Economic Implications of the Coronavirus
Summary
Last week’s post highlighted the likelihood that the scope of the problem was significantly under-reported in China. Markets spent the week digesting this reality, commodities were hurt the most. This week Chinese economic activity will grind to a halt as measures to contain the virus hit the broader economy. There is is a very clear trade-off - the more effective the response; the bigger the hit to growth (though expect more stimulus as well). 2020 GDP is likely to be lower by 1-2% even if this is contained. The hit could be as much as 3% in a more protracted lock-down. Even China’s own propaganda machine has acknowledged growth could fall in the 4% range from 6% today. Efforts to contain the virus will be painful given how widespread the virus is - China now has over 14k cases and 17 regions with 100 cases or more. That said, it’s worth noting that China has a population of 1.4B people. It’s still containable and China is the one area that can deploy extraordinary measures better than anyone else.
However, judging by the size of the observation pool (>100k), I still think we have a few more days of rising cases ahead and could leave things looking like they are growing at an exponential rate. That, along with Democratic primaries and selling from systematic strategies (CTAs and vol controlled annuities) is likely to keep buyers on the sidelines as positioning unwinds from elevated levels. Oil has already adjusted and will soon be attractively priced (though there is still a lot of spec length to wash out). It could serve as a nice hedge against a short equity position if we avoid a full blown pandemic.
Market Action
Last week’s market action was dominated by an asset’s sensitivity to the coronavirus. China is the world’s largest energy consumer and it’s no surprise that oil was among the hardest hit. Movement in the country has slowed dramatically as people stay indoors. Copper will also face headwinds - China consumes about half of global supply. Despite the pullback in US equities, the declines are relatively modest compared to EM and commodities.
Rates markets have been pricing in pain too. The 10y is back at 1.5%. Breakeven inflation fell in sync with lower oil prices and real yields are priced to be below zero for the next decade. Markets have priced in strong odds of two more rate cuts for 2020 and the yield curve inverted again after steepening at the end of 2019. Bonds are telling you this is a pretty material hit to growth.
Overall markets spent the week digesting information and recognizing the risks. They have now priced in a reasonable probability of something bad happening. It’s also had the effect of materially dampening sentiment and expectations which were quite ebullient a week ago.
Assessing the Damage
The short answer is that this is going to lead to at least a .5% hit to Chinese GDP and about .2% hit to global GDP when you consider both the direct and indirect effects. Push that closer to 75bps for China and 25bps for the world (per week) if this lasts longer than a week or two. For perspective, the 2003 outbreak which was more concentrated shaved off a full percent from GDP. Oil demand could also fall by 3-6m barrels a day.
China is the engine of global growth (much different than 2003). Given the size (1.4B people and the second largest global economy) and growth rate (>5% and twice that of the US) China’s contribution to global growth has been very outsized (>25% of global GDP growth and more when you consider the downstream impacts on EM, Europe and the commodity cycle). Any hiccups in China are going to be like hitting a speed bump while driving full speed. In addition to the slowdown, it also has the potential to disrupt supply chains and weigh on sales on companies elsewhere (even Apple derives 20% of its revenue from China).
Contribution to Global GDP Growth: China has a very outsized impact given it’s large size and high growth rate
Most of the economy (areas representing >80% of Chinese GDP) are going to be shuttered for at least another week. This is in addition to the lost activity during the Lunar New Year. Let’s naively assume every week of no activity would represent a ~2% hit. Assuming activity instead falls by 50% you’d be looking at a 1% hit to GDP. Some of this will be made up later (ex. a car purchase) but a lot will not (services). It’s also going to to be difficult to make up for the lost gross output of simply not working. Let’s assume a 50-75bps hit per week with this likely on the larger side the longer this lasts. A 50bps hit seems like a best case scenario if the liquidity measures help to boost growth by the end of the year.
However, given the widespread distribution (more than a dozen cities have 100 or more cases) this is unlikely to be resolved in a week. There is also already a hit from the weaker holiday season. I am penciling in a 2-3 week lockdown and growth in the 4.5%-5% range for 2020 vs 6% to end the year.
From here the key variables that matter are:
how long will this take to get under control
do we see moderation in the exponential growth in the next few days
Will it it gain a foothold elsewhere, like in Thailand.
My expectations for those three variables are: are 2-3 weeks, yes, and a weak no (Thailand may already have a cluster).
