First and foremost, our thoughts are with the people affected by the virus. The situation remains fluid and uncertain as new cases are discovered in different parts of the world.
It is positive that the rate of new infections reported by health authorities in China — both including and excluding the province of Hubei — appears to be falling, notwithstanding the one-off spike in the reported number of cases yesterday (13 February) after officials changed the way suspected incidences of disease were diagnosed. That resulted in more than 15,000 cases being added, but most of them reflected the reclassification of “clinically diagnosed” patients (i.e., those identified by CT scan). The more pertinent datapoint is that the number of new cases reported on 12 February (2,068) was down 47% from the peak one week earlier. The government’s containment strategy and other measures to stem the spread of the virus seem to be working. Things could change rapidly if there is a further surge in the coming days, following the introduction of the new diagnostic method. Meanwhile, the spread of the virus and fatality rate outside mainland China remain low.
It’s too early to declare victory, but the impact of the virus on the Chinese economy is likely to be sharp but short-lived. Evidence from previous viral outbreaks where new infections started to decline would suggest a two- to three-month drag on economic activity. Investors should brace themselves for a tough couple of months for activity indicators, as well as supply-chain dislocations. Should new infection rates continue to decline, the Chinese economy could contract in the first quarter by as much as 2% on an annualised basis, according to Goldman Sachs estimates, followed by a recovery in the second and third quarters. Overall, the impact of the virus could shave 0.5-0.6% from full-year growth. The recovery in output will be led by massive restocking in the industrial sector, as well as policy support to counteract the temporary demand destruction.
We believe the Chinese authorities will use everything in their policy toolkit to hit their growth targets of 5.5-6.0%, pulling both monetary and fiscal levers. Their efforts are likely to include a forbearance strategy, monetary easing and an infrastructure push. Last week, the Chinese central bank injected record levels of liquidity into the financial system, including a single-day injection equal to half of the total US stimulus since September 2019. Repo rates are falling and we are likely to see more reserve requirement ratio (RRR) cuts during the year, further easing credit conditions.
From a corporate perspective, earnings are at risk of near-term downgrades within China and across the broader region. But as we outline below, we believe impacts will vary.
At the sector level, we think the coronavirus will prove to be a tipping point for ‘new economy’ China, which includes e-commerce and online content companies. These stocks underperformed through much of 2019 and only started recovering performance during the fourth quarter of last year. We see the current entry point as attractive.
For historical context, the 2003 SARS (Severe Acute Respiratory Syndrome) epidemic built Chinese e-commerce. Taobao, Alibaba’s online retailing platform, was launched in May 2003 during the SARS outbreak. JD.com, the largest retailer in China, came into existence around the same time. Today, Alibaba and JD.com are the two largest MSCI index constituents in the consumer discretionary sector, highlighting the changing composition of China’s equity markets and the fact that consumer behaviour in China has changed dramatically over the last 15 years. We believe the coronavirus (now with an official name of COVID-19) will prove to be a similar watershed moment for this sector.
Since the outbreak of the virus in Wuhan, online shopping has been in demand, especially for fast-moving consumer goods and fresh food. Alibaba’s Freshippo app and other online retailers have reported increases in demand. Our baseline expectation is that the share of online to offline retail sales, currently at 18%, could reach 20% by the end of 2020. Other beneficiaries could be select healthcare companies and insurance companies that also offer online health assessment. Once the virus has passed, we expect industrials and big-ticket consumer discretionary names to benefit from restocking inventories and a fixed asset investment (FAI) stimulus push by the Chinese government.
From a broader Asia perspective, we would note that the Chinese economy is now much larger than it was during the SARS outbreak, with GDP of US$13.4 trillion versus US$1.7 trillion in 2003. Also, regional linkages are deeper, with the rest of Asia more dependent on local Chinese demand, tourism flow and China’s role in the manufacturing supply chain.
Markets like Hong Kong and Macau are good proxies for Chinese consumer discretionary demand. They will no doubt be hit in the near term from falling retail sales and gaming revenues. Chinese tourism demand is also a significant driver of GDP in Thailand and Singapore. The 5G supply chain is likely to see disruption on the handset side from plant shutdowns as workers are kept at home, while the accelerating capital expenditure on 5G across China may slow. This could impact several IT companies in Korea and Taiwan over the current quarter.
Does history offer any guide to what to expect in markets? The peak-to-trough drawdown in China’s equity markets during the SARS epidemic was 12-13%, and the trough coincided with the high point in daily new infections. This was mostly led by price to earnings (PE) compression, as the earnings impact of the SARS episode was less than 1%. The market recovered as investors drew comfort from the speed at which the rate of new infections was dropping.
We think it would be inadvisable to get too pre-emptively bearish on China. We are in the midst of a developing situation and investors need to ensure they are making rational, not emotional, decisions. This is a humanitarian catastrophe with over 1,300 people dead and nearly 64,000 infected at the time of writing. But China has shown its ability to recover from disasters before, like the Chengdu earthquake and SARS epidemic. As investors, we are in the business of assessing and pricing risk, and we believe that the risk/reward opportunity in the Chinese equity market has improved. We are cautiously optimistic that this virus will clear in two to three months. Valuations are attractive at 11.2x one-year forward PE, particularly given our expectation that the policy response and liquidity environment will both be supportive beyond the containment measures.
General risks: The value of investments, and any income generated from them, can fall as well as rise and will be affected by changes in interest rates, currency fluctuations, general market conditions and other political, social and economic developments, as well as by specific matters relating to the assets in which the investment strategy invests. If any currency differs from the investor’s home currency, returns may increase or decrease as a result of currency fluctuations. Past performance is not a reliable indicator of future results.
Specific Risks: Emerging markets (inc. China): These markets carry a higher risk of financial loss than more developed markets as they may have less developed legal, political, economic or other systems.