Equity Update: Virus Fears 2.0

Reality bites across Asia today as the spread of coronavirus picks up outside China. South Korea and Italy have both reported rising COVID-19 case counts over the weekend, and today reports of 161 new confirmed cases in South Korea has spurred risk aversion even deeper. South Korea being another supply chain centre and key logistics hub is now on high alert level, intensifying the already ongoing regional supply chain disruptions. Shutdowns and production delays have the capacity to cause unexpected bottlenecks across many production lines even if the virus spread peaks soon. And it is those non-linear supply side effects like production bottlenecks that are the real wildcard in terms of further downgrades to growth, earnings and longer term disruptions.

These bottlenecks are already visible at a company level, particularly in the auto, garments and consumer electronics sectors. Nissan has halted production in Japan due to lack of Chinese parts, Fiat has curbed production at a plant in Serbia for the same reason. And Jaguar Land Rover has warned production will stop within a fortnight unless "the Chinese supply chain comes on stream again". Inventories of brands such as Gap, Nike and Uniqlo are being affected by ongoing disruptions to their Southeast Asian supply chains. And Apple’s warning last week is as big an alarm signal as any in highlighting the disruptions to the consumer electronics sector. These are key reads on how heavily intertwined global supply chains are being disrupted as shutdowns trickle down production lines. And of concern not just in terms of the direct effects, but also the capacity for non-linear secondary effects to cascade. Markets have been slow to recognise and price these risks, focussing firmly on the glass half full, but as the outbreak spreads this is changing.

As we have written many times over the past week, equity markets have been remarkably resilient in the face of a double whammy demand and supply shock ready to hit economic activity. Instead opting for a more sanguine outlook, focussing on the impending assault of fiscal and monetary stimulus from a brigade of policymakers. Even though it is far from clear how effective monetary stimulus and tax cuts will be whilst people are quarantined, factories operate at reduced capacity and uncertainty prevails.

With contagion picking up outside of China, complacent markets have woken up to the realities of what has clearly been a huge mispricing of risk. For every day that new shutdowns and quarantines are introduced, the corresponding loss in economic activity renders a deeper and more protracted impact than the optimistic outlooks embedded as both US and Australian stocks hit fresh record highs last week.

At time of writing Aussie stocks are down more than 2%, the biggest drop since December 3^rd 2019. The Hang Seng is off by more than 1%, but the Kospi really feeling the brunt of the pain sliding more than 3%. FOMO working just as well on the upside as it is on the downside today, as gold continues to shine as the virus buffer of choice maintaining recent upside momentum. Gold is one haven that benefits from the sheer uncertainty of the situation and is not dependant on ultimate impact on supply chains. The Aussie dollar also hitting fresh 11-year lows as risk sentiment continues to fade, the USD remains strong and traders weigh the Australian economy as one of the most China dependant economies globally. Being a risk proxy, the China proxy and with the added impact of more than 30% of Australia’s goods and services exports heading to China, meaning the domestic economy is heavily impacted by ongoing shutdowns in China, the AUD is primed fall further. And this is just the first hurdle for the currency, the domestic outlook and prospect of continued easing from the RBA presents an additional drag. Despite a lot of bad news already reflected in the currency already, As market pricing for continued easing ramps up the AUD will remain under pressure.

As we said Friday, with equities having rallied hard recently, valuations are stretched at present. These increasingly stretched valuations and an incoming hit to earnings has left the market vulnerable to a near term correction. So beyond todays price action, continued risk aversion will see an ongoing re-rating across equity markets and it may take some real containment before dip buyers step in again. We expect price action to remain volatile as the toll of coronavirus spread mounts and begins to materialise in hard data and company earnings. As the contagion picks up outside of China, increased measures to control the outbreak lends the potential for the anticipated recovery and ripple effects to be much more drawn out than expected. Notwithstanding the supply disruptions and production bottlenecks that ensue. The impact on company earnings is therefore likely to be larger than is currently being accounted for, putting the previously forecast earnings recovery in jeopardy.

China Activity

Meanwhile, aside from the state of play in markets the COVID-19 outbreak continues to dampen economic activity and impact business activity. Although 5 provinces in China have downgraded their emergency status, activity data in China continues to point to an economy running well below usual levels. Some factories are still closed for business, and many of those open operate at reduced capacity meaning the disruption to supply chains continues. Cinema ticket sales, car sales, traffic congestion and property sales are all more than 80% below usual levels. Traffic congestion data is not only a good measure of how quickly activity is returning to normal levels in China, but also an indicator of sentiment amongst the population. Willingness to travel may not recover quickly even as officials encourage a return to work given that there is a lot of uncertainty and concern about the virus outbreak amongst the Chinese population. Notwithstanding the risk of a 2^nd wave of infections if people return to work too early. Electricity demand has begun to recover, according to an uptick in coal consumption, but again points to significantly depressed activity relative to the usual state of affairs. Local governments in China have begun to relax quarantine measures and are urging factories to resume work. The problem is that many factories still don’t have enough workers to resume at full capacity. According to officials in Chinapost the Lunar New Year holiday only 30% of workers have returned from rural areas to cities to work. The Ministry of Transport stating “the number of migrant workers returning is about 300 million, and about 80 million have been returned so far.” For smaller firms, these issues are magnified tenfold. Having less access to traditional funding lines, they are unable to meet debt and employee payments despite the cuts to funding costs last week. According to Bloomberg, a survey of small- and medium-sized Chinese companies conducted this month showed that a third of respondents only had enough cash to cover fixed expenses for a month, with another third running out within two months. These smaller private firms account for 80% of jobs and more than 90% of new jobs, according to the National Development and Reform Commission. So it is crucial that authorities in China deliver increased support for these smaller firms in order to limit job losses. Not just because that is key for social stability but because mass lay offs would place the economy on a slower trajectory for a much longer period once activity resumes.

Amongst many unknowns and dependant variables, at this stage the ultimate impact is impossible to predict with any certainty and remains a moving target. This means that within any forecast outcomes should be embedded an enormous degree of variability. As we have said before, the COVID-19 outbreak may represent an example of a fat tailed distribution for which a normally distributed model will understate various outcomes, leading to large mispricing of risk. We simply do not know how elevated the tail risks are. Price action will therefore be highly susceptible to virus related headlines as fears mount. The spread of COVID-19 beyond China now means more transparent reporting from countries like South Korea and Italy which could further heighten volatility and risk aversion.