US markets stumbled on Thursday, taking a breather from the run of fresh highs over prior sessions. News of a spike in COVID-19 cases from China’s Hubei province post revising its diagnosis methods initially saw equity indices falter, but investors nerves were soothed after the WHO said a spike in China’s coronavirus diagnoses didn’t necessarily reflect a sudden surge in the epidemic.
Later in the session, news that the FED will dial back their overnight repo operations starting today pushed US stocks into the red, posting their first decline this week.
Heading into the European session stocks are mixed in Asia – some indices have maintained the dampened sentiment from Wall Street and others have pushed higher. Australian equities are pushing higher, despite an indecisive start to trade. The banks, index heavyweights, are driving upwards momentum as Commonwealth Bank (CBA) pushed to a 5 year high, trading above $90. This after reporting a resilient trading update earlier in the week, along with NAB – more on those updates here. In the current environment, where rates are set to stay low and there is ample liquidity in markets investors are focusing on the worst being over, taking all the good news they can get and running with it.
New cases in Hubei have jumped as diagnosis method changes - A detailed analysis of what this step means should be left for the medical professionals and epidemiologists, but as we noted yesterday one thing is for sure, there is a huge question mark over the reliability of all data relating to COVID-19 cases. This means that within any forecast outcomes should be embedded an enormous degree of variability. As is often case, garbage in, garbage out - incorrect or poor-quality input will produce faulty output which is likely the case here given the lack of reliable data.
The situation remains fluid, however equity markets still don’t appear to be overly worried whilst the outbreak is relatively contained within China. If we look to commodities and haven treasuries we see a different picture, where the scale of demand destruction is considered and caution is visible. Equity investors sentiment is complacent given China’s contribution to global growth and importance within intertwined global supply chains generating the potential for production bottlenecks – particularly in tech and autos sectors, notwithstanding lost output as it relates to goods and services trade. Forecasting that is dependent upon the 2003 SARs outbreak is likely not a good replica – China is a far larger component of the global economy than in 2003, and consumer spending also makes up a bigger share of China's economy.
Shutdowns in China look to be more protracted than original expectations, many factories have not resumed production and cities are still on lockdown as measures are taken to limit the virus spread. This is particularly concerning not just in terms of the direct effects but also the capacity for non-linear secondary effects to cascade as shutdowns become more protracted, this is not priced into equities. However, upside momentum is strong, particularly for US equity indices, and investors are heeding the impending monetary and fiscal stimulus and influx of liquidity from China. 2019 has already proved how costly it is to fight liquidity, and investors are heeding the central bank put, as globally a raft of policymakers have already exhibited by word and deed their willingness to intervene and lend support. Given the complete lack of reliable data we must balance complacent markets with elevated tail risks, participating in the upside momentum and maintaining optionality with respect to potentially much more negative outcomes.
Fat-tails – Fat tail risk events are rare but bring with them the prospect of large negative returns. Tail risk events can occur at both ends of the spectrum, but it is the negative ones (left tail) we are concerned about.
Traditional methodologies of deriving asset pricing or market returns rely on a normal bell curve to make assumptions; typically, markets do not actually behave this way. Within a normal distribution, most variations fall within 3 standard deviations of the mean of the distribution. This then understates the magnitude of extreme risk and volatility events, as in reality markets have fatter tails. The current virus outbreak may represent an example of a devastating real world event for which a normally distributed model will understate various outcomes potentially leading to large mispricing of risk.
Luckily, many tools are available to protect portfolios and hedge against these tail risks. Diversification across multiple asset classes and geographies significantly reduces portfolio risk. Along with hedging strategies that use options or CFDs as a risk protection mechanism.
Current fallout – today’s update
Given the question marks over the reported case data, we look to examine the ongoing fallout as it relates to supply constraints, company earnings, trade data and travel/tourism.
Alibaba, a company who are probably one of the best bellwethers to give us an update on the true state of affairs on the ground in China, are concerned. On Thursday’s earnings call, Alibaba Group’s CFO Maggie Wu said overall revenue growth for 1Q would be negative, as the economic shock from the virus has already shut down two-thirds of the Chinese economy. The Group’s CEO Daniel Zhang also warned that the Covid-19 outbreak in China is developing into a “black swan event”.
Royal Caribbean Cruises earlier today slashed their earnings outlook and cancelled 18 cruise itineraries.
Mattel, the toy maker, said production would be delayed given their manufacturing workforce in China has been impacted. Mattel were expecting to resume factory production in the first week of February but have pushed that out to next week.
Fiat Chrysler will be halting their operations at a factory in Serbia due to lack of parts from China. This is a key read on how heavily intertwined global supply chains are being disrupted as the shutdowns in China trickle down production lines. Can the Eurozone’s languishing manufacturing sector afford to have nascent green shoots trampled by production bottlenecks?
Passenger car sales in China have slumped by 22% YoY in January 2020 – the largest ever drop for the month of January. The lockdown of Wuhan, the Chinese city were the epicentre of the virus outbreak sits, is the primary reason for this weakness. This will also affect the German auto manufacturers for whom China is an important market. China accounts for about 40% of VW's global passenger vehicle sales, and about 30% at Daimler and BMW.
Other Activity Measures from China
Charts courtesy of Capital Economics