Why it could be worse than SARS

Just as markets were ready to look past trade tensions and rally around a recovering macro environment, the Coronavirus outbreak has injected a degree of uncertainty not seen since the height of trade wars. Forecasts for growth, not just in China but globally, are coming down as the economic toll of the virus and quarantine are becoming clearer. 

If history is a guide, epidemics tend to have a short-term impact; but over the medium-to-longer-term, markets and economies are driven by the economic and business cycle. Nevertheless, we think the economic toll for China and the global economy will be significant in the first quarter and depending how long the virus remains uncontained, into the second quarter as well.

While the situation remains fluid, we recommend investors continue to take a long-term approach and focus on sectors facing secular growth prospects.

Growth in China will be under significant pressure in the first two quarters. Production, retail consumption, and travel numbers are expected to fall sharply in China, along with regional trade, transport, and tourism across Asia. The SARS[1]  period can be used a starting point for understanding the potential impact, but it’s worth noting that a number of key factors are different with this epidemic, making it less effective as a comparison. Differences include:

  1. Scale of the response. The scale of the current quarantine response is much larger and wide-spread. The economic impact of the virus is not simply a function of its severity. The reaction and response are likely to have a much larger economic impact than during 2003. 

    During SARS, schools were shut down and workers were told to work from home for a month, but the transportation service was still functioning and most other places in the country outside the affected areas were working as usual. 

    That’s not the case now. There is an unprecedented quarantine and near shut down of economic activity. The current response includes an extended national holiday to keep businesses and financial markets closed, major cities have stopped running public transportation, and even tiny rural villages are discouraging family gatherings. Entire cities are quarantined and people are encouraged to stay off the streets. The scale of this unprecedented response will likely reduce economic activity far more than the SARS response.  
  2. China’s growth then and now.  In 2003, growth was robust in China and most major economies. Then, China had recently joined the World Trade Organization (WTO) and both exports and production were seeing rapid growth from very strong global demand. These conditions meant that industrial production and fixed asset investment were largely unaffected by SARS. In contrast, China today is structurally slowing and the economy is showing many cyclical vulnerabilities.
  3. Structure of the Chinese economy.  The sectors most hit, namely consumption and services, now make up a much larger share of the economy than in 2003. Since then, as China has rebalanced away from exports and investment, its vulnerability to a slowdown in domestic demand has increased. A downturn in domestic consumption of goods and services will have a much larger overall economic impact.  

    Moreover, China is a much larger share of the global economy today. It is a significant importer of commodities and electronic components and the main source of tourism for many economies. As China’s connectivity to the global economy is much larger now, its slowdown will have a much larger global economic impact.  

China’s growth will slow significantly in Q1 and Q2. Its official GDP might indeed be below 5% for the year, but actual economic activity could very well be much lower. In sequential quarter-on-quarter growth terms, GDP is likely to contract in Q1, with significant pressure in Q2 as well. This would bring actual year-on-year GDP in the 2.5% range for Q1 leaving full year growth well below 5%. Thus the impact on China and the global economy are likely to be worse than in 2003. 

Regionally, Thailand stands to be impacted the most via tourism though, while Malaysia has the greatest exposure to manufacturing supply chains. India and Indonesia are less exposed to the impacts, although shifts in commodity prices can impact them, albeit asymmetrically.

That said, one of the most defining characteristics of the 2003 SARS epidemic was its lack of lasting impact. Production, trade, investment, retail sales, property activity, virtually every macro variable essentially bounced back up to the end-2002 trend line by the summer. Every single major Asian equity market was trading higher in June 2003 than in December 2002, on the eve of the outbreak. 

In short, there was a large slowdown in economic activity for a few months but after the virus was contained, economic activity bounced back. Pent up demand and delayed production ensured a strong rebound once the situation stabilizied. We expect the same pattern this time. Once the virus is contained, pent up demand will likely spark a strong rebound in activity. The key factors are how long the virus remains a threat and how long authorities keep in place quarantine restrictions. 

  1. Spread of the virus. Both within China and its impacts on other countries. How long will it take to contain the virus? We leave the epidemiology to the epidemiologists, but from an economic/market perspective, whether the disease is regionally contained or has a global impact will determine how it impacts the global economy. If the spread of the virus is broadly contained within China, the global economic impacts will be limited; however, should it turn into a pandemic and economic activity is restricted across most global economies it needs not saying, the impact would be much greater; however, still short-lived.

    Within China, if the virus is contained and China’s suspension of normal travel is relatively short, it is not likely to have much impact on the overall business cycle, since the usual seasonal slump for the holiday has already been under way. The key question for coming weeks, therefore, is how long the government plans to keep these restrictions in place. The answer depends very much on the progress of the virus. 
  2. Policy response. China has already announced a raft of measures including liquidity injections and fiscal support to lessen the impact on growth. We note these can help offset the negative drag on growth but China has far less policy space than before given record high debt levels. That said, new stimulus measures will likely be needed to help businesses in the most affected sectors get through these tough months. Globally, how China and other central banks respond to cushion the blow particularly in impacted economies will be a key metric to watch.  
  3. Production disruption. China is much larger hub of production than it was in 2003 and the extended Lunar New Year holiday coupled with the quarantine measures have the potential to disrupt global supply chains. It’s already being seen in the auto industry and given China’s role in the global electronic supply chain, and further shutdowns beyond the usual New Year disruptions could have a major impact. One way this could be felt more globally is through disruption of parts and supplies.  

China’s growth will suffer in first half, but should rebound strongly once the virus is contained with limited lasting impact on GDP. The business cycle tends to dominate over the medium term and here things have been looking more positive globally. Company earnings data have been favorable; the upside to electronics demand still looks to be in place for the year; USD funding conditions remain favorable. PMIs (Purchasing Managers’ Index) have troughed and relatively tight inventories globally are encouraging production. Other signs include an improvement in Korean exports which is a leading indicator that the trade and manufacturing cycle is improving.

In this environment, we continue to focus on long-term growth trends, particularly around technology and healthcare. We recommend seeking income through cash-flow generating assets and adding diversification through alternative safe havens such as gold. While the Chinese and broader Asia economy are likely to experience a significant slowdown over the near-term, not all sectors will be affected equally. 

Some sectors are likely to see greater resilience on their earnings performance. Asian technology companies with global business exposure or focused on stay-at home services such as gaming or delivery are likely to face less volatility in this environment. It is also important to focus on the long term, and the fact that economic activities should bounce back once the outbreak subsides.

Uncertainties from the outbreak are also expected to reinforce the dovish bias for central banks around the world, especially China when it prepares to support the economy once the outbreak is contained. This should provide support to government bonds and selected Asian and Chinese high grade corporate credits.

1 Severe Acute Respiratory Syndrome (SARS) was recognized at the end of February 2003. WHO coordinated the international investigation with the assistance of the Global Outbreak Alert and Response Network and worked closely with health authorities in the affected countries to provide epidemiological, clinical and logistical support as required. Source: World Health Organization. https://www.who.int/csr/sars/en/