Grim warnings on Tuesday 25 February from public health officials about the spread of the coronavirus coincided with new cases appearing across Europe, sparking a sell-off in markets and stirring new worries about a global pandemic. The Chinese government is ramping up its policy response, with sharply increased fiscal stimulus, credit supply and rate reductions. The Japanese government has also started a large fiscal stimulus program which kicked off last December to counter economic stagnation. These policy actions will cushion the economic blow of the virus infection to China and Japan. However, policy paralysis has continued in the eurozone. Federal Reserve Vice Chair Richard Clarida said yesterday that the Fed was “closely monitoring” Covid-19 to see whether it warranted a more dovish stance. But he warned “it is still too soon to even speculate” about whether it would “lead to a material change in the outlook.” The coronavirus has now infected more than 80,000 people in at least 33 countries. Officials at the Centers for Disease Control and Prevention on Tuesday warned Americans to prepare for the disease to spread in the United States, and a day after its worst one-day slide in two years, the S&P 500 continued to tumble.
This purpose of this piece is not to down play the seriousness of the virus or pretend that we are infectious disease experts but it is important not to lose sight of fact that in an age of social media where information and noise can travel fast , panic levels appear to spike beyond reasonability. The escalating number of people infected is scary, especially since it has now expanded beyond the borders of China but when looking at the numbers affected by flu/influenza every year it does help put things in perspective. In China 60 million get the flu with 600,000-700,000 hospitalizations and around 30000-40000 deaths. This compared to 2663 deaths and confirmed infections reaching 77,658 as of the 25 Feb 2020. In the US it’s a similar picture when it comes to the influenza impact each year as seen in the below graphic:
Global equity prices have taken a hit this week as investors are panicking over the spread of the COVID-19 in the rest of the world. However, the chart below shows that the impact of world epidemics on stock prices has been inconclusive at best. Maybe this time is different but selling into a panic is never a good strategy. What is certain is that when this crisis has blown over (assuming it will), the world economy will be left with plenty of monetary and fiscal stimulus, much reduced interest rates and attractive valuations in places like China, Europe and Emerging markets.
Whilst the virus provides the context and the narrative, the backdrop of markets is that we are coming out of a strong period in Q4 and generally a robust 2019 where equities have seen strong gains last year. This momentum carried over into January until it hit a roadblock due to the virus. Chinese markets have broadly consolidated last year because of the Sino-US trade conflict and started to break higher in Q4 as relations with the US started to improve.Therefore, the relevant economic backdrop for China and its financial markets is positive and we would interpret some of the declines simply as profit-taking after fairly substantial gains last year where investors are looking for excuses to lighten up on their exposure. Valuation levels in Hong Kong or the mainland were certainly not stretched when markets entered the current corrective period. Dividend yields in Hong Kong are near 4% and approaching 3% for Shanghai-listed names. Price/earnings multiples are in the single-digits for both markets. We believe that both, the profit-taking as well as the virus outbreak, will be short-lived and transitory in nature. In the past, markets tended to turn approximately half-way into the infections cycle when growth rates stabilised and declined.
Portfolio discussion
The IZA Wealth Global Balanced portfolio has recently been adding diversifiers such as ILB’s (Inflation linked Bonds) and Gold which has delivered upside during the sell off . Gold’s attraction is easy to understand given low rates and its safe haven status while the ILB portfolio has over 12 years of duration which means as real rates move lower as they have been doing (US 10 YR below 1.35%) the fund delivers positive performance similar to a traditional bond portfolio . The added benefit being that if inflation does rear its head eventually because of all this monetary stimulus the ILB portfolio will be well insulated. Listed REITs which make up over 5% of the portfolio have also offered some relief as they have rallied given the sharp move lower in rates .The fund has obviously not been completely immune to the sell off given its equity exposure, however relative to other flexible peers we have maintained a slightly lower allocation (below 60%) which has benefited the portfolio in February and means the fund is still slightly positive as we write this note. Cash available provides dry powder to deploy at good entry points as things settle, with China looking attractive having been first to suffer and now starting to stabilise.
At this early stage, the outlook is unclear and it remains difficult to determine how long it will take before the epidemic can be brought under control. From an economic perspective, interactions with managers indicate that they are seeing broad declines in demand and orders as well as production facility and store closures, with further disruption to logistics and supply chains. However, from an investment perspective, the value of a stock is essentially determined by the long-term cash flows it generates.
In addition, unlike the apparent decline in actual demand during a recession, extraneous economic shocks such as this may cause a global economic slowdown but are likely to have only a short-term negative impact in the form of a delay to the underlying recovery in demand. A rapid recovery in demand can therefore be reasonably expected as the spread of the virus settles down and is implications become clearer. The stock market will therefore eventually enter into a recovery phase after pricing in the downward revisions to earnings, although close monitoring is required concerning the spread of the virus and the impact of containment efforts.
Closer to Home
The potential impact of a widespread outbreak of the virus in Africa could be devastating for the region, especially if healthcare services shut down like they did with the Ebola virus. However, up until now Africa has largely been spared, with only one case reported in Algeria in recent days. The World Health Organisation has already placed a lot of emphasis on the region and has identified 13 countries most susceptible thanks to their trade with China. It is worth noting though that compared to other parts of the world, the potential for the virus to spread through travel is much lower thanks a much lower level of traffic between Africa and the rest of the world. See the heat map of air traffic around the world on the busiest day of air traffic in recent years.
South Africa of course is the most developed market in the region but is yet to restrict any travel to or from China. Thanks to a highly developed healthcare system, the country should handle an outbreak better than poorer African countries. Even though SA remains insulated at this point, we expect that local assets will take direction from the developed world, as is the case in most crises. The recent sell-off off on the JSE has little to do with the weakness of the SA economy or the consequences of the Budget Speech delivered this week, instead the bourse is moving in lockstep with major indices such as the MSCI World Index.
