The COVID-19 outbreak is emerging as perhaps the greatest risk the global economy has faced since the 2008 financial crisis.
A significant part of the Chinese economy, the world’s second largest, remains idled and it is not hard to conceive that perhaps a quarter of total working hours may be lost in the first three months of 2020. Our modelling suggests that China’s economic growth could decelerate to 2.5% yoy in Q1, and despite assuming a relatively quick recovery for the remainder of the year would still leave overall 2020 GDP growth at around 4 ½ % , down from an earlier forecast of 5.8%. If there is more permanent damage to consumer behaviour, we forecast 2020 GDP growth could be as low as 2.5%. We are certain that Beijing will not want to report such dismal statistics but a larger drawdown than many commentators suggest is now our base-case scenario.
As the virus spreads and other countries join China in implementing widespread quarantines and travel bans, we expect global GDP to be negative for the first quarter of 2020 for the first time since the 2008 financial crisis. Global linkages have also deepened in the last decade and the initial shock will be amplified across regions through travel, tourism and trade channels worldwide – a recent survey by the Wall Street Journal suggest the impact on airlines could be greater than 9/11. There is a likelihood that COVID 19 creates a domino effect across Asia , similar to what happened during the Asian financial crisis in 1997. Given the unpredictability of the emerging virus ‘hot-spots’ we should expect economic activity to be disrupted in a number of other regions simultaneously over the next few weeks.
The policy response
The virus holds particular risks for the world economy because it creates both a demand and supply shock to goods and services. A demand shock alone can be mitigated by interest rate cuts and central bank support, as we saw in the aftermath of the financial crisis – the goal then being to encourage consumers to spend and businesses to invest. However, if labour is quarantined, critical supplies become unavailable and public gatherings are restricted, then the impact of rate cuts will be mute at best. Would consumers go to the cinema with the risk of virus infection simply because their mortgage payments were lower, or would a factory manager restart activity if their loan costs were reduced but key components in the supply chain were still unavailable?
Monetary policy impact is also limited because many central banks are already ‘maxed-out.’ Interest rates are close to zero or negative in much of Europe and Japan, and there have been already three massive rounds of official bond purchases (‘QE’)in a decade that have left central bank balance sheets bloated. Banking profitability in Europe is also particularly weak making further rate cuts potentially self-defeating. Even in the US, the comparisons with 2008-9 make uncomfortable reading – then the Federal Reserve had ‘room to cut’ with the federal funds rate at 4.25%, today they sit at just 1.5- 1.75% and analysts are already pencilling in two additional rate cuts by mid-year.
In consequence, Chinese and other policy makers face an unenviable trade-off: arrest the shock to GDP or contain the virus and prevent a full-blown health panic. President Xi has declared that the growth targets for 2020 (circa 6%) will be met, suggesting an incredible amount of stimulus once the virus is contained. Despite the aggressive rhetoric, we believe that China will prioritise containing the spread of the virus and so suffer the economic consequences. This dilemma will affect other economies – yes, fiscal spending will rise aggressively (even in Europe) but this will take time to deliver and will likely conflict with containment strategies for the virus for some months yet.
Against this backdrop expect some radical initiatives that will be designed to offset a cash squeeze and stabilise investor confidence. In Hong Kong the main feature of the annual budget announced last Wednesday was a payment of HK$10,000 ($1,284) to each permanent resident of the city aged 18 years or older1 . ‘A cheque in the post’ as George Bush famously enacted with direct fiscal transfers after the 9/11 attack may well be replicated in other economies (and would likely be enthusiastically adopted by the White House in an election year). We also expect heightened international co-operation – if, for example, policy rates are cut, expect a simultaneous move by the world’s major economies. As in 2008/9 more radical, joined up policy thinking can be effective in supporting investor and consumer confidence.
Our positioning today
We moved quickly last week to reduce our overweight equity position across all our balanced mandates after the strong rally of the last few months. We sold equity positions in travel, selected banks, emerging markets and some China-focused technology names.
With the proceeds, we added to our already larger than normal cash balances along with some additional UK gilt purchases. We were steady buyers of gold through 2019 and retain our positions today as a hedge against an aggressive new easing of monetary policy.
Our bond portfolios (which have risen strongly) have a duration of around 11 years and are around 50% exposed to government or agency debt. Overall they have a strong average credit rating of A+. We have very little exposure to higher-yield products or more vulnerable emerging market debt.
Our global equity holdings are well diversified, broadly under-leveraged and are generally exposed to long-term trends that are not overly cyclical or Asia-centric. While none of our holdings have been immune from recent sharp declines we see few long-term signs of material disruption to business models and little risk to dividend yields (which are now close to all-time highs relative cash and bonds). Our thematic and ESG focus means we have very little fossil fuel or metals exposure and no direct exposure to the auto-industry where some dividend cuts might now be expected.
Finally, many of our balanced accounts and in particular our target return mandates have embedded portfolio insurance via equity index puts (on the MSCI world index) acquired when equity volatility levels were low. These positions will offset some equity losses at current index levels.
The Outlook
The stock market correction has been sharp with the S&P500 recording its fastest ever 10% decline, while the US 10 year bond yield, the anchor of global financial system, has just touched an all-time low. Part of this move is in anticipation of a material shock to global earnings, but a part is also a reaction to an exogenous shock – the ultimate economic impact of which is huge and unknowable. It is the latter that is now driving the aggressive fall in financial markets, and could reverse, at least in part, if the spread of the virus appeared to be peaking.
Yes, there will be some more permanent damage. Cash flows will have been squeezed severely across many businesses especially in Asia (where leverage is high), refinancing will be difficult with new issue markets frozen and revenue outlooks will be cloudy for some months. However, the sorts of investment that will suffer from long-term scars are not what we hold for our clients – our positions are well capitalised, diversified, broadly liquid and driven by strong secular trends. Their cash flow and dividend yields look extraordinarily robust, all the more so if central banks cut rates further.
1 Source: Bloomberg