3/2/2020
Considering the difficulties in precise real-time measurement, as well as determining the transmission mechanisms of the virus, the potential impact is still difficult to predict. Updates have been coming out on a daily basis in recent weeks, although the virus itself has been circulating since last November. The uncertainty about severity and the open-ended time-frame around the two key elements—human and economic—has been undoubtedly the catalyst behind last week’s financial market meltdown.
Pandemics, which are essentially widespread and more severe epidemics, are feared today for the same reason they’ve been feared throughout history, even though medical science has undoubtedly improved. (As an aside, despite the ominous sounding name, a ‘pandemic’ only describes the broader spread of a virus to multiple regions, as opposed to any gauge of its severity.) Initial causes and methods of transmission often begin mysteriously, which can create a sense of paranoia among the public. It is also a byproduct of an increasingly globalized world, where the speed of movement of people and goods can also exacerbate movement of diseases. This was most famously seen on a widespread scale in the Black Plague of the mid-1300s, which was likely carried to Europe by trading ships from the Far East. From there, the pandemic spread outward, destroying Europe, and surfaced again several times in subsequent centuries in a variety of regions. The widespread mortality shaped several civilizations for generations, including political and religious institutions, which goes along with the embedded social fear that accompanies pandemics. The other more recent noteworthy pandemic, the Spanish Flu of 1918, in the waning months of World War I, caused approximately 50 mil. deaths globally (nearly a quarter-million in the U.S.). However, it has been noted that the mortality number was made far worse by post-virus bacterial infections, as modern antibiotics had not yet been invented.
This pandemic event comes at a current political era where many leaders, including those in the U.S., are already skeptical of the high level of global integration. The trend has been away from ‘peak globalization’ towards a more protectionist paradigm, and events such as this don’t help the cause of those wanting a continued integrated world. At the same time, economic growth is still much more intertwined between nations, meaning that a slowdown abroad affects everyone—as both customers and manufacturing supply chains remain very globally dispersed for the world’s largest firms.
Where does the economic fear begin? The slowdown in growth starts with the obvious. As a starting bottom-up example, as a quarantine measure in China’s Wuhan province, the movement of residents was restricted in attempts to contain the virus’ spread. This means those residents: (1) can’t go to work, (2) can’t travel, and (3) essentially can’t buy anything. (Working remotely and shopping online would be available to some extent, but represent far smaller proportions. It also does not capture the secondary effects, such as a hesitancy to frequent shopping malls, sporting events, or public places, which could cause fears and sentiment to worsen.) This creates a downward spiral of no economic activity, which affects the economy directly—no buyers and no sellers of goods/services. This is a simple starting example from a local level, but this model of economic impact is easy to carry further in today’s interconnected system of manufacturing supply chains. Manufacturing has become so specific that, for example, an auto factory in Japan was forced to shut down temporarily as a key part only made in China was unavailable. This may happen further as manufacturing inventories are depleted and unable to be replenished quickly.
As with the epidemiological impact, the economic spread is also radial. Closely-tied nations in the Far East are the most affected for now, with the U.S. and Europe less so, although there are specific exceptions, such as in auto and parts manufacturing. The longer such an event carries on, or spreads, this isolated shutdowns would impact more industries and create deeper bottlenecks in global production and distribution. This is the essence of how such an event can significantly affect global growth. In a time where companies have been looking for supply chain sources outside of China, for a variety of trade policy and intellectual capital protection reasons, this may well accelerate the effort to diversify these global operations.
What do the numbers look like? It’s possible that China’s growth will dip to zero for the first quarter, and estimates for U.S. growth have already fallen from 2% or so down to near 1%, with perhaps similar or even slower growth in Q2, before an assumed recovery. With the outbreak’s timeframe remaining open-ended, numbers remain fluid, and could easily improve or worsen. In essence, the longer it lasts, the deeper the impact, which is not reassuring for markets that seek certainty above all else. The Chinese central bank has already accelerated monetary and fiscal stimulus measures to offset the impact of the economic slowing, and other central banks, including the Fed, appear likely to follow suit if conditions become severe enough. Already, fed funds futures markets rates are predicting a -0.50% rate cut in March and a total of four cuts in 2020, totaling -1.00% (even though these can change quickly). This represents a difficult situation for a central bank, which doesn’t want to be perceived as acting rashly, but also wants to avoid ending up ‘behind the curve’.
More directly, the catalyst has been from U.S. corporate earnings, with Apple and Microsoft (two popular tech stocks, driven by strong price momentum lately). The firms, no doubt to be echoed by others, noted that the shutdown in China may destroy all global growth in Q1. Again, based on the GDP estimates, this is not a surprise, but becomes much for tangible for equity investors when earnings-per-share are involved. For an equity market already looking a bit frothy in terms of valuations, this was the straw that broke the camel’s back.
While we’re hesitant to quote medical stats, which lie outside the financial realm, it appears that the total number of cases in China peaked in mid-February—which is positive news for that region—although it has spread to an increasing number of other nations. At the same time, it is unknown whether the cases spread more recently, or they were only captured on tests more recently. Eventually, assuming cases peak elsewhere (as similar viruses in past decades have, with SARS in 2002-03 being the most commonly-used comparative), economies will open again, and the flow of goods/services will eventually create a snap back in the quarters following the crisis. But, again, the longer the crisis, the longer the bounceback will take. The following article from a China expert provides an interesting, and balanced, narrative about the issue relative to prior pandemics: https://us.matthewsasia.com/resources/docs/pdf/Sinology/022420-Sinology.pdf
It’s important to remember that equity markets have corrected by -10% at least once per year—based on historical averages. It’s been some time since we’ve seen a correction, so when you couple higher valuations and needing an excuse for profit-taking, you’ll often get one. Hoping for the best, this will result in minimal human and economic damage, and end up as another small blip on the chart of financial history.