The Wuhan coronavirus (now known as COVID-19) has significantly impacted markets over the past month, with equities fluctuating and interest rates down sharply. Massive quarantines in China have caused demand for energy to fall by an estimated 20%, causing a rapid decline in global crude prices. Prior experiences with past epidemics hold some lessons, and yet there is much that is unique about the rapidly unfolding events in China. While modern-day epidemics rarely permanently derail a developed economy, investors will likely have to contend with lower yields and heightened volatility for several months.
A new coronavirus causes big ripples
A coronavirus originating in Wuhan was initially reported in December and has increasingly caused a significant disruption in China and beyond. The mortality rate appears to have settled in around 2%, well below that of SARS, which was closer to 10%. While so far this virus looks to be less fatal, it does appear to be more contagious. COVID-19 has spread more quickly than did SARS over a comparable time period, and total deaths have already surpassed that of the previous epidemic.
The Chinese government’s reaction to COVID-19 has been to effectively quarantine more than 50 million people in Wuhan and surrounding cities, a level of intervention that is unprecedented. There is concern that this may indicate the disease is more widespread and a bigger problem than the Chinese government is openly revealing.
One particular area of concern is that there are now patients in 29 out of 33 autonomous regions in China.1 However, news has been fluid and reporting is contradictory. Are there simply cases in each region or mini epidemics? The answers to these questions over the next days and weeks will be closely watched.
The good news is that China has been enormously forthcoming scientifically and has published the genetic sequence of the coronavirus. In addition, China has expeditiously built two hospitals with over 1,000 beds each and is designating hospitals to house patients. These exceptional measures speak to the speed at which this has moved and their expectations of a huge patient base.
Economic impact of epidemic
We look for the economic impact of the current epidemic to be significant, but hopefully short-lived, which will probably be apparent in weak Q1 economic data. Currently there are more unknowns than knowns, and any estimate right now is simply an educated guess. Still, it is worth looking at the past episode of SARS – another coronavirus – in 2003, and checking in on what is similar and what is different today. Wuhan is the seventh-largest city in China and is considered the transportation hub of central China.
The SARS outbreak began in early 2003 but became acute from April–May 2003, severely impacting Q2 2003 GDP in China. There was an almost complete rebound in Q3, and total GDP in 2003 was 9.1% vs. 2002 growth of 8.0%.2 At that time, the biggest sectors impacted were travel and tourism, retail sales, and freight or transportation. At present, these are also sectors that we would expect to experience the biggest dislocation of activity.
There are some critical differences this time around. The size of the current quarantine is significantly larger, which could lead to a bigger economic disruption than SARS. Yet again, there are some caveats. Now, for example, Chinese retail sales are approximately 20% online vs. what was probably close to 0% in 2003. Of course, China’s economy was smaller in 2003 and accounted for 4.3% of global GDP, whereas now China is the second-largest economy in the world and contributes 15.8% of world GDP.3 All of these factors will impact the data but make it difficult to predict how deep or lasting the disruption to Chinese and global growth will be.
The IMF expects Chinese GDP to grow 6.0% in 2020,4 continuing its decade-long structural slowdown. Should authorities succeed in getting COVID-19 under control, there is every reason to expect that the likely economic disruption in early 2020 will be fully recovered by year-end. However, against the backdrop of heightened uncertainty for the Chinese economy given U.S.-China trade tensions, this could cause the broader trend of slower growth to become more pronounced.
Financial markets face more uncertainty
Financial markets are wavering under the heightened uncertainty of this epidemic. The S&P 500 traded down more than 3% over the final two weeks of January and then recouped those losses in the first week of February, reflecting the volatility that the outbreak has induced. The MSCI China Index experienced a drawdown of nearly 10% before mitigating a portion of those losses.
Fixed income markets have also reacted as flight-to-quality flows have pushed up demand for U.S. Treasuries (a global safe-haven asset) and driven 10-year Treasury yields down to a low of 1.51%, a drop of 41 bps in the course of one month. This has flattened the yield curve significantly, and the 3M-10Y pair has gone from a positive slope of 36 bps at the start of the year to inversion to start February. We are aware that further bad news could push long-term U.S. yields lower. However, in our view, the more severe yield curve inversion over last summer (-51 bps for the 3M-10Y) is unlikely since the Fed cut rates and brought short-term yields down in late 2019. Finally, oil markets are also feeling the impact as prices have fallen from a high of $63/bbl to hovering around $50.
Clearly our broad expectation that interest rates will remain low did not forecast the outbreak of COVID-19. But it shows that while U.S. equity valuations remain close to cycle highs, the fixed income market has remained only cautiously optimistic as reflected in yield curve dynamics about global growth prospects, which could prove fragile in the face of uncertainty. Uncertainty may keep markets cautious and volatility heightened as events evolve over the next several weeks, at minimum.
