Heartbreaker: Spreading Impact of Coronavirus
Complacency is finally being put to the test with regard to the impact of the coronavirus on global/U.S. growth, earnings estimates and stocks.
Complex global supply chains are being put to the test; with the virus representing a massive supply shock.
U.S. and global central banks are expected to ease policy; but the impact is likely to be limited.
Complacency has been evident with regard to the stock market’s behavior and the impact of the coronavirus on global growth … that is until today perhaps. In mid-January, I wrote about highly-optimistic investor sentiment—seen in both behavioral and attitudinal measures of sentiment. The initial outbreak of the virus conspired to shake that optimism; but after a mild 3.3% pullback in late January, complacency built yet again on hopes of a containment of the virus.
~80k and counting
The latest coronavirus news is not good, with a surge in cases outside of Mainland China. For those who haven’t yet discovered it, this dashboard from Johns Hopkins University’s Center for Systems Science and Engineering (CSSE) provides real-time updates of the number of cases, deaths and recoveries; as well as the geographic distribution thereof. [Caveat: As of today, we are finding that the site has been sporadically down.] As of early this morning, the total number of cases globally is approaching 80k, with more than 77k in Mainland China; but a rapid increase in recent days in South Korea, Italy and Japan (there are now 35 cases in the United States).
Other than during wars, the scope of the shutting down huge swaths of the world, associated with the virus, is unprecedented. There are about 60 million people in China alone that are quarantined. Labor-intensive manufacturing and service sectors are finding it difficult to re-open because of the difficulty of getting their migrant workers through quarantine and/or across provincial boundaries. Bloomberg estimates that the Chinese economy as a whole is operating at well less than half of normal capacity.
Not just China’s problem
Outside the region, Italy and South Korea (the eighth and 12th largest economies in the world, respectively) are shutting down public buildings, sporting events and schools in parts of those countries. In the case of Italy, at least 10 towns around Milan have gone under lockdown; and authorities are increasingly concerned given that all flights to/from China were canceled as of early February.
Some of the more troubling data is associated with the singular geneses of some of the spreading. The nearly 700 infections on the Japanese cruise ship are reported to have started with one man who came from Hong Kong. In South Korea, it was discovered that one person had the virus and attended a 1000-member church service—now there are more than 800 people infected in the country (not all tied to the church attendee); with an increasing number of city lock-downs and quarantines.
A burgeoning number of companies are issuing warnings about the impact of coronavirus on their business, the global supply chain and global economic growth overall. BCA Research has zero growth expected for global GDP in the first quarter, while Evercore ISI’s head of China research, Don Straszheim, expects GDP growth in China could decline by double-digits in percentage terms in the first quarter (not that China is likely to report that publicly). In addition, ISI’s widely-watched weekly company surveys include one recently of 21 multinationals; with that survey showing that sales weakened to a record low (in the 15-year history of those surveys).
Deglobalization receives another push
“Deglobalization” had already become a dominant macro theme—elevated courtesy of the U.S.-China trade war—with the coronavirus magnifying the complexity—and vulnerability—of global supply chains. Companies around the world are increasingly bemoaning the quick eruption of component shortages; with many suspending production. Most of the impact to date has been in emerging Asia, but most developed market purchasing managers indexes (PMIs) are also feeling the effects—including a lengthening of supplier delivery times.
Adding to the speed with which information is incoming has been social media’s influence. Earlier this month, the World Health Organization (WHO) referred to the coronavirus as a “massive ‘infodemic’,” referring to an “overabundance of information—some accurate and some not—that makes it hard for people to find trustworthy sources and reliable guidance when they need it.” Prior viral outbreaks like SARS did cause some panic globally; but today’s social media power acts as an amplifier.
Earnings estimate haircuts
As you can see in the chart below, since the beginning of January, estimates for S&P 500 earnings per share have been cut for every quarter this year—with the largest haircut given to the first quarter. This has resulted in a move from expected growth of nearly 10% for calendar year 2020 to less than 8% at present. It’s hard to imagine that there aren’t more cuts to come; especially if the U.S. dollar continues to strengthen. For the first quarter, the largest slashing of estimates has been for the consumer discretionary, industrials and materials sectors.
