- The coronavirus outbreak represents a significant shock to both supply and demand in China and is likely to have repercussions for both Chinese and globaleconomic growth.
- Shuttered Chinese factories have disrupted global supply chains and may further motivate multinationals to diversify their supply chains geographically.
- Response by Chinese policymakers has been swift, but their efforts may exacerbate existing financial imbalances and increase the structural vulnerability of the Chinese economy.
- While the fatality rate of the coronavirus thus far has been relatively low, negative expectations can sometimes override material impact.
- First Eagle's search for portfolio resilience from the bottom up has long limited our exposure to Chinese equities, the risks of which, in our view, are not fully appreciated by the market.
A novel coronavirus (2019-nCoV ) first identified in Wuhan, China, has spread to more than 20 other countries and has set the world on edge. Below we provide a preliminary look at the effects this virus and the efforts to combat its human and financial impact may have on the global economy in 2020.
Broad economic impact. The outbreak of the coronavirus represents a significant shock to both supply and demand in China. Widespread restrictions on travel and other public-health measures have hurt the service sectors of the economy, while many factories have been forced to close as authorities seek to contain the public-health damage. With the prov-inces most effected by the virus accounting for around 80% of Chinese economic activity in our estimation, we believe it's quite likely that Chinese GDP growth will contract in first quarter 2020 on a quarterly basis, though it's uncertain whether official government data will reflect this.
With the trajectory of the outbreak remaining unclear, so too does the timeline for China's return to normalcy and thus the total economic impact. Assuming factories reopen at the pace currently planned by authorities, business and consumer activity likely will snap back sharply in the second quarter before returning to growth more consistent with trend levels in the third and fourth quarters. Even so, full-year 2020 economic growth in China appears very likely to slow from 2019's 6.1% pace.1 With more than 25% of worldwide economic growth derived from China,2 a meaningful slowdown could translate into a considerable hit to global growth. Should produc-tion come back online more slowly than anticipated, the impact obviously would deepen.
Meanwhile, China had committed to buying an additional $200 billion worth of goods from the US over the next two years as part of the "phase one" trade deal between the two countries.3 Though it seems highly unlikely China will be able to make good on this pledge given the economic impact of the coronavirus outbreak, the effect on trade tensions remains to be seen.
Spillover impact. The spillover impact of the outbreak also has demand and supply components. Many Asian economies depend on mainland China as their primary source of tourist spending; travel restrictions have kept Chinese nationals at home, while coronavirus fears in general have scared off visitors to Asia from ports worldwide. Meanwhile, waning industrial demand has resulted in meaningful weakness in the prices of economically sensitive commodities such as copper, oil and gas.4
Closed factories have disrupted countless global supply chains that rely on Chinese manufacturers, the cascading global impact should play out over the coming weeks. While a staggered re-opening of factories has begun, many employees--away from home for the Lunar New Year holiday as travel restrictions went into effect--have found themselves stranded and unable to return to work, leaving these facilities oper-ating well below capacity. Already alerted to the risks of supply-chain concentration thanks to the US/China trade war and US technology restrictions, the coronavirus outbreak is likely to inspire greater numbers of multinational companies to build redundancies into their global supply chains, which may benefit of other low-cost manufacturing centers at the cost of efficiency.
Policy response. Prioritizing growth over debt control, economic policymakers thus far have been proactive in responding to the coronavirus outbreak, and more measures are expected going forward. The People's Bank of China (PBOC) in early February cut reverse repo rates by 10 basis points (for comparison, it had cut the rate only 5 bps as the trade battle with the US escalated over the course of 2019) while injecting 1.7 trillion yuan of liquidity into the system. The central bank also introduced special re-lending funds that certain national and local banks can use to extend loans at a sub-market rate to businesses involved with food and healthcare.5 The China Development Bank issued more than 13 billion yuan of one-year bonds at 1.65% to raise funds in support of the fight against the coronavirus.6
The coronavirus outbreak was a gut punch for the country's small and medium-sized enterprises (SMEs), which were already being battered by the Sino/American trade war and the Beijing's crackdown on the shadow-banking system. Given the broad impact widespread SME bankruptcies would have on the Chinese economy in general and employment in particular, authorities are expected to be accommodating. The PBOC has instructed banks to exercise leniency with borrowers based in the most effected parts of the country, and there are signs that policymakers may take a more permissible attitude toward the unregulated shadow-banking sector that SMEs historically have turned to when unable to secure government financing. Local governments are offering subsidies to companies struggling to cover the costs of such essentials as electricity, gas and water; with municipal government financial conditions generally poor, however, funding for this effort ultimately will come from the federal level and exacerbate a fiscal deficit that we believe likely is already above the 3% limit. In aggregate, the policy actions taken to offset the economic impact of the coronavirus outbreak presumably will worsen existing financial imbalances and increase the structural vulnerability of the Chinese economy.
