Summary

• In the last few days, equities and other risk assets have sold off amid increasing concerns about the potential for the coronavirus to spread further than was initially anticipated. Safe-haven assets such as gold and US treasury bonds have rallied.
• The number of cases across the globe has now increased to around 80,239 as of February 25.  Meanwhile there have been 2,700 deaths from the disease.
• Overall, our base case remains intact – we still expect global economic growth to return to trend over 2020 and 2021, albeit with higher downside risks than previously anticipated.
• Equities could fall further if the disease becomes a global pandemic and efforts to control the spread further disrupt economic activity. However, equity market investors should look beyond short-term economic disruptions, and the downside could be cushioned by any monetary policy response.
   

Background

Market sentiment has been progressively impacted in January and February as investors have assessed the potential impacts of the coronavirus outbreak. The virus spread rapidly in the epicentre, Hubei Province in China, and while the number of people infected continues to rise, the rate of infection may have peaked as a result of the stringent quarantine and travel measures. In addition to the significant human costs, economic activity in China has been impacted severely as a result. Recently the spread outside China has accelerated – with more than 30 countries affected, South Korea, Japan, Italy and Iran in particular. 

Little is known about the virus, though it is known to have emerged in early December 2019 in Wuhan, the largest city of central China’s Hubei province. Investor concern initially grew with reports of the first human-to-human transmission on January 20. Since then, the number of confirmed cases has increased considerably, even if the mortality rate has remained stable at 2%-3%, significantly lower than for SARS and MERS. Whilst easily transmittable between humans, its transmission rate is much lower than for measles but higher than for seasonal flu.

The virus is estimated to have an incubation period as long as 14 days. Many people do not show symptoms during this period, which implies that it may have spread much more widely than we currently are aware, particularly before restrictions on people movements and forced quarantines, were put in place.

To prevent the virus spreading throughout China, Chinese authorities implemented travel restrictions in and out of Wuhan and other cities in Hubei province in the week commencing January 20. Since then, a number of provinces have extended Lunar New Year holidays, and many companies have either remained closed, or have encouraged workers to work remotely. Meanwhile, major airlines have cut flights to China, and a number of other countries have closed land borders and implemented restrictions on arrivals from China.

The most important channel of economic impact will likely be the hit to Chinese consumer spending. That’s less a function of the inherent danger of the virus — which is still unknown — and more about the precautionary response of the government and Chinese consumers leading people to stay home instead of heading to the shops, eating out, traveling or doing leisure activities. Other government containment efforts will also add to this — including lost output as businesses stay shut for longer following the Lunar New Year.

Economic implications

Our central view for global growth remains for a gradual pick up to trend over 2020 but the impact of the virus is certainly going to detract from growth in the first half of the year at least. Under the scenario, some of the lost growth in the first half of the year is likely to be recovered in the second half. China’s economy amounts to over 15% of the global GDP, up from 4% during the SARS epidemic back in 2002/03. Early estimates suggest the detraction in Chinese growth for the first quarter of 2020 will range from 1.0-2.0% which will contribute -0.2% to -0.4% to the global GDP growth. Growth across China’s major trading partners is likely to come under more threat, given their interdependence with the Chinese economy, particularly in the service sector such as tourism.  

Domestically, the service sector may be hard hit in the short term but some mitigating factors are in place such as digitisation of the economy; core consumption remained stable. China’s central government have mandated against price increases across core products which may help to reduce panic and disruption if this remains a temporary situation. Industrial activity is likely to be disrupted, with the factories extending the Luna New Year holidays due to virus outbreak. This may also disrupt supply chains across Asia, weighing on other economies with close links to China such as South Korea and Japan. If this situation persists, we could see disruptions on a global level, reminiscent of ash cloud of 2010.  

A combination of both monetary and fiscal stimulus is likely to be implemented in the foreseeable future. The People’s Bank of China (PBOC) already responded by providing short-term liquidity across interbank markets and by cutting interest rates to 2.4%. Further reduction is the Reserve Requirement Ratio (RRR) may also be implemented in the coming months to ease financial conditions. Fiscal policy is likely to be relaxed further and we expect to see the government shift its fiscal deficit targets to allow more room for action.

Financial market implications

Although the virus may lead to short to medium term disruptions, we retain our view that global growth should return to trend levels over the course of 2020, especially on more supportive central bank policies.

The initial financial market impact of the virus was limited, with a sharp decline in Chinese shares reversing itself quickly on the promise of more stimulus. However, at the time of writing global markets have reacted more meaningfully as investors attempt to price in the risks in what is a highly uncertain environment. A flight to safety has seen world share markets falling sharply and defensive assets such as bonds performing strongly as bond yields head back towards record lows.

We believe volatility will likely remain elevated in markets over the coming weeks as more news on the virus emerges. As both a supply and demand shock, there is significant uncertainty as to how much damage the virus may cause in the short-term together with potential medium-term disruptions (such as forcing companies to change their supply chains). If the global response is effective in curtailing the spread, the result will be that economic demand is delayed, leading to pent-up demand led growth.

In this scenario global growth will gradually pick up back to trend over 2020/21, though the impact of the virus will certainly detract from growth in the first half of the year, at least. Early estimates suggest the detraction in Chinese growth for the first quarter of 2020 will range from 1.0% to 2.0%, implying around 0.2% to 0.4% negative drag off global GDP growth (year on year). Specifically, the service sector (especially tourism) is being hard hit in the short term.

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