Coronavirus: Low probability – High Impact Event

The economic effects of coronavirus have been adding deflationary pressures to the Chinese economy. The outbreak of the virus came at the time of mediocre economic growth in China, while the US and European equities were trading, at all-time record highs.

Despite equities bull run in major bourses, we believe that the impact of the virus has been underestimated outside China. Advanced economies (ex: Germany), that rely on Chinese processing and/or manufacturing, face significant risks associated with supply-side disruptions, on intermediate or final goods. The reason is that manufacturers in China have been forced to stay out of work, as a precautionary measure to prevent the outspread of the virus.

Therefore, with closed factories and millions of people in quarantine, we expect earnings of high capitalization companies to deteriorate in the first quarter of 2020. Interestingly though, despite facing higher risks for a market correction, we cannot claim with confidence that a significant deterioration in corporate earnings growth will lead equities to sell-off.

Earnings growth has been weakening consistently in 2019, while stocks have been rallying, with the S&P 500 generating a 29% return that year. That simply means the correlation between stock prices and earnings growth has turned minor, during that period.

An explanation for this contradictory move can be found in the massive amount of liquidity provided by central banks. Strong liquidity inflows have compressed volatility levels, improved sentiment and inflated asset prices in a self-reinforcing cycle. In this environment, most companies, are likely to purchase back their own stocks; a move that artificially supports earnings per share (P/E ratio) and raises stock prices.

In our view, there is a low probability that Coronavirus will spread worldwide. However, in case it does, markets will perceive it, as a high impact event and are likely to sell-off across the board. This will create an economic shock, if the virus’s outbreak is severe and lasts for a long period of time. In this environment, major central banks (ex: FED, BOE) are likely to cut interest rates, to offset additional negative shocks and support economic activity, by providing liquidity.

Overall, we expect further easing in financial conditions coupled with fiscal expansion policies, especially in Asia and in Europe. Therefore, we overweight equities to bonds. We find emerging market equities attractive, as well as European manufacturing and US infrastructure. In addition, worries over the outspread of the virus are likely to boost the US dollar versus emerging market currencies in a – Flight to Quality – move. In our view though, the dollar is likely to depreciate relative to EUR, ceteris paribus, in 2020.

From our hedges, we like silver more relative to gold, and CHF relative to YEN. Also, oil prices are likely to be under pressure, which creates an opportunity to gain exposure to this commodity. From a portfolio point of view, we suggest implementing more defensive strategies and be more selective in our asset classes, while riding this liquidity wave. As the phrase goes, “bear in mind, the higher they rise, the harder they fall”.