Although the global economy had ended on a weak note in 2019, both manufacturing and services survey data was suggesting a rebound was underway. It is now clear that the recovery has been put on hold by the coronavirus outbreak.
Prior to the weekend of 21-22 February, risk asset markets were near all-time highs, both the US and Australian markets were pricing in little to zero chance of rate cuts as markets seemed to be treating the virus as a China-only supply chain story.
Circumstances changed dramatically over that weekend as news on the Italian contagion set the risk- off wheels into motion. The news flow progressively worsened during the week as numbers of infected patients rapidly rose in South Korea, Japan and Iran. By the end of the week almost every country in the EU had reported cases, schools were shut in Japan, large gatherings were banned in France and there was a run on hand sanitizers in most US cities and toilet paper in Australia. The bottom line being, the coronavirus situation had changed, had gone global and the markets savagely reacted. The situation has changed from a large supply shock to a potential global aggregate demand shock as well. GDP will and has been materially impacted–particularly in China, but the shockwaves are being felt globally. GDP in China will likely contract in 1Q20, the first time in modern history.
In the first week of March both the RBA and US Federal Reserve (Fed) reduced rates, with the Fed reducing by 50 bps out of cycle. Both central banks indicated they were prepared for further action that may include qualitative easing.
The combination of the coordinated central bank stimulus and some positive news on the containment of the coronavirus are the keys to turning the global economy around. Previous similar episodes have resulted in a short and sharp economic impact followed by a “v” shaped recovery. However, given the huge uncertainty at present, and the actions from governments in trying to reduce the spread of the virus, it is difficult to have a firm conclusion on the length of any downturn.
The February reporting season was one of the weakest since the global financial crisis and that does not include the likely impact to earnings from the coronavirus. Many companies commented that it was likely to adversely impact but had little visibility on the quantum as yet. Revenue was the area called out as most at risk whereas very few had experienced supply chain disruptions yet. The risks around supply chain disruptions out of China may be starting to alleviate given workers are returning to work and factories are starting back up.
The economic impact of spread of the coronavirus beyond China to the rest of the world and the subsequent coordinated central bank responses to lower interest rates to ease financial conditions magnifies the relative attractiveness of defensive and otherwise coronavirus-isolated names.
The Portfolio is positioned to take advantage of the global economy moving away from outright bearishness and risk-off, to a more “normal” environment. The defensive bond-sensitive and quality names remain in “bubble” territory and would be expected to correct heavily when the market moves into more rational territory. The valuation divergence is illustrated by the gap between high and low PE names, which remains extreme and as such there is significant further upside potential in the Portfolio as and when market valuations correct to more appropriate levels.
Brad Potter, Head of Australian Equities – Nikko Asset Management