Fear of China’s coronavirus, like the disease, showed dangerous signs of contagion as equities sold off this week. Central banks’ commitment to supporting asset markets has been a cure-all panacea in recent years, but is this crisis different?
True black swan events force a complete re-set of assumptions. Arguably, a dangerous virus spreading from the city of Wuhan, despite a government ban on travel from the city, doesn’t yet count. Financial commentaries shouldn’t overlook what is already the human tragedy unfolding but it hasn’t become a pandemic, so the physical impact alone isn’t yet enough to make investors panic.
What sort of shape is the economic superpower in?
Hopefully, further loss of life can be limited, so the question is could coronavirus have ramifications for markets further down the line anyway?
China bulls pointed to GDP growth being driven by domestic consumption last year, mitigating the drag from US trade tariffs. Clearly, it is household spending that will be hit hardest by a crisis that has ruined Chinese New Year - the world’s largest festive holiday. Couple that with residual damage from the US rivalry, and it is quite reasonable to expect subdued economic performance.
Fund managers who invest in China hope the prognosis isn’t too bad. Mike Kerley, Co-manager of Henderson Far East Income says “Earnings will be impacted in the short term but the medium to long term impact will be limited, assuming a Sars scenario (the 2003 virus outbreak), as consumption gets delayed rather than cancelled. Tourism spend will likely take longer to recover although, in 2003, casino visitation and gaming revenue recovered quite quickly.”
Waging trade war with America has taken its toll, however. Throughout 2019, when trade rhetoric was at its toughest, China steeled itself with a combination of expansive fiscal policy and easy monetary policy. The former entailed municipalities taking on more debt for infrastructure, the latter was largely enacted by lowering banks’ solvency requirements. It’s not difficult to see how a major public health crisis could hurt businesses and see defaults on loans rise, which would pressurise the banking system.
Of course, this is all conjecture and even if it came to pass, President Xi Jinping (remembering criticism of the government’s slow response to Sars) has already given a “whatever it takes” style speech to show resolve. The state is uniquely both prime lender and borrower in China, so perhaps a debt crisis is one contagion that can be stymied.
The thing is, China’s important. The Asian Infrastructure Investment Bank largely finances critical developments as part of the Belt and Road Initiative and the 21st Century Maritime Silk Road. These two pillars of Xi’s long-term vision have encouraged a degree of dependence amongst recipients of aid and loans. It would be naïve not to imagine fallout from a forced shift in focus to support China’s domestic financial system.
International investors have little exposure to Chinese capital markets, especially debt markets but emerging market debt – including bonds issued by countries peripheral to China – is a popular asset class. Tightening of investment from China would hurt these countries’ economies, which would cause investors to demand a higher yield on their bonds and be bad for equities. Investors with exposure to the Asia Pacific region through an exchange traded fund (ETF) or investment trust, should expect volatility but thanks to last year’s pessimism, engendered by the Sino-US trade dispute, the silver lining is these markets won’t be falling from super expensive levels.
Japan’s geographic proximity provides interesting aspect for asset markets’ response to the coronavirus as it unfolds. Traditionally the Yen is seen as haven in a crisis, but when Japan is in the firing line, that means the flight to safety is likely to be more concentrated towards other assets. Gold is now at $1,571 per oz, and there is a story in the currency it’s priced in.
Coupled with demand for US treasury bonds – the benchmark 10-year yield is down 30 basis points (bps) since the turn of the year – rising appetite for fear assets boosts demand for the US dollar. It seems strange to talk of dollar shortage in the modern era of electronic money printing but the spike in demand for hard currency is a double-whammy for emerging markets, which will see their cost of borrowing from world capital markets rise at the precise moment the Chinese may be forced to pause their sovereign investment strategy.
For now, the world is talking about a worrying threat to health, that has sadly caused 362 deaths (as of Monday morning). British Airways’ ban on flights to China is a sensible precaution in a highly interconnected world. Financial markets are super-connected, and once this crisis has hopefully been contained and passed, investors should reflect on how their portfolios are constructed to cope with what can’t be forecast.
