Novel coronavirus, it appears, is on the verge of becoming a global pandemic and its impact on the global economy will likely be much larger than was initially thought. Markets are in turmoil because of the threat to global growth and related uncertainty that this brings. It is just too early to predict what the ultimate impact will be. This lack of visibility has manifested in abnormally volatile share prices since the end of January 2020. The Bulls and the Bears are engaged in a tug of war where both appear reasonably equally matched for now.
The Bulls are fundamentally optimistic
The Bulls believe that the economic impact on China and the world will be severe but short-lived. Gross Domestic Product (GDP) in the first quarter (Q1) of 2020 should experience a deceleration (and possibly even a mild recession) induced by a sharp contraction in Chinese manufacturing. As the virus subsides naturally into the northern hemisphere summer, Chinese manufacturing and global economic activity will rebound sharply resulting in a V-shaped recovery. Annual GDP growth should therefore only experience a small negative impact. Bulls draw from the SARS experience in 2003 where Chinese growth fell to just 3% in Q1 2003 but by the end of that year the impact on annual GDP was less than 1%. They argue also that central banks around the world are injecting massive monetary stimulus into the system, which will also be complemented by fiscal stimulus in the most affected economies. Historically these policy interventions have been hugely positive for equity markets even though their effectiveness, in relation to economic growth, is questionable at best. The Bulls therefore advocate “buying the dip” which has been a very profitable strategy over the past decade.
The Bears are fundamentally negative
The Bears believe that China has underreported the severity of the virus and that the economic impact will be much worse than currently forecast. In the short-term, large downgrades to global GDP growth mean that earnings expectations will be sharply downgraded. Given that global markets were already significantly overvalued before novel coronavirus, the de-rating could be far more severe than many expect. Warnings from large corporates are increasing by the day. Industries such as airlines, luxury cruises, shipping and tourism have reported drastic drops in current and projected volumes. These industries have high fixed operating costs and will likely experience financial distress which could have knock-on effects in banks and the financial system in coming months.
Longer-term market implications are more concerning. Multi-nationals have concentrated the bulk of their supply chains in China. Global pharmaceutical, telephony, technology hardware, automotive and mineral processing are but a few which will be forced to reassess the diversification of their business models. This reshaping will have a medium term economic impact which could lead to inflation, supply disruption and margin contraction. Earnings growth could remain below trend for some time which will ultimately lead the market lower.
The Bears are also more sanguine about the likely success of stimulus i.e. the US Federal Reserve’s (Fed) recent surprise cut. They argue that this is predominantly a supply shock and that demand is merely pent up due to containment measures and fear. Cheaper money is therefore largely ineffective in its ability to stimulate additional demand. Instead, a comprehensive package of policies that support troubled businesses is needed. This falls within the domain of fiscal stimulus, which thus far has been absent. Fiscal measures will also take far longer to effect. The size of the response requires greater visibility of the size of the problem. This will only become clearer as the pandemic peaks, which is still some time away.
Markets were expensive and on shaky ground even before Coronavirus emerged. Global growth had already been slowing and 2020 earnings growth projections were in the low single digits; hardly a recipe for rampant equity market rallies. Yet, that is exactly what happened over the past six months. Global equities rallied to record highs in January 2020. Driving factors included the Sino-US “Phase I” trade deal, three US Fed cuts and $500billion of quantitative easing, Chinese monetary stimulus and avoidance of a hard Brexit. The world is flush with cheap money which has underpinned expensive valuations. Despite the recent sell-off, global markets are only 10% or so lower than historic highs – hardly a panic.
Until valuations more adequately reflect fundamentals, our funds will remain conservatively positioned in risk assets. We continue to advocate exposure to cheap, high yielding equities with strong balance sheets and sound fundamentals. These companies will likely be affected but will have the financial strength to weather the effects of a potential downturn. Our funds also hold above average levels of cash, which will provide optionality when markets re-price downward.
At this stage, the South African Reserve Bank (SARB) will probably not want to be seen to panic and will highlight risk-premia to keep foreigners invested. As such, while cuts in 25 basis point increments over the next few meetings are anticipated, a deep cut with more possibly to come by the US, could mean we have room for 50-100 basis point cuts if the picture deteriorates.
That said, Coronavirus has merely accelerated the return to normality. We have no doubt that this, like most other epidemics, will pass. At this stage, however, it is too early to predict the impact on global economic activity and earnings. Until a clearer picture emerges, a cautious approach is warranted.