Since our last update in late January, investors' fears about the potential impact of the virus on global demand and on global corporate profits' growth have increased sharply.
As the number of reported coronavirus cases outside of China has risen, the prevailing market narrative has shifted: from the coronavirus being a predominantly China issue, to the coronavirus being a global problem. Ironically, investors' reaction to the increase in confirmed coronavirus cases in Korea, Italy and Iran comes at a time when official data shows the pace of new coronavirus cases in China is slowing.
The growing human tragedy aside, there is considerable uncertainty about how the coronavirus will impact the global economy. This is itself a major contributor to increased investor risk aversion. In recent days, global equities and credit have generally fallen sharply while traditional safe havens such as government bonds have outperformed. At the time of writing, yields on both 10 and 30 year nominal US Treasuries stand at all-time lows.
Exhibit 1: Germany and Italy: Key Indicators and Coronavirus Cases
Our view coming into 2020 was that global economic growth would re-accelerate as the first half of the year progressed.
That view was largely predicated on the lagged impact of the significant loosening of global monetary policy in 2019 and expectations that easing trade tensions between China and the US would support a rebound in manufacturing and profits growth across the emerging market complex.
In our view the coronavirus delays, but does not derail, the improving underlying demand trend evident in recent lead indicators and high frequency macroeconomic data that pre-date the coronavirus.
But that underlying momentum is not likely to reappear consistently in global macroeconomic data in the short-term. We advise caution on drawing major investment conclusions from any single data release as the impact of the coronavirus unfolds.
The recent flash global Purchasing Manufacturing Indices (PMIs) are a case in point. The PMIs revealed some of the largest supply side delays in the history of the series due to the coronavirus. But as such delays have historically been driven by excess demand, rather than by supply side shocks, the development was treated as growth positive by the index methodology.
While not our base case, we should acknowledge the high degree of uncertainty that surrounds the potential global economic impact of the coronavirus - and the possibility that the virus will spread further in Europe and take hold in the US to a degree that could ultimately lead to a more significant slowdown in global activity than we currently expect and to recession.
As the experience to-date in China shows, the coronavirus can spread quickly and lead to major hits to consumer and business sentiment. At a minimum, the rise in cases outside of China clearly lengthens the period during which the virus is likely to impact global growth and remain a source of uncertainty to investors.
In our view, there is a degree of potentially dangerous circularity with regard to the virus and perceived US political risk. Falling equities and any deterioration in economic conditions are likely to boost the chances of a more progressive Democratic Party candidate such as Bernie Sanders winning the US presidency, for which investors are understandably demanding a higher risk premium.
But our base case remains that the disruption to demand growth from the coronavirus is likely to be concentrated in the first half of the year. Driven largely by the drop in offline domestic consumption and services, the hit to 2020 Chinese GDP even on our base case is nonetheless sizeable: we currently estimate that annual demand growth in China will be around 50bp-75bp lower due to the coronavirus.
Apart from the material short-term hit to intra-Asian travel and tourism, to which Asian countries including Thailand and Singapore are particularly exposed, we see the other major economic impact of the coronavirus via the disruption to global supply chains - as highlighted in the most recent PMIs.
China's economy has evolved significantly away from its prior reliance on low value add manufacturing. But China is now a much larger economy, and a larger part of the global economy than it was, for example, during the SARS epidemic. In simple terms, China still produces a lot of the world's intermediate and finished goods across economic sectors. With many Chinese businesses not even opening their doors, the reduction in output is creating serious issues for an increasing number of companies outside of China. A recent report (Business Impact of the Coronavirus – Dun & Bradstreet) estimated that at least five million companies globally – and some 94% of the Fortune 1000 – have one or more suppliers in the area of China affected by the coronavirus.
As of 25 February, around 30% of China's SMEs had restarted business, according to China's Ministry of Industry and Information Technology, as China tentatively returns to work. In Chinese provinces away from the current virus epicenter, that figure is likely to be higher. But issues including logistics backlogs and personnel shortages still represent meaningful hurdles to the normalization of business and fulfillment of orders.
In time, companies may seek to de-risk their value chains away from China and turn to other Asian countries including Vietnam and Taiwan for manufacturing fulfillment. But in the meantime, these supply chain issues are starting to be felt at the corporate level globally. Apple, the world's largest company by market capitalization, recently revealed that it would miss its profits target for the current quarter due to supply problems and lower than expected demand in China, both caused by the coronavirus.
Significant as the potential impact is, we do not yet believe that the virus represents a more structural downward shift in potential global growth. Developed world consumption growth remains supported by generally healthy household finances and by low unemployment.
Yes, major geopolitical risks remain a threat to our base case, most notably in the forthcoming US elections and in the ongoing US/China trade disputes. But in aggregate we see the economic impact of the coronavirus outside of Asia as potentially limited. In particular, lower population densities are likely to be a key factor in limiting the spread of the virus in developed countries.
But the principal driver to the rebound in global growth we expect later in the year remains accommodative monetary policy. The theory that monetary policy has lost its power is not one we subscribe to. Thirteen central banks across emerging markets have already reduced policy rates in 2020. We expect further cuts to key policy rates globally including in the US, Canada, UK and Australia. The recent fall in nominal bond yields further loosens financial conditions globally.
