Global stock markets seem to be in free fall this week, accompanied by bigger drops in energy prices, credit spreads shooting up, credit market seizure, junk bond sell-offs and U.S. rate collapses as people seek haven assets.
The fear is reflected in one volatility measure, VIX, with its level approaching 50, an elevated level last seen in January 2018 and summer 2015.
It all started with a mysterious, fast-spreading virus that paralyzed billions of people. We try to understand the transmission mechanisms about how and why it affects the market, and how we think about portfolio strategies in this turbulent time.
- What’s the impact of coronavirus on China’s economy, business and communities? What are the supportive policies in place and challenges to recovery?
A Nation Under Siege: While writing this piece in Manhattan, I can’t imagine what New York City would be like if it shuts down for 24 hours. The impact of the mysterious coronavirus on China’s economy and its society is simply unprecedented. We probably have never seen a situation in modern history wherein a giant economy went silent for nearly six weeks. Almost 1.4 billion people were kept off from once-busy streets, workplaces, schools, daycares, shopping malls, restaurants and all public spaces, hunkered down in their apartments, in fear of the unknown, for extended periods.
I have family and friends who live across China, thousands of miles away from Wuhan, the epicenter. Although not quarantined, the restrictions of movements still apply to everyone in the country to contain the unknown. In the absence of any medicine for treatments and vaccine for the new virus, isolation seemed to be the only choice to protect people and prevent the fast spread. Many families use the permission passes to get outside their gated high-rise communities, once every two days per family in some areas. Thanks to e-commerce giants Alibaba and JD.com, which never stopped delivery of groceries, even during the darkest time. Meitou, Erleme (Are You Hungry), the Chinese Uber Eats—just much more epic in scale—made sure that their customers still get fed.
Confirmed Cases: Peaked in Mid-February
Source: National and Province Health Institute, Daily Update as of 2/27/2020
From my perspective, the good news is that the worst appears to be over. The new cases peaked in mid-February In many provinces, the new cases have declined to zero for a few days now. Companies and factories started reopening, at least partially. Starbucks announced many of its shops just reopened. But how many customers are comfortable to get back in remains to be seen. Based on the latest Bloomberg Research, this week, the Chinese economy is operating at about 60-70% of its normal level.
Big firms like Starbucks and Alibaba don’t need to worry about their business survival. Yet tens of thousands of small to medium-sized firms are struggling with no revenues but still paying rent and salaries. Firms with weaker balance sheets and limited access to capital are especially vulnerable.
The Chinese government is trying to strike a balance between preventing virus relapse and getting the economy going. The major economic areas, such as Guangdong province in the south and the Shanghai-Hangzhou area are much quicker to restart the economy. The governments at both central and local levels have initiated supportive policies to support small and midsized firms. Here are some examples:
- Started new programs to delay, reduce or even forgive tax bills and business loans.
- Directed state-owned banks to purchase antivirus corporate bond at below-market rates. For example, Shenzhen Airline has lost two-thirds of its bookings, and just issued such bonds to fund operations.
- On Feb. 20, PBOC, the central bank, cut key leading rates, and made 300 billion RMB available to commercial banks to support firms.
The efficacy of these programs remains to be seen. The monetary policies typically help the supply side. Yet the key to the recovery is having customers buying again. It has been six weeks since the whole country basically shut down. When all the movement restrictions are lifted, and people are eventually ready to spend, there might be a lot of catch-up spending to come.
- Why did market sell off now?
As of Feb. 27, the S&P 500 index has lost over 12% since its peak on Feb. 19, and possibly more. Some firms and industries have already experienced more than a 20% contraction. The last major correction happened during the fourth quarter, where the market lost over 20%, and bottomed on Christmas Eve.
Source: Bloomberg, as of 2/27/2020
There are probably two major triggers for this correction, which coincide.
Escalation In Rest Of World
One issue has to do with rapid rises of new cases in many countries outside China, especially in South Korea and Japan, both having China as their biggest trading partner and their largest export markets.
Rapidly rising cases in Northern Italy reported on Feb. 23 caused more panic around the world. Thursday morning, I spoke to an industry friend whom I visited in her home outside Milan last fall. She said 14 schools in her town were closed and all the soccer games were canceled.
The U.S. doesn’t seem be immune to the spread. This week the Trump administration named Vice President Mike Pence to lead the potential war on the virus, while California announced over 8,000 persons were being monitored for suspected cases.
Twin Challenges Revealed At Earnings Season
More U.S. companies have revealed the twin challenges they face as a result of the China shutdown: Losing customers and losing parts. For most U.S. firms, the Chinese market often represents both its largest customer outside the U.S. and its largest supplier.
