The coronavirus has tightened its grip, especially in China, with some 50,000 cases confirmed and the death toll now over 1,000. As the human and economic costs spiral, we assess the potential impact of the virus, outline what the Chinese government is doing to offset this impact, and discuss the investment implications for our portfolios.
The first point to make is that the economic impact will almost certainly be larger than it was from Sars in 2003. This is partly a function of the fact that there are already five times as many confirmed cases of the new coronavirus, with the number of infections doubling every four days. It is also because the Chinese authorities have acted more decisively to contain the virus, restricting people’s movements and extending public holidays. In Hubei province, the epicenter of the outbreak, a population the size of Italy’s is currently under complete lockdown. All this will mean more severe disruption in the short term. Consequently, while Sars crimped Chinese annual GDP by 0.2%, the coronavirus could reduce growth by more like 0.5%. We therefore expect China to expand at 5-6% in 2020, and probably at the lower end of this range.
The biggest initial impact will be on consumption. Following the Sars outbreak, passenger traffic numbers in China slumped by over 40%. Service sector businesses including shops, restaurants and hotels all suffered, as did property sales. It will be no different this time around. For example, it is estimated that the coronavirus will lead to a 99% reduction in cinema visits in China.
Weaker consumption trends will lead to impaired profitability and ultimately lower investment. Smaller companies will likely be hit hardest. In a survey of 1000 SMEs by Tsinghua and Beijing University, only 18% said they could survive 3 months on their current cash position, 29% said the virus has reduced their revenues by 20-50%, and 36% said they planned to lay off employees in the next few months as a result.
What has the government done so far and what more could it do?
Such economic dislocation will clearly require action from the government to help stabilise the economy. Thankfully, Beijing recognises this. The central bank has already conducted open market operations, injecting RMB1.7 trillion of liquidity into the system. Such liquidity injections will almost certainly be maintained. There is also scope to cut the deposit rate.
Meanwhile, local governments plan to increase lending to SMEs and micro companies, and to reduce funding costs. They have also announced various waivers for SMEs including rent and utilities, and postponed tax payments for 3 months. Importantly, once the virus begins to die off as the weather becomes warmer, there will be an acceleration of infrastructure projects. While this will likely see the government’s fiscal deficit rise above 3% of GDP, it should help to drive an economic recovery in the second half of the year.
Our base case is that the virus will undoubtedly disrupt economic activity in China and further afield in the short term. However, we believe this will ultimately be a temporary phenomenon and that the Chinese economy will rebound in H2 2020, driven by an acceleration in infrastructure projects and a pick up in consumption. This is precisely what happened following the Sars outbreak 17 years ago. In annualised terms, quarter-on-quarter growth slowed from 11.1% in the first quarter of 2003 to 9.1% in the second. However, by the second half of 2003, growth had recovered as consumers indulged their pent-up demand for everything from white goods to cars.
Consequently, we have been using recent weakness to add selectively to Chinese companies where we felt a considerable amount of bad news and prospective deterioration had been priced in. Some of the individual stocks we have added to had corrected over 20% in a very short space of time. If one thinks that the virus is serious, but ultimately a one to two quarter event, then that is arguably excessive.
One example is Momo, a Chinese social network that fell over 25% in just a few days, despite several encouraging stock-specific catalysts. We saw this as an attractive entry point and bought a position in our Global Emerging Markets strategy.
Meanwhile, in our Asia strategy we bought Times China Holdings, which fell over 15% in January. It is a lowly valued Chinese property developer, focused almost exclusively on the Greater Bay Area, which is one of the markets that we are most positive on in the long term. Our thesis is that Chinese urbanisation will continue, as will migration to Tier 1 and 2 cities, particularly in the Greater Bay Area, given the vibrancy of the Tech sector there.
We have also been buying certain companies that should be direct beneficiaries of the coronavirus. One example is Yonghui Superstores. As a supermarket operator that is widely acknowledged to have a competitive advantage in fresh produce, we believe it is best placed to take share from wet markets, where dead and live animals are sold out in the open and where the virus is thought to have originated. Another example is Ping An Good Doctor, a telehealth service that has seen a spike in users following the outbreak.
As discussed above, whilst we are acutely aware of the risks associated with the virus, we do believe it will be a temporary event and that much of the downside has been priced in. So what would cause us to reassess our relative benign base case?
100 million people were due to travel on 9th-10th of February as part of Chinese New Year. It is as yet unclear how many of these people were carrying the virus. We will discover over the next week or so, but clearly there is a risk that the number of cases rises exponentially, magnifying the impact of the virus. While China has acted quickly and decisively to contain the virus in Wuhan, further significant outbreaks in other regions could stretch the country’s resources to breaking point.
There is also the risk of significant outbreaks in other Emerging Markets. China’s centralised system is very effective in terms of planning and mobilising a huge national response to an emergency such as this. Unfortunately, other Emerging Markets are unlikely to be as well organised. Many developed economies could also struggle with a substantial outbreak, particularly as their health systems are already under significant strain during the winter months owing to their older populations. Most analysts’ economic models are only making assumptions based on containment of the virus in China.
There is also uncertainty about just how deadly the virus is. To date, nearly 90% of cases have resulted in neither recovery nor death. That is to say, their treatment is ongoing and the ultimate outcome is as yet unknown. Thus, while the fatality rate is currently estimated at just 1%, there is a risk that this is far too low. This would certainly be the case if the virus mutated to become significantly more lethal. Encouragingly, Sars had a molecular proofreading system that reduced its mutation rate, and the new coronavirus’ similarity to Sars at the genomic level suggests it does, too. This makes the mutation rate far lower than for traditional flu or HIV.
Any of the risks outlined above have the potential to exacerbate the impact of the virus on economic activity in China and the rest of the world as global supply chains suffer protracted disruption. This would cause us to reassess our base case and likely take a more defensive stance in our portfolios. However, even if some of these risks did materialise, it is unclear what this would mean for equities. While slower economic activity is clearly negative for earnings growth, it would likely be met with more easing in China, Europe and the US. Such liquidity should keep stocks well supported.
It goes without saying that we will continue to follow the virus closely and are ready to shift positioning in our portfolios if circumstances change. Indeed, one of the key benefits of having focused teams such as ours is that we can quickly make investment decisions to protect our portfolios or capitalise on opportunities as and when they arise. This is evidenced by the fact that we were nimble in de-risking our portfolios immediately after the virus outbreak, then redeployed the capital when we felt certain stocks had become oversold. Of course, markets have since bounced strongly, meaning that the risk/reward trade-off from these levels is more nuanced than it was two weeks ago.
Nothing in this document constitutes or should be treated as investment advice or an offer to buy or sell any security or other investment. TT is authorised and regulated in the United Kingdom by the Financial Conduct Authority (FCA).