First Eagle: Searching for Resilience in an Uncertain World
The coronavirus outbreak joins a long list of risks to China that we believe are not fully appreciated by the market, from trade battles with the US and other geopo - litical tensions to a massive domestic credit boom and rapidly aging population, all happening amid the backdrop of an ongoing reorientation toward an open, market economy. As of January 31, 2020, our Global Value portfolio had 0% direct exposure to companies domiciled in mainland China and less than 4% exposure to revenues derived from China by companies based elsewhere (compared to 6.0% revenue expo-sure of the MSCI World);7 Chinese exposure among our other strategies was similarly limited. The near-term impact of the coronavirus outbreak has been most evident in our energy positions, as softer demand from China has weighed on global oil prices.
Note that our historically limited exposure to China is not suggestive of any top-down bias; rather, it reflects our search for portfolio resilience in the face of an inherently uncertain future. One way we work toward building resilient portfolios is by identi-fying well-managed, well- capitalized companies that we believe have the potential for persistent earnings power over time by virtue of possessing a scarce, durable asset--a tangible or intangible factor that in our view provides it with a long-term operational advantage and is highly difficult to replicate, such as a well-located physical resource or an advantaged market position. In order to commit capital to such companies, we also require a "margin of safety" in price, which we define as the difference between a company's market price and our estimate of its intrinsic value. Though our research hasn't revealed investment opportunities in China that offer such a combination, our holdings in cash and cash equivalents allow us to capitalize on such opportuni-ties wherever they arise while maintaining consistent investment standards as market dynamics shift. Meanwhile, gold--scarce and stable in supply--serves as an incredibly valuable potential hedge in our portfolios over time.
While the coronavirus outbreak remains at a precarious stage, the fatality rate thus far is relatively low. That said, the crisis is weighing on sentiment at a time when the global economy remains mired in a stall zone and manufacturing is struggling to emerge from recession. As we've seen in the past, expectations for a negative event sometimes can be more damaging to markets and economies than the measurable impact of said event.
Given their symptomatic similarities--but notable genetic differences--comparisons have been made between the coronavirus and the Spanish flu, a devastating pandemic in 1918-19. Strikingly, the Spanish flu occurred in three distinct waves over 18 months, suggesting 2019-nCoV may warrant caution for some time, even after the spread of the virus appears to lose momentum. Further, though medical care and tech-nology have evolved immeasurably over the past century, it can be argued that public health systems today remain poorly equipped to battle a virus of this severity should it become a global pandemic.8
While we are hopeful that the worst of the coronavirus outbreak is behind us, we don't know what the future holds. However, the unexpected emergence of this global public health threat highlights the many risks--both seen and unseen--investors face 10-plus years into the current bull market and underscores a key precept of First Eagle's invest-ment philosophy: to seek resilience in portfolios from the bottom up.
- Source: Bloomberg, as of January 16, 2020.
- Source: Bloomberg, as of May 6, 2019.
- Source: Wall Street Journal, as of January 15, 2020.
- Source: Bloomberg, as of February 12, 2020.
- Source: Reuters, as of February 2, 2020.
- Source: Xinhua News Agency, as of February 6, 2020.
- Source: FactSet, as of January 31, 2020.
Greenmantle, "The 1918-19 Influenza Pandemic," February 11, 2020.
The opinions expressed are not necessarily those of the firm and are subject to change based on market and other conditions. These materials are provided for informational purposes only. These opinions are not intended to be a forecast of future events, a guarantee of future results, or investment advice. Any statistics contained herein have been obtained from sources believed to be reliable, but the accuracy of this information cannot be guaranteed. The views expressed herein may change at any time subsequent to the date of issue hereof. The information provided is not to be construed as a recommendation or an offer to buy or sell or the solicitation of an offer to buy or sell any security. The information in this piece is not intended to provide and should not be relied on for accounting, legal, and tax advice.
There are risks associated with investing in securities of foreign countries, such as erratic market conditions, economic and political instability and fluctuations in currency exchange rates. These risks may be more pronounced with respect to investments in emerging markets.
This article first appeared on GuruFocus.