An unexpected and unfortunate outbreak of the coronavirus puts pressure on the sustainability of the increase in global growth momentum. The fact that the uptick in momentum had only just started makes it relatively vulnerable to any negative shocks. In addition, the significant amount of uncertainty related to containing the virus as well as its economic impact requires an appropriate cautious stance on risky assets. ‘Appropriate’, however, does not imply getting too gloomy too early, as other factors remain positive for risky assets, and for equities in particular.
Global health emergency
On 30 January, the World Health Organization declared a global health emergency related to the coronavirus outbreak in China. Since then, an increasing list of countries and companies have taken numerous measures to prevent the virus from spreading further. Many of these measures are aimed at limiting transport and travel to and from infected regions, with several airlines suspending flights to China. In China itself, the epicenter of the outbreak in Wuhan is under lockdown, and several other cities have severely restricted movements. Chinese New Year-related travel was down as much as 80% on some routes, and the holiday period has been extended, with many workers not returning to their jobs yet.
The measures, which at times are drastic, are likely to increase the odds of fast containment. At the same time, however, they are also likely to impact Chinese growth, and therefore global growth. From this angle, comparisons to the outbreak of the SARS virus back 2003 are futile. The Chinese share of global GDP has tripled since then, and China has become the marginal buyer of virtually every commodity. It’s sheer size means other emerging countries in the region will face at least a temporal setback in growth as well.
Removing our overweight to equities
It is the combination of a growth shock in China – by far the most important country in terms of share of global GDP growth – with the uncertainty of how long and how deep this shock will be (at a time when equities were already pricing in a lot of good news) that made us erase our overweight to equities. However, this does not mean we have become outright negative on equities. We will elaborate on this in detail below.
First, when compared to ‘similar’ events, economic activity that is lost during a viral outbreak is largely recouped once it is contained. For example, during the SARS outbreak, Chinese retail sales growth briefly halved before making a strong comeback after the virus was brought under control, making up for most of the sales decline. Other parts of the economy such as construction were hit as well, but they also recovered once the spreading of the virus started to decline. We expect a comparable pattern this time, and do not forecast a major interruption of global supply chains.
Earnings growth on the horizon
Second, the global economy showed numerous signs of improvement prior to the outbreak. One example is the global manufacturing PMI, which rose to 50.4 in January, its highest level since April 2019. The ISM Manufacturing Index is also back above 50, following a much bigger-than-expected rise in January. The Citi Global Economic Surprise Index has turned positive and risen to its highest level in almost two years. And export growth in very open economies such as South Korea has improved markedly, revealing that the downward pressure from the China-US trade war is abating.
Stronger export growth in countries like South Korea also points to a reversal in global earnings per share, which has been declining in the last year-and-a-half or so. In fact, the earnings of US companies are coming in much stronger than expected, resulting in the first (albeit small) rise in earnings per share for the S&P 500 Index. Roughly halfway through the reporting season for the fourth quarter of 2019, earnings surprises are the strongest they have been in the last three quarters, with sales surprises the most upbeat in the last four quarters. Other regions have lagged the US – as they have done for years – but things are looking healthier here as well. Earnings revisions have improved significantly on the outlook of better global growth. Earnings revisions in emerging markets are now higher than in the US, suggesting earnings momentum is broadening.
And let’s not forget central bank policy. While bigger central banks like the Federal Reserve and the European Central Bank (ECB) have signaled that their policy is appropriate right now, that policy remains extremely accommodative. Short-term interest rates remain low or even negative, with central bank balance sheets growing again. In addition, central banks have made it very clear that the hurdle for monetary policy tightening is very high. Both the Federal Reserve and the ECB are ‘rethinking’ their monetary policy, with a very likely outcome that they will allow inflation to overshoot the target to make up for ‘lost inflation’ in the past. At the same time, their willingness to increase stimulus is high if a negative shock like the coronavirus were to endanger the global economy. The Chinese central bank already injected a massive amount of liquidity once markets reopened after the Chinese New Year. Global liquidity remains enormous, and will grow even larger in the coming quarters.
Finally, we do not believe that investor positioning was ‘euphoric’ coming into the last couple of coronavirus-dominated weeks. Fund managers, hedge funds and so on did buy equities in the final quarter of 2019, but only to get rid of their somewhat overly cautious positions. Hence, we expect investors to step in in the event that equities start to decline sharply, as the baseline scenario of a gradual recovery in global growth and earnings is not off the table.
As mentioned at the beginning of our monthly special theme, we believe that at this point in time, proportionate cautiousness is warranted concerning the outbreak of the coronavirus. Obviously the fact that the virus originated from China – by far the largest growth engine in the world – is of importance here. We would like to stress, however, that other more constructive forces for equities are also at play. Given the fact that events such as the outbreak of the coronavirus tend to have a temporal rather than a structural impact on growth and earnings, we refrain from becoming outright negative on equity markets.
For government bonds, we believe that yields have priced in a lot of bad news related to the virus outbreak. Hence, we feel comfortable with a close to neutral position in sovereigns for now, but expect to return to an underweight once the virus is contained and its impact become clear.