Friday, 31st of January 2020
“The epidemic is a devil. We cannot let the devil hide.”
– Xi Jinping
Markets were choppy this week as the novel coronavirus spread beyond China and the first human-to-human transmissions were reported in Germany, the US, Japan, and Vietnam. On Thursday, Russia closed its immense land border with China in an effort to contain the outbreak and the WHO was forced to declare it a global health emergency. More than 200 people have died from the virus so far, mostly in Hubei province where it first emerged at a wet market in late 2019. Almost 10,000 cases have been confirmed worldwide, more than 100 of which are outside China (concentrated in Hong Kong, Japan, Thailand and Singapore). Within China, there are at least another 15,000 suspected cases and more than 100,000 people who have had close contact with sick individuals are being monitored closely. Although the rapid response by Chinese authorities has been praised by the WHO, the worldwide tally of coronavirus cases is now much higher than during the 2003 SARS outbreak which killed 774 people. Work is already underway to develop a vaccine, a process aided by knowledge of closely related viruses like SARS, the successful sequencing of the novel genome by Chinese health officials on 10 January, and technological advances that speed-up the vaccine development process. However, most experts believe that an effective vaccine is many months away and that the next week or 10 days will determine whether the outbreak becomes a global pandemic.
The SARS outbreak in 2003 shaved 2% off China’s Q2 GDP growth but the economic consequences of this particular episode could be much more severe, reverberating well beyond China’s borders given the country’s systemic role in the global economy today. At present, 16 cities including Wuhan are in quarantine (with Shantou having reversed a partial lockdown on 26 January), and roughly 60m people in Hubei face travel restrictions related to the coronavirus outbreak. Here the economy has effectively ground to a halt. However, beyond the provincial epicentre, things also look very grim indeed. Crucially, many people have chosen to stay at home rather than risk infection during the normally bustling Chinese Lunar New Year holiday, and this has sharply reduced consumer spending during one of the most important weeks in the Chinese shopping calendar. Meanwhile, cross-border trade and tourism have also been seriously impacted by the outbreak. China has banned all outbound travel tours indefinitely and airlines such as British Airways and Lufthansa have cancelled all flights to the Chinese mainland until mid-February at least. Even Hong Kong, which is still reeling from many months of pro-democracy protests, is pulling up the drawbridge. The local authorities have closed multiple border checkpoints, cancelled tourist visas, and cut bus services and flights to the mainland by half. In addition, all non-essential government employees have been asked to work from home and many private firms have followed suit. Given its high level of dependence on Chinese business, tourism and purchasing power, the outbreak is likely to have major economic implications for the Asian financial centre. The situation is similar for other neighbouring countries, from Japan to Indonesia. Asia’s economic fate is tied to that of China and with the country on lockdown, a chill wind is set to blow through the region just as things were looking up after the signing of the ‘phase one’ US-China trade deal.
Base metals (which are tied to Chinese growth prospects) are already feeling the heat, with copper and nickel down -11.3% and -12.0%, respectively, since the two peaked after the trade deal was signed on 15 January (and the first reports emerged of possible human-to-human transmission). As of Friday morning, the Chinese domestic stock market (as represented by the CSI 300) is also down -5.0% from its 13 January peak and we believe that the index could fall further as the implications for growth become clearer. The 3m and 10Y points on the US yield curve even inverted briefly on Tuesday, before snapping back, as the bond market rallied on the risk-off turn. Looking ahead to Q1 earnings results, we expect some sectors to suffer more than others from the outbreak with luxury goods being an obvious loser: LVMH is already down -10% and this could only be the beginning if the virus spreads and the quarantine continues. In light of all this, we are happy to have rolled protection at the start of the year, mindful that when optimism peaks (as it did in late 2019) there are simply no bears left whose conversion can drive the rally higher. As such, we feel well-prepared to weather any sell-off, should the market gyrations we have seen this week continue. To be sure, a virus-related drawdown will be an opportunity to buy back in at lower levels because it says nothing fundamental about the trajectory of global growth. The release of any pent-up demand in the wake of the outbreak is likely to drive a swift recovery in economic aggregates. But until then we are more than happy to stay defensive.
The other big news this week is that today is Brexit Day! At 11pm GMT on Friday evening, the UK will cease to be a member state of the European Union and will embark on a new future outside the block. Little is expected to change on day 1 (as the UK will immediately enter the ‘transition period’) and the battle to remain in the EU despite the referendum was lost back in December when the Tories won the election on a manifesto to deliver Brexit, so the event itself will pass by without much flourish. Over the next 11 months (and unless the talks are extended, which has been ruled out by Prime Minister Boris Johnson), the EU and the UK will seek to negotiate as comprehensive a free trade agreement as possible. Given the timetable and the number of matters up for discussion, this will be tough. But a Political Declaration has already been signed alongside the Withdrawal Agreement and this gives some indication of what is possible if both sides hit the ground running. We will know soon enough whether that happens or whether negotiators fumble their way to a very thin deal or none at all.