Positive mood challenged? | Top Down

27 February 2020

Positive mood challenged?

As we write, financial markets are gripped by another round of coronavirus fears. In a matter of 4 days the US and the euro area equity markets have dropped between 8% and 9%. The spread of the infection outside China, with a rapid build-up in cases in South Korea and latterly the outbreak in Italy has caused investors to reassess the impact on the global economy. Will there be more severe disruptions elsewhere around the world than previously thought and could they last longer? Indications coming from China are saying that there is significant disruption, but the length of that disruption does not look like it will be any greater than originally thought. Consequently, we are increasing exposure to equities in this pull back.

"Despite the news flow, the data around the impact of the virus supports the contention of a short, sharp reduction in activity only. Accordingly, we are increasing our exposure to equities in this pull-back."


Momentum was building

Before getting into the detail of current developments it is worth reflecting on what had been happening in January. The economic data released through January were encouraging. It looked like we were embarking on a synchronised recovery across the globe. In the euro area, sentiment surveys were indicating that the manufacturing slump that had occurred in 2019 was beginning to pass. The composite PMI in the euro area was above 50 and rising and was doing this while showing some impact for the virus outbreak in China. Declining export orders and delays in shipments were noted within the surveys but despite that the overall figure moved into expansion territory.

In the US, the worrying data series (the ISM Manufacturing survey) turned positive in January moving back above 50 indicating the manufacturing recession in the US may be coming to an end. Most encouraging was the significant improvement in the forward-looking New Orders sub index. The payrolls number for January was strong and there were small upward revisions to the previous month’s figures. China was also experiencing an acceleration in the economy. Both Manufacturing and Services PMI’s were better than expected and Retail Sales growth was also faster than forecast. The OECD lead indicators from across the major regions have now moved into the recovery phase indicating a stronger global economy as we travel through the first half of the year.

Could it be stopped?

But that was all before the virus outbreak began. It has caused a lot of human anguish and suffering, but it will also have an economic impact. In China, year-on-year economic growth for the first quarter has been reduced by close to 2%, followed by a sharp rebound in the second quarter, but it would leave growth for the year 0.5% lower than we expected at the start of the year. We are likely to see cuts in other regions, but the critical issue is not whether the recovery will be stalled, but whether it will be derailed. Will the bounce-back in the second quarter occur?

Signs suggest the impact will be short lived

The first cases in China were identified at the start of January but the number of suspected cases started declining on a daily basis from the middle of February. The number of suspected cases diagnosed as having the virus is flattening on a day-on-day basis. The contagion seems to be declining after about a 6-week period. This is in line with any other outbreak of influenza and does support the contention of a short sharp, reduction in activity in the first quarter followed by an equally sharp rebound in the second quarter.

People closest to it seem to think that way too

The outbreak of the virus has been with us now for nearly eight weeks but the global market reaction has been most violent over the last week. If you look at how the Chinese equity market is reacting, which is most affected by the impact of the virus, it is encouraging. The Chinese market reacted most at the end of January as the outbreak gathered pace. It fell 12% in the space of 10 days. But, it has now rebounded 11% from that low point and has only declined 1.5% in the recent turmoil. The ones who would judge the impact of the virus best seem to think it is transient.

Nervous times

The outbreak of a lethal virus is similar to the threat of terrorism. You do not know where it will strike or when. People are un-nerved, there can be sensational headlines and it does have an economic impact. The difference with terrorism is that a virus can be brought under control. Despite the news flow on this side of the world, that now appears to be happening where the outbreak began. To us the recent reaction in developed markets seems unwarranted. Profit growth is likely to be disturbed for a quarter but that should not have a meaningful impact on the value of what is a long-term asset. Consequently, we are increasing our exposure to equities at the moment.

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