However if the pandemic in uncontrolled, this has the potential to be very big. Moody’s actually said it has the potential to be a “black swan like no other” and that it could even exceed the GFC. Right now it seems entirely possible a multi-week lockdown can help eliminate the threat, but we are now staring at a non-trivial possibility (10-20%) that this may get out of hand. At the moment we have over 14,000 cases (now almost certain to be 2x the size of SARS) with 100k under observation. There are over 14 areas in China with more than 100 cases. The fatality rate in Wuhan (where it’s had the longest to incubate) is north of 3.5% for confirmed cases and is going to rise further given the lead lag. The left tail from a week ago has been realized. The odds of this becoming truly nasty are non-trivial.
How long will this last?
The incubation period was initially reported as 14 days but new research suggests it’s much shorter, at around 5 days (though with a wide range for patients). This is very good news as it means the Chinese lockdown could be much shorter than some have speculated (though the paper’s authors still recommend a 14 day observation period). I am not epidemiologist but I think the international data suggest it may be a bit longer. The Chinese new year began on the 24th and assuming they left a day or two early, then we should should have seen peak cases already. We didn’t. There was a notable acceleration on Thursday and Friday (though this admittedly could be due to delayed testing or because other family members also contracted the virus). As a result, I am penciling in an 8-9 day period of time before people feel they are actually sick enough to get tested. Given it’s still shorter than the 14 day cycle, I am going to pencil in a two week shutdown for China with something that looks like a gradual reintroduction back for those who have not been labelled high risk.
With the shorter half life the bigger risk is probably around containment (will it find a footing outside China) vs an extended lockdown that lasts months. I am also discounting the exponential growth in cases we have seen in the last few days (for the same reason I thought it was understated). Part of that ramp up in reported cases was likely due to the fact that only a small number of people can physically be tested each day. The “sickest” are probably being tested first.
One other aspect that few have commented on is that this is producing a very large strain on the medical system. If hospitals reach capacity it could keep sick people in the normal population and extend the duration of the outbreak.
The other downside of the outbreak is that we are going to reverse the Q4 progress over the last few months. PMI’s and new orders were starting to perk up globally. German, Asian and regional Fed indices were all pointing to a nice bounce. Now they are likely to remain below 50 for the next quarter.
Commodities
An oversupply in Q1 was already likely despite the OPEC cut and this will just make things worse. Oil consumption is going to be hit hard both from the weaker domestic travel, weaker industrial activity and international travel/shipping. Total oil consumption is around 12mbd in China. Pencil in 2-4mbd decline per week and you have a problem if this thing has legs or spreads elsewhere in Asia. For comparison OPEC’s cut to support the market was only 1.7mbd. However we are also now below the cost of production for US shale and we’ve had friction in Libya (1.2mbd), Saudi Arabia, and proposals from the US to ban fracking. This should help keep a floor on things. Barring an extreme left tail in China, oil is probably attractively valued. The big wild card is how much US production was locked in during the SA and Iran incidents when oil prices were north of $60. This could keep shale pumping for 2-3 despite lower prices and weaker growth. This is the main reason I think we could dip below $50 in 1H. I am a buyer if we see another leg lower (below $48) or moderation in new cases, and this would be a hedge to my short equities position.
Positioning
I am still short, mainly in the US. Right now we have a lot of systematic length in the market (CTAs and vol controlled annuities are quite long) and gamma just flipped negative which together can create quite a selling vortex. I think the combination of negative news and systematic selling could last for a few days. This had been possible for the last few weeks, but we didn’t have a catalyst. We just found it. I still think the “buy the dip” mentality will return (cash and bonds are negative real yield assets given how easy the Fed is and consumers are still holding up), but not right away given the magnitude of losses and headlines. At the moment ~100k people under observation while there are only ~11k confirmed cases. As long as the numbers are rising people are going to still be nervous. We still have another week or two of this but hopefully the growth rate starts to slow in the next few days.
We also have Iowa caucuses and Bernie is sitting within the margin of error Biden. It’s hard to see people loading up on risk ahead of that on Monday. We’ve also got a rich market with plenty of gaps to close from the Icarus like rally over the past few weeks.
Looking Ahead
If this blows over without serious consequences, the barbell trade that has worked for the last two years (defensives/tech vs rest of world) may finally see a reversal. Safety and “clean shirts” have been way overbid. EM completely missed out on the recent rally. Assuming growth stabilizes by midyear this will be an interesting long short trade.
