouped – but we would expect that as the official response to the pandemic evolves activity should be able to recover, even if this involves accepting the existence of the virus as a new fact of life and focusing on mitigation. There is also the potential for monetary and fiscal policy reactions, of which there have not been many announcements yet.
Potential Implications for our strategic asset allocation
Whilst our portfolios will be negatively impacted by the recent volatility in markets, we also see it providing some opportunities. Recent strategic asset allocation (SAA) changes have seen a reduction in risk based on the stage of the economic cycle and the view that the global economy had a much greater vulnerability to unanticipated shocks. The good news is that it may now give us a good backdrop to potentially benefit from market opportunities, which we are imminently studying for the 2020 SAA.
When setting the SAA, we seek a diversified mix within the portfolio, such that we can achieve good risk-adjusted returns over the long term. Recent events highlight the importance of diversification as well as considering the relative value of assets as asset price movements have been rather indiscriminate.
Going forward, we will be tracking developments across three broad areas:
- Assessing the market action relative to estimates of economic impact
- Understanding the vulnerabilities in different economies and regions. Some regions are more vulnerable than others, and we may seek to allocate away from these areas. On the other hand, some areas may be less impacted
- The short-term versus the long-term economic impact of the spread of the virus itself and of the monetary and fiscal policy response function.
As an example, within fixed income, there are now interesting opportunities to further diversify away from developed market debt, and benefit from diversification across a larger number of central banks as well as higher real yield. With respect to our equity allocation, we continue to monitor current market pricing in terms of what it implies for future earnings growth relative to how coronavirus developments are unfolding. Coming into the year we had been cautious about the economic rebound already priced into equity markets but depending on how the correction evolves, it potentially presents opportunities.
Markets appear to be getting close to pricing a moderate pandemic taking hold, though there remains significantly wide bands of uncertainty. On balance, we are of the opinion that whilst the full scale of the impact is impossible to know at this stage it is not directly driven by internal fragilities within the global economy and the financial system. In the meantime, we are monitoring to what extent market prices /extrapolate these risks, whilst being conscious of knock-on impacts and vulnerabilities, and act on opportunities accordingly.
Stepping back from the economic and financial considerations, our thoughts are with all those already affected by the outbreak and whilst we seek to treat developments objectively, we do not lose sight of the human cost.
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1A disease that can be transmitted from animals to people. The disease normally exists in animals, but which infect humans.
 Sun, P., Lu, X., Xu, C., Sun, W. and Pan, B. (2020), Understanding of COVID‐19 based on current evidence. Journal of Medical Virology. doi:10.1002/jmv.25722
 Guan, Wei-jie et al (2020), Clinical Characteristics of Coronavirus Disease 2019 in China, New England Journal of Medicine, DOI: 10.1056/NEJMoa2002032
2 See McKibbin & Sidorenko, “Global Macroeconomic Consequences of Pandemic Influenza”, Australian National University, 2006. We would caution that the structure of the global economy has changed substantially since the model was estimated in 2006 and consequently treat the output with caution.