It took investors a few days, but they think they have the effect of the new coronavirus from China worked out. The broad thrust: Suppliers to China, and travel and holiday stocks, will suffer, but nasty effects for the market as a whole will be offset by central banks. The virus will be controlled enough that it won’t cause a recession in the West.
Leaving aside the heartbreak experienced by relatives and friends of those with the illness, as well as the many deaths, this coldblooded analysis rests on several assumptions that may turn out to be unsound—notably, the big risk that this virus could follow a different pattern than the 2003 outbreak of severe acute respiratory syndrome, or SARS, the financial effects of which are being widely used as a model.
The new coronavirus has spread rapidly in China since emerging in Wuhan in December. So far its spread outside China has been limited, with around 100 cases and, so far, not much human-to-human infection—although the U.S. State Department is concerned enough to warn against all travel to China.
Investors have reacted in what looks like a rational way: Since human-to-human infection was confirmed on Jan. 20, the biggest China exchange-traded fund, iShares MSCI China ETF, is down 11%; the U.S. airline sector is off 7%; and Brent crude oil, the global benchmark for the main transport fuel, is down 13%. Stocks in China-dependent Taiwan and South Korea have lost 6% and 9%, respectively, in dollar terms, while the U.S. benchmark S&P 500 is down only 3%.
Bond yields are significantly lower, and investors are pricing in a 60% chance of a Federal Reserve rate cut by June—compared with just 15% before human-transmission confirmation. Those lower yields are once again cushioning the impact on U.S. stocks, following the lesson of the past decade that equities thrive when money is cheap.
The trouble is the assumptions underlying the market reaction. The first is that the effects of the virus will be short-lived, and so can be (mostly) ignored. Investors care much more about the long-term prospects for earnings than a short-term hit to sales; there are going to be lots of profit warnings blaming the infection. But, investors assume, things will rapidly return to normal.
Unfortunately, we have little idea whether this is true. If people can pass on the virus before they show symptoms, or if it turns out to be easier to catch than first thought, it may spread rapidly outside China.
Second, investors are assuming that the wider population outside China remains calm and that preventive action by governments and companies isn’t terribly disruptive. If people aren’t willing or able to go about their ordinary lives, the economy will be hit hard and so will stocks. Confidence is a fragile thing and hard to predict.
If confidence crumbles, it will be doubly bad. The S&P 500 was the most highly valued since 2002 just before the outbreak, with investors verging on exuberant, so any loss of faith could hit prices hard. Worse, the U.S. economy has been reliant on confident consumers for the past year as manufacturers and exporters struggled. If consumers close their wallets, there is no backup source of demand.
Third, investors assume there are no cliff-edge effects, such as highly indebted companies just clinging to life that could be tipped over. “For a few weeks, it’s not a big deal, but if it lasts a few months, then sustainability of debt becomes an issue,” says Vincent Mortier, deputy chief investment officer at Paris-based fund manager Amundi. A series of vulnerable companies collapsing would probably push up corporate bond yields and make it more difficult for junk-rated companies to borrow, in turn hurting the economy.
Analysis is difficult partly because of the shortage of precedent. SARS in 2003 was mainly a China threat, reflected in a big hit to Hong Kong stocks but not much impact on assets in the rest of the world. Hong Kong stocks bottomed out when new SARS cases started to fall, anticipating the end of the problem, which makes sense. But it is a poor example for the rest of the world, where the picture was clouded by the U.S. invasion of Iraq just as the virus began to spread globally.
The effects of previous pandemics—and note that so far this is very far from a pandemic—on stock prices are similarly obscured by other events. In 1918, for example, the Dow Jones Industrial Average rose as the Spanish flu intensified, just as World War I was nearing its end. When the index finally fell, losing 11% during the winter, it only took the Dow back to where it stood in June, three months after the infection was first identified. Trying to separate how prices were affected by the flu from how they were affected by the end of the first world war is a matter of guesswork.
Two other flu pandemics, in 1957-58 and 1968-70, killed 1 million or more people world-wide and coincided with U.S. recessions, but didn’t obviously cause them.
The Congressional Budget Office attempted to model the economic effects of a flu pandemic in 2009. It estimated that additional U.S. deaths of around 100,000, comparable to the 1957 and 1968 outbreaks, would knock about 1% off the U.S. economy—but probably wouldn’t cause a recession. A 1918-style pandemic could create a full-blown recession on its own, but as the researchers said, there are huge uncertainties both about patterns of infection and about the economic effects. Medicine is far better today, but the world is better connected, speeding contagion.
We should hope that markets are right and that this infection can be contained to China. My concern is that investors are overly confident in their assumption that easy money will keep the U.S. economy and stocks up.
Write to James Mackintosh at James.Mackintosh@wsj.com
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