The six-week silence in China’s economy has caused pains both in revenue and supply chain disruption for consumer brands such as Apple, Yum Brands and Nike, to tech giants such as Microsoft and Nvidia.
- What’s most vulnerable? How much is priced in?
Many of industries have already been hit with deep contraction. Yet it’s harder to tell how far the bottom is. It’s largely based on how quickly China can get back to its normal level, and how the rest of the world can handle the new situations.
- Consumer brands where China has been a key market, including smartphones, auto, both conventional cars and EVs, luxury goods, sportswear and jewelry.
- Travel related, such as hotels, resorts, cruise lines and airlines. The Chinese are the most influential global traveler today, having made 150 million international trips in 2019. Their spending overseas creates an economy of its own, a quarter trillion USD, larger than the size of economy of Peru.
- Firms that depend heavily on China for sourcing, either for consumer end products or intermediary parts.
- Possibly more travel blows globally: The spread of the virus to other regions will exacerbate the loss of travel-related activities globally. Several industry shows have already been canceled in Italy, Switzerland, Spain, the U.S. and Japan. The Summer Olympics in Japan this year is now in question. The Japanese government just ordered a two-week shutdown of all schools.
- Where is the safe haven?
There is no safe-haven in equity markets. There are some areas that traditionally see less stress in relative terms.
- Lower Beta: Some industries traditionally have lower market average volatility, such as consumer stables, utilities and certain REITs names.
- Domestic Theme: While the US economy is relatively stable, it might make sense to favor industries and firms that are more domestic oriented, such as certain regional banks and service-oriented firms.
Outside equities, the traditional safe-haven assets include the following. They may form part of your overall portfolio, as a natural hedge to stock market corrections. Yet one needs to be careful about getting into too-crowded trades too late.
- Traditional Haven Assets: Low or Negative Correlated:
- Gold ETFs, which are up 7.8% YTD, while U.S. equity is at -7%.
- Mid- to longer-duration U.S. Treasuries, such as the iShares 7-10 Year Treasury Bond ETF (IEF), is up 1.7%.
- Long-duration Treasuries, such as the iShares 20-Year Treasury Bond ETF (TLT), can offer the most protection during market meltdowns like today. YTD it is up 4.1%. However, due to the nature of its long duration, it can snap back and lose its value quickly once equity starts to rally again. The dosage in a portfolio needs to be consistent with portfolio goals, and what else is in it. Use with extreme caution and thoughtfulness.
- What to watch next?
It is key to watch the February macroeconomic releases in the coming days, especially those from China. The first batch on purchasing managers indices will come out on Friday evening, Feb. 28, our Saturday morning. It’s likely that numbers are worse than expected. The Caixin index could be more worrisome; measures the activities at small and mid-sized firms. That might potentially trigger another round of fear on the market.
China just announced its 2019 GDP: 6.1%. It recognized that Q1 and Q2 could be very tough this year. Even if it might take longer for the Chinese economy to get back to the normal level, markets could still attempt to find the bottom, at this pace of correction, before the virus situation around the world gets settled.
We are at a turbulent time. If there is any blessing under disguise, the forced shutdown in China has given us a glimpse of how the world would function if global trades are completely delinked. It tells us what the end game of a full-blown global trade war may look like.
The world communities have become very entangled with each other, from company to company, from company to customers, community to community. We are experiencing the consequence from just a month-long disconnection. We can imagine that a deliberate and prolonged process of disengagement of the global system as we know it can only be traumatic for us all.
Postscript: Just heard from my sister. The 3M N95 masks I shipped via the fastest UPS delivery a month ago finally reached her due to canceled flights to China and delays at customs. Her family was overjoyed. Masks are still hard to find in China, online or offline. Two days ago, I rushed to get some masks to ship over to my friend in Italy. She can’t find them in her town. Masks are hard to find in the U.S. now, both online and offline. A few new vendors have them, with delivery time in mid-April, charging $80 shipping fee. They can’t come from China, right?
About Purview Investments
Purview Investment is a registered investment advisor that specializes in ESG and investment research, ESG ETF model portfolios and ETF subadvisories. Purview prides itself on original investment research and unique perspectives based on both the U.S. and local knowledge and resources. Please contact us for our product and services, or sign up for research at www.purviewinvestments.com.
The views in the article represent the author’s research efforts to help better understand the transmission mechanism from a health crisis to real economy, business, society and capital markets. They are meant for educational purposes, not for investment advice.