Intro: Understanding the full impact of the Coronavirus on the global economy is currently unknowable and the fear of global pandemic is terrifying markets. Cases of Coronavirus outside of China are increasing at an alarming rate, especially if you consider this as a Jurassic Park problem, where the real danger lies in the data you can’t see yet. And unlike the flu, or other diseases of known documented pathology, we have no familiarity with effects and impacts of broad based local transmission. This lack of visibility will feed into higher volatility and constrain busimess decisions that will likely lead to lower economic growth for the year.
The problem with the Coronavirus so far is that time is serially correlated to the spread of the virus outside of China. What that means is that the longer governments wait to respond to the outbreak, the higher the likelihood of seeing broader local transmission as opposed to imported cases. Initial data models that we’ve looked at found a 65% correlation between Chinese cases and rest of world transmission over time, which means that local transmission is becoming a more prevalent agent in determining what shapes the current stage of the outbreak. In the case of local transmission, the spread vectors become increasingly more severe with additional spillover effects into the broader economy. From the last set of data points pulled from the WHO Situation report we see an average growth rate of 18% in the amount of reported cases in the rest of world ex-China category. As of March 3rd the number has jumped to 12,200 cases up from 10,300 the previous day. In China we have seen a significant slowdown in the amount of new cases, with new cases falling below 1% and hovering just above 80,000. Of course, we must consider to what degree Chinese government data can be accurately relied upon, but it seems locally contained within China for now.
That’s not to say there won’t be economic shocks as a result of the virus, latest manufacturing purchasing manager index out of China showed a decline to 35.7 from 50. This highlights a severe and immediate contraction in the country’s manufacturing output and will put strain on supply chains, especially technology and industrial sectors of the economy that source parts and manufacture in the region. This will lower the ability to deliver goods into end markets affecting real final sales. This is the categorical definition of a supply shock, as well as lower the demand for commodities globally and defer CAPEX spending and investment which could also dampen economic growth. OECD global growth forecasts have been slashed to 2.4% from 2.9% prior to the outbreak. The US economy is also likely to see sub-2% growth and China falling below 5%. The question is how transient these shock effects are and what does the shape of recovery look like. There is an argument to be made that the economy will rebound much like it did in the past when confronted with epidemic shocks. Especially as Central Banks around the world seek to develop coordinated efforts in order to backstop economic growth. Looking at Dow Jones Market Data over the last 10 epidemics ranging from SARS, Swine flu, MERS and Ebola there hasn’t been a single period where markets didn’t bounce back in the first six months after the news of epidemic broke. This time might be different, although looking back to SARS in 2003 after the initial 15% decline in the market, the markets were able to rally back to close the year up 20%. However, we are in a different phase of the economy now as opposed to then with a higher sensitivity to compounding effects and additional risks.
Additional risks to the economy range from consumer sentiment re-trenching leading to additional demand shocks and moderate declines in commodity markets. We have already seen Europe take pre-cautionary measures by cancelling public events and towns in Germany have been placed under quarantine. Economies reliant on tourism and travel are also likely to suffer, estimates from IATA have suggested negative airline growth globally, with most of the brunt being felt by Asia-Pacific carriers. That adds up to revenue loss close to $30 billion in airline travel alone. Cruise lines have also warned on earnings with the big three, Carnival, Royal Caribbean and Norwegian all estimating a 5-15% loss of earnings for the year. The additional story is the impact on corporate earnings for US firms, technology firms have the largest China exposure at nearly 15%, followed by energy and materials at roughly 5%. We’ve seen some of the larger sell side houses like Goldman Sachs already call for zero earnings growth this year as a result of Corona, with downside scenarios or global pandemic calling for minus double-digit growth. It’s obvious that the market is digesting the risk velocity of seeing some of the downside scenarios in their earnings and what that means for future prices. Even with the Federal Reserve’s emergency rate cut of 50bps it has failed to halt the decline in equity markets. The data that we have modelled point to a high degree of significance between growth in rest of world cases and volatility, our R-squared measures at 0.915. Additionally, the bond market reaction has been severe, with the 10-year yield falling over 50bps in 5 days and the two-year yield declining by 66bps over the same time period. This points to a market looking for safe harbor and a risk-off attitude in the short term.
Conclusion: As long as the rate of global transmission increases, markets and economies will be unable to pursue a path of orderly growth. Uncertainty and volatility go hand in hand, which unfortunately plays out into a chaotic dynamic. When analyzing chaos in dynamical systems you have to ask if the system is ready to settle into an orderly state, which in the near term this does not appear to be the case. The current state of play remains fluid and fearful as it is too early to determine the impact of multiple economic shocks at once. We just don’t have the required data to price out worse case scenarios yet. The good news is that markets will react quickly to positive changes in data and economies have the ability to recover over the coming quarters if we can decrease the risk velocity of local transmission. Longer term, governments and corporations will assimilate lessons learned from this current crisis to develop multiple solutions to manage outbreaks. This includes increasing risk and crises management tools, building out capacity across multiple supply chain nodes and additional funding for infectious disease research which will lead to a more robust global system.