No one can predict the future but, for investors, it is important to have as complete a picture as possible of situations that could affect their assets. For those who invest in financial markets, then, few things could be more alarming than reading news of the continued and unpredictable spread of COVID-19 (coronavirus) cases.
Conspiracy theories aside, there is little doubt that the scale of the crisis was underestimated in its early stages – not necessarily by the media, but by the markets. Particularly in Europe and the United States, the virus had made almost no financial impact until this week, with the Dow Jones posting its worst day in two years on Monday as coronavirus fears made their mark.
The postponement of public events in Italy may also concern newsreaders, but the spread outside of China is not a surprising development. It is reasonable to expect the spread to continue to other parts of the world, too. The reassuring detail is the success of containment strategies outside of the epicentre of the Wuhan region. In no other region or country have more than 1,300 infections been registered (at the time of writing).
The situation for the markets in emerging countries is different, though. Investors have already begun to register losses related to the virus, generally in Asian markets (for obvious geographical reasons). This highlights the potential for the markets to move independently of public perception of an event. The importance of managing risk with a diversified strategy and an expert approach is only heightened in these situations.
The IMF has predicted that, despite slowing infection rates in China, the economic effect of the worldwide spread of the virus could be a hit to global growth. Precaution is appropriate from a public health perspective. For investors, though, it is important to avoid knee jerk reactions to temporary volatility and, instead, to focus on the long-term.
For now, we can look at a number of scenarios to anticipate how the situation might evolve. The epidemic could be categorised as a black swan: an unforeseen event which could have a significant and exponential negative impact.
As the situation currently stands, we believe there are two primary factors which could impact financial markets. Firstly, we have the worst-case scenario: the coronavirus becomes a serious global pandemic. The probability of this is extremely low, something the financial markets seem to have bet on.
The second major negative effect could be poor company growth. Corporate earnings disappointed in 2019, but valuations have nevertheless continued to grow, partly thanks to some expansive monetary policy from central banks. To justify these valuations, more pronounced economic and earnings growth is required this year.
Even optimists, however, are now broadly in agreement that global growth remains relatively fragile. This is where coronavirus comes in: if the disease continues to spread and governments take additional measures to contain it, this could lead to major changes in consumer and business behaviour, in China and beyond. Less travel, fewer purchases, cancelled holidays – the potential list is extensive. The longer this containment continues, the greater the impact on global growth could be. The key is to understand when the damage could become structural, affecting medium-term GDP prospects.
For these reasons, the coronavirus will not necessarily have to kill thousands more people to have a significant impact on markets. The virus will only need to be active for a few months to change the behaviour of consumers and companies.
Last but not least, we must consider the impact that coronavirus could have on economic momentum. In consumer goods, as prices rise, there can be a positive effect on demand. The same can be seen in financial markets; as we well know, there are periods in which price growth feeds on itself.
This positive trend could be hindered by an external shock, as we have seen in the case of numerous financial crises. The coronavirus could be the latest to play this catalysing role.
Possible effects on GDP
From a medium-term perspective, it is sensible to consider the possible effect of this crisis on the wider economy. This kind of emergency could affect everything from circulation and consumption in the short-term, to global investment and trade in the event of an escalation.
Let’s analyse these areas, starting with consumption. This represents one of the fundamental components of GDP. It is also the metric that could take the greatest hit from the travel ban and quarantine, to which almost 50 million people are being subjected. This is a conservative estimate, too, with many facing soft, self-imposed travel bans as a precaution.
It is currently the holiday season in China. This could, depending on the perspective, be both an advantage and a disadvantage. The positive side is that, in this period, production is already running at a reduced rate. Many factories had scheduled production breaks in place before the outbreak of coronavirus.
We make money simple for over 90,000 investors
Find your ideal ISA todayStart now
As with all investing, your capital is at risk. T&Cs and ISA rules apply.
On the other hand, one possible negative could be the effect on internal consumption. In general, when an external factor depresses consumption, the resources earmarked for this item of GDP are set aside for later use. If the epidemic does not persist for a long time, the effect on consumption should reduce short-term volatility. The case would be different if the external factor hit the seasonal peak of consumption, as could be the case with holidays.