Should growth fall more than we expect in the short-term, we expect central banks to increase the policy stimulus. Monetary policy is also likely to be complemented by an increasing fiscal impulse in a wide range of developed countries including Japan and the UK that can further cushion growth. While the precise timing of any demand rebound is not easy to pinpoint in the context of the coronavirus, we see sufficient supports to believe that growth momentum will return. It has the potential to do so strongly.
More specifically, the Chinese authorities have the full suite of potential policy measures at their disposal to combat the domestic growth slowdown. Cuts across key market lending rates, the deferral of loan payments for impacted businesses, cuts to social security payments, fee waivers, automatic re-lending and utility subsidies are just some of the measures already put in place to help struggling Chinese businesses.
We expect more to come across all policy channels, but see the Chinese authorities turning increasingly to fiscal stimulus via tax cuts and increased infrastructure spending when the coronavirus dissipates sufficiently to allow local government spending plans to be reviewed and approved.
Within Investment Solutions our major views on asset classes have not changed materially. With all the industry comment coming into 2020 over the threat to traditional multi asset portfolios from a structural shift higher in equity/bond correlations, recent days have underlined the critical role that government bonds still have to play in improving the risk-adjusted returns potential of multi asset portfolios.
Within the universe of major global nominal government bonds, our favored market is China. On top of attractive yields on a relative basis, we continue to see Chinese government bonds as a very effective multi asset diversifier in the context of the coronavirus.
Within the global credit universe credit we remain positive on EM local and hard currency debt. Our view that global equities will outperform global government bonds over the coming twelve months also remains unchanged. Relative to bonds, global equities remain attractively valued – and we believe that global growth and earnings will rebound in the second half of the year.
The repricing of growth expectations and risk across asset classes due to the coronavirus has been far from uniform. And while the dislocations across markets are likely to offer opportunities on a selective basis, we remain focused amidst the noise and volatility. In our view, these are markets that are likely to reward staying disciplined and diversified.
Within Fixed Income, we have reduced credit risk and positioned strategies to benefit from increased demand of high quality sovereign and corporate bonds. Our focus is on developed and emerging markets where central banks still have the scope to manage downside risk through further policy accommodation.
Within Global Equity markets have seen a clear 'flight to safety' with defensive sectors outperforming cyclical stocks and growth outperforming value. We have already seen a number of companies providing warnings on earnings with areas such as autos, leisure and airlines especially impacted. We are using such short term dislocation to increase holdings where shares have fallen below our estimates of long term value, while being mindful of the risk of further disruption.
For Emerging Markets Equities, the short-term economic impact from coronavirus could be significant, largely because of the considerable precautions taken (particularly in China), like travel restrictions and factory closures.
In China, many large companies and state-owned enterprises have resumed work, but smaller companies face more of a struggle. Coal mining, steel, food manufacturing have seen faster pace of work resumption, while less so for travel, tourism and auto-related sectors. Depending on the sector and progression of the Covid-19 situation, it is estimated that the impact of work disruptions could last for one to two quarters.
As for supply chain, even prior to Covid-19, the move to reduce dependence on China had started and Covid-19 provides an additional impetus to diversify. Favored destinations are South-East Asia (esp. Vietnam), India and reshoring, especially back to North America, Korea or Japan. Restructuring the supply chain is often accompanied by automation, benefitting factory automation companies.
But the outbreak of coronavirus is also accelerating fundamental, long-term changes in consumer behavior within emerging markets. For example, consumers are shifting online for services like after-school tutoring; fragmented industries like real estate and restaurants are consolidating; higher demand for better connectivity is driving investment in IT networks, and healthcare companies are investing in R&D and innovation to deliver new drugs and health services.
Despite the uncertainty caused by coronavirus, we remain confident in these fundamental, long-term changes playing out in emerging markets and our portfolios are focused on quality companies associated with them. That said, we remain cautious and haven't made big moves, but we are holding slightly higher cash reserves should opportunities emerge.
From a UBS Hedge Fund Solutions perspective, fundamental strategies may encounter some near term volatility as hedge funds digest the potential economic headwinds related to containment of the virus, but our relatively low net exposure should help mitigate the risk so we can be front footed after the uncertainties are resolved. Our overweight to macro trading and fixed income relative value should provide the opportunity to monetize the volatility created as markets digest the potential recessionary risk and government policy response to the crisis
For UBS O'Connor, beta is managed very tightly, and we have yet to see sustained or systematic risk aversion related to the coronavirus fears. The combination of tight beta management and the use of index derivative products enables UBS O'Connor to approach the recent short-term dislocations just as much as an opportunity as an exercise in risk management.
Coronavirus is a risk to economies and real estate markets, particularly in Asia Pacific, but any impact will be short term if it is contained. There has been a dip in investment activity and share of international capital flows. We have seen interest rate cuts leading to yield falls in some markets, with real estate pricing around average versus index linked bonds. We do not see a big inflation risk and our analysis suggests that real estate offers suitable inflation protection.
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