2020 Earnings Estimates Getting Cut
Source: Charles Schwab, I/B/E/S data from Refinitiv, as of 2/24/2020.
Many comparisons have been analyzed between the coronavirus and the SARS outbreak in 2003. Economically, the impact is likely to be felt much more globally given the growth in not only China as a share of global gross domestic product (GDP), which has quadrupled; but China’s consumer as a global powerhouse as well. You can see the growth of both in the chart below.
China’s Weight in Global GDP Has Quadrupled
Source: Charles Schwab, World Bank, as of 12/31/2018.
As you can see in the table below, at the country level the United States is most exposed in dollar terms; but is well down the list in percentage terms. Topping the list in percentage terms are Singapore, Taiwan and Korea.
Source: Charles Schwab, FactSet, MSCI as of 2/19/2020.
In terms of leading indicators, Asia Pacific leading indicators have never been as significant a driving force of U.S. (or European) economies in history. Up until the early-1990s, the rolling 10-year correlation of OECD composite leading indicators for Asia Pacific and the United States was very low or often in negative territory—meaning U.S. leading indicators lead Asia Pacific indicators. However, today, the correlation is calculated by Arbor Data Science at nearly .80, meaning Asia Pacific leading indicators are leading (by about six months).
China’s changing dynamics
McKinsey Global Institute recently did a comprehensive report on “China and the world,” in which they analyzed the “dynamics of a changing relationship.” A few of the more interesting statistics cited:
- China has become the world’s largest source of tourists (the United States is now second)—most to Greater China—but increasingly they are visiting other global destinations.
- The United States is fifth among the top-10 destinations (excluding Greater China) for Chinese tourists’ spending: three million trips in 2017 and four thousand dollars spent per trip in 2016 (but representing less than 1% of U.S. total private consumption)
- China became the largest exporter of goods in 2009 and the world’s largest trading nation in goods in 2013.
- China has been reducing its relative exposure to the world, while the world has been increasing its exposure to China.
- China’s role in supply chains has drastically changed over the years; with Chinese manufacturers often playing the role of final assembler in value chains (although in recent years, Chinese firms have moved into higher-value-added activities).
- China represents at least 35% of global gross output; and as high as 48% in sectors such as electrical equipment.
- The number of Global Fortune 500 companies headquartered in Mainland China or Hong Kong increased from 22 in 2007 to 111 in 2018.
Impact on U.S. growth
We are starting to see the impact on the U.S. economy; although the good news is that there are some economic tailwinds that were in place prior to the virus’ outbreak, including some stabilization in U.S. manufacturing and strong housing data.
In the bad news column though were IHS Markit’s “flash PMIs” for the United States. Its services flash PMI plunged four points in February, which was the largest drop since October 2013. That brought the index to 49.4, signaling the first contraction (< 50) in services activity in four years. New orders plunged at the fastest rate since at least October 2009 when the data was first published. Markit’s manufacturing flash PMI fell 1.1 points, its third consecutive decline, to 50.8 (a six-month low); with factory production, new orders and employment all softening. The even more widely-watched ISM PMIs will be released next week.
Fed to rescue?
As a result of this recent weakness in activity and fears for more bad news to come, expectations that the Federal Reserve will cut rates have been rising. The fed funds futures market now expects at least two rate cuts this year. In addition, more than 200 basis points of global easing, from seven major central banks, is now priced in by the end of 2020—up threefold from the end of 2019 according to Bloomberg’s World Interest Rate Probabilities (WIRP) function.
Interest rate cuts work best and most quickly when the economy faces a demand shock. The coronavirus represents more of a supply shock, although China represents the demand side for the global economy as well. Fed rate cuts may provide some support to risk assets; but they won’t help factories produce more if supply chains are disrupted; and they won’t speed up the process of developing a vaccine.
Risk off in vogue again
Although most “factors” were weak last week due to the worsening of the virus; unlike a few weeks ago both momentum and expected growth factors declined. The rotation out of the technology sector late-last week (which put the defensive utilities sector in the number one performance spot for the year-to-date) exacerbated the drag that “risk on factors” have been having on the market this month. We continue to recommend that investors focus on diversification and rebalancing; and an emphasis on quality growth at reasonable prices, with a bias toward more defensive larger cap stocks at the expense of more cyclical smaller cap stocks.