On closer inspection, the fluctuations in Chinese consumption do not seem to be characterised by particular seasonal trends. In this sense, for the moment, the effect on consumption is probably temporary and localised.
If the state of emergency continues, other components of GDP, such as investment and exports, are likely to be affected. At this stage, we do not believe that these areas have been significantly hit. Again, the key will be to assess the situation throughout the emergency.
Finally, we must consider the possible impact on Western economies. Already, we have seen companies such as British Airways cancel flights to China. In Italy, public events such as football matches were postponed after numerous cases had been reported. Practical measures taken to limit the spread of the virus could have a concrete effect on the economy, but the scale is very much dependent on the eventual scale and duration of the outbreak.
A useful yardstick could be the SARS epidemic. The crisis did not lead to the economy slowing in any significant way (although we cannot say for sure what growth would have been without the virus).
However, we were dealing with a very different China. Between 2000 and 2008, its economy grew at an average rate of over 10% year on year. We are also dealing with a different epidemic – coronavirus has infected and killed more people than SARS did 17 years ago. The mortality rate of around 2% is one-fifth of that of SARS, but coronavirus has already infected ten times the number of people.
In recent years, China’s real growth has suffered as a result of trade wars. Economic growth, although positive, slowed in 2019 by almost 1 percentage point when compared to levels in 2017. Even without considering the effects of the coronavirus outbreak, expectations for 2020 (5.9%) and 2021 (5.8%) are already reasonably low. The Chinese economy remains fairly weak and, despite high debt rates, capital requirements for banks have been lowered to stimulate investment. In a situation of high debt, the effects of exogenous shocks on the economy are amplified.
We believe that, even in the absence of a widespread pandemic, the impact on the economy will primarily hinge on the duration of the emergency.
Finally, it is worth considering the potential impact on the price of crude oil. Despite the country being the world’s largest investor in renewable resources, oil is still China’s primary energy source and demand has steadily increased in the past decade, by about 12% per year. In terms of oil consumption, China is second only to the United States, so the impact of the Asian giant’s demand on the price is significant.
We have already seen a downward trend in oil prices this year, driven primarily by the supply-demand dynamic.
In the short term context of supply and demand bringing the price of a barrel down, uncertainty only adds further volatility. In the medium term, if the epidemic were to have concrete effects on aggregate demand (both in China and globally), this will inevitably have a negative effect on the price of oil.
In any case, our vision for 2020 remains relatively conservative, regardless of tensions related to the virus or resulting geopolitical tensions.
The positioning of Moneyfarm’s portfolios is reasonably conservative across all our risk profiles. This decision forms the basis of our investment philosophy and medium to long-term strategy. Our goal has always been to incorporate and contain the effects of spikes in short-term volatility onto our portfolios. The volatility caused by coronavirus has been, so far, largely within acceptable risk levels and should not compromise medium-term risk-reward projections.
Going forward, our asset allocation team will monitor developments daily. We have already carried out an analysis of potential scenarios related to the virus and, for the moment, we are not in what we see as an extreme situation. At present, our focus is more on getting our diversification strategy right than on reducing equity (which, as we have explained, is relatively conservative).
At the moment, we see no real need to act on our allocation. Markets have been affected but not to the extent that we see the need to make any drastic changes. To us, there is insufficient evidence to suggest an impending dramatic downturn, and certainly not enough to necessitate a reduction in risk tolerance within the portfolios. For the moment, we maintain our current position, albeit while keeping a keen eye on the development of the situation going forward.
Match with a portfolio and start investing today
Simple, efficient and low cost, Moneyfarm helps you protect and grow your money over time.
Sign up with Moneyfarm today to match with an investment portfolio that’s built and managed to help you achieve your financial goals.
Make your money work harder for you, without breaking a sweat.
As with all investing, your capital is at risk. The value of your portfolio with Moneyfarm can go down as well as up and you may get back less than you invest.