The effects of coronavirus (COVID-19) on the markets are already being seen in sharp movements in asset prices—sharply downwards in riskier assets such as equity markets and certain sections of the corporate and high yield bond universes, but also sharply upwards in traditional risk-free assets, as yields on US Treasuries, gilts and bunds plunge. In the case of US Treasuries, perhaps surprisingly, yields have fallen to all-time lows, with the 10-year US Treasury currently yielding below 1.20% at the time of writing—discounting at least two further interest rate cuts from the Federal Reserve (Fed).
The question at hand is whether this volatility represents an overreaction in financial markets to what may be a hitherto undiagnosed respiratory viral infection, albeit a serious one, but one which has characteristics similar to previous outbreaks.
While the World Health Organization (WHO) has yet to declare the outbreak a “pandemic”, the economic effects are already broadening and hopes that medically the incidence of the Novel coronavirus might be contained only to the immediate areas of outbreak are being shattered, as diagnoses of COVID-19 are now being made in many continents well beyond the epicentre of the disease. A much-quoted statistic is that the only continent to be free of coronavirus is Antarctica, where economic output realistically has little impact on global gross domestic product (GDP). There is little doubt, therefore, that there will be lost economic output to add to the health concerns many share.
To the known facts: COVID-19 follows in a similar vein to MERS (Middle Eastern Respiratory Virus) seen in Saudi Arabia in 2012 and SARS (Severe Acute Respiratory Syndrome) first identified in 2003. Mortality rates, while concerning, are not significantly higher than for other forms of winter respiratory illnesses, with particular vulnerabilities among those with pre-existing medical/respiratory conditions.
True, diagnosis of new incidents outside the core areas of infection are now higher than in the initial areas of quarantine, but this does not necessarily imply a worsening of impact. As investors, we have suddenly become amateur epidemiologists, although even professional and medically qualified epidemiologists cannot describe with any degree of certainty how the disease may play out.
Economically speaking, the impact in China could be compared to the phase, “It’s like canceling Christmas”. The phrase has resonance in Hubei Province in China and in many other areas of Asia. Both Southeast and Northeast Asia, where the outbreak occurred just around Chinese New Year—described by many as the annual largest migration of humans as families in normal circumstances visit one another to celebrate the festival. The Year of the Rat will not be remembered fondly.
The big question is whether the undoubted economic impact on China’s first-quarter growth will be carried over in fully lost growth, or whether, taking a positive assumption that there is no worsening of diagnosis, subsequent quarters see a rebound in growth.
The dependence on supply chains in many economies to China suggests output will be lost not only in a sharp decline in the growth rate of Chinese first-quarter GDP (which is still anticipated to be positive) but also result in a slowing growth rate in many economies with links to China’s supply chain. Deferred Chinese New Year celebrations are likely to be permanently deferred, and it seems unlikely that a similar celebration next year will result in twice the consumption of food. Empty flights and empty hotels do not lend themselves to higher prices to encourage greater occupancy.
However, weaknesses in supply chains, now made evident by the dependence on China, may result in trying to find alternative sources for these parts either overseas or domestically, and it seems difficult to assume that this disruption will come at anything other than a higher (inflationary) cost.
The question is, how will central banks respond? Markets have already moved to give their answer. And interestingly, not immediately in the way that one might infer from direct linkages with China and/or risks from the novel coronavirus.
Declines in sovereign debt yield have been greatest in the US Treasury market, and least in Japan, which geographically is much closer to the epicentre, and where President Shinzo Abe has announced the closure of schools, and officials are expressing concern for the 2020 Tokyo Olympics.
Saudi Arabia has announced that foreign pilgrims will not be allowed to visit the holy site of Mecca, although it remains premature to determine whether the Haj in July will be similarly affected.
More prosaically, the Rugby match between Ireland and Italy (now the European country most affected by an outbreak of COVID-19) has been postponed from 6 March. However, we can be sure, assuming a rescheduling of the match later in March, that as many pints of Guinness will be consumed at the rematch as would have taken place on the original day—a perfect example of where consumption is simply deferred. But in many other areas, GDP will be permanently lost.
For central banks, as we see for the medical profession’s Hippocratic Oath, “doing no harm” will spring to the fore. We believe in response to the coronavirus central banks will refrain from taking measures in the near term that could slow growth and hurt markets. At the margin, there may be “insurance” cuts in policy rates, but one might argue that many central banks were already predisposed in that direction.
And to the potential question of whether increased costs of new supply chains cause a small increase in prices, Federal Reserve Governor Lael Brainard, albeit a known dove, has already given her clear opinion of how the Fed might react—she asserts that the Fed should be allowed to run inflation “hot” (above a normal target) in order to compensate for previous periods of inflation undershoot. And if the hit to global GDP is actually more acute than currently thought, a continuation of global central bank dovishness seems assured.
We have become used to “low for longer.” Our multi-sector and global aggregate strategies have generally favoured less duration exposure in risk-free markets, which in our view have overreacted as default “go-to” markets in times of worry. But interestingly, proxy positions have acted well to balance returns when markets have remained choppy. Our negative view on US interest rate risk is perhaps well known—less well known has been our favourable view on proxy positions in Australian government bonds (currency hedged), which have acted as strong ballast to the Asian economic slowdown. However, with currency hedged, we gain the benefit of rallying bonds without the risk of loss arising from currency volatility. In Europe, needless to say, Italian bonds have underperformed German bonds given recent events. However, owning both does allow investors the flexibility to reduce in one (Germany) to add to the other (Italy) if markets become too dislocated.
The situation continues to evolve, and we are monitoring developments as they arise. We stand ready to act should conditions change materially. In our view, this recent market shock is another example of why active management and the ability to be nimble is so critical in market environments such as these.
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