Last week, in our Market Summary, we commented:
“A correction could come in one of two forms — either a boring, sideways grind lasting several months, or a sharp decline of 4–8%, coincident with some appropriate externality, followed by a renewed uptrend. The recent outbreak of a SARS-like coronavirus in China reminded us of the correction that accompanied the last big Ebola scare back in 2014. That, or a piece of bad news from the Middle East, would be a very serviceable excuse that markets could use for a decline.”
Following that script closely, markets responded with nervousness to the accelerating emergence of 2019-nCoV. As of this writing, the S&P 500 is a little more than 1.5% off its January 24 high. That implies that market participants are not yet alarmed about the risks posed by the novel virus.
On balance, as we look back at similar events in the past several decades, they’re right to be sanguine. Global stocks were higher both three months and six months after big viral outbreaks in most cases. This was true for the 2003 SARS outbreak in Asia, the 2009 swine flu (H1N1) outbreak, the 2013 MERS outbreak in the Middle East, the 2014 Ebola outbreak, and the 2016 Zika scare. The 2018 Ebola outbreak saw global stocks down over 10% three months out; they had almost recovered by six months from the outbreak’s start. (Of course, in each case, there were many other things going on besides the outbreaks. It matters a lot whether an external event like a viral outbreak is occurring early in a bull market, or late; late-stage markets are often more fragile in their response to such events.)
Certain sectors and industries — particularly travel, including cruise lines and airlines — show the most downside volatility. A few biotechs outperform, usually those with promising treatments for the epidemic. That’s happening this time as well, as crazy Mr Market considers pricing in the end of international travel.
We’re treating the risk with some lightness, but there could always be a “black swan” — an unexpected and devastating development, what the world of wonky analysts calls a “fat tail risk.” We can be sanguine but we can never rule out such an event. What often happens is that the news worsens and fears of such an event rise — particularly if there are unusual developments that suggest something unusual is going on.
What Could Make Markets Freak Out?
There is fodder for plenty of that in the present outbreak.
For one thing, the response of Chinese authorities has been inconsistent (some would say incompetent). They early on insisted that they had identified the source of the outbreak as the Huanan Seafood Market in the city of Wuhan — a significant logistics hub in south-central China that, with 11 million inhabitants, is the size of London. (Coronaviruses originate in animals, and thus “new” viruses that are able to make the jump into humans often do so when humans eat exotic animals. One theory is that the new virus originated in bats sold at the Huanan Market for food.)
However, later analysis of the outbreak’s first several dozen casualties has shown that the real source of the outbreak was not in that market, and remains unidentified. Millions of Wuhan residents fled the city ahead of a quarantine. Well-heeled travelers seem able to evade travel bans throughout China and those covering international travel. Such developments do not help the international climate of opinion to remain calm.
Further, the authorities initially assumed that the disease was not contagious while patients were still in the incubation stage; this assumption is now known to be incorrect, and asymptomatic patients have been responsible for transmission. That means, in turn, that containment strategies based on the experience with SARS are likely to have been ineffective. Epidemiologists are now working with assumptions of more rapid transmission, and some of the models are alarming.
Finally, there are voices beyond the usual lunatic fringe suggesting that the outbreak had its origins in a botched experiment in a biowarfare or genetic engineering lab. Scientists from the Wuhan Institute of Virology participated in 2015 research at the University of North Carolina in which a SARS-like virus was genetically modified with coronavirus elements to be able to infect mammalian respiratory systems more easily. That type of research, while it is focused on laudable goals (assessing the risk of new viruses emerging; planning potential responses to an outbreak), has since become controversial and probably would not be undertaken today.
According to a former non-U.S. intelligence officer quoted in the Washington Times who has studied Chinese biological warfare, the Institute, which is the only site China has declared to be capable of working with the most deadly viruses, is linked to Beijing’s covert bio-weapons program. He stated: “Certain laboratories in the Institute have probably been engaged, in terms of research and development, in Chinese [biological weapons], at least collaterally, [although] not as a principal facility.”
Whether or not there is any truth to these rumors, they are also not conducive to calm global markets as the outbreak spreads.
The Real Effects
In short, history suggests that things will be fine — but there are plenty of catalysts to cause more fear for investors and more volatility in markets. The decline so far has been a very modest one — really, more of a squiggle than a decline. There may well be more to come.
Beyond stock markets, and in the objective reality of the economic realm, the episode may have a sharp impact on first-quarter Chinese GDP growth. China’s economic strength is largely based on its robust supply chains, and the quarantine of manufacturing and transportation hubs will hurt.
Some estimates put the hit to Chinese GDP growth as high as 1–1.2% for the year. Going from a more sober estimate for actual Chinese GDP growth than that presented by official statistics, that would put Chinese growth in the neighborhood of 3%. It could shave perhaps half a percent off global GDP growth, and perhaps 0.2% off U.S. GDP growth in the first two quarters.
Such effects, if they emerged, would have an impact on global stock markets. So here, markets have a rational reason for concern.
Investment implications: History suggests that the effects of the current novel virus outbreak in China will be tragic for those affected, but transient for global stock markets and the global economy. Of course, there is always the risk that this time will be different, and as long as there are hints of unexpected risks and further uncertainty about unfolding events, the chance of further market volatility will remain high. Further disruption could result in material damage to Chinese and global GDP growth, and less so, to the U.S. as well. Our baseline scenario remains one in which the virus is contained, and the market recoups any losses. To us, a more serious decline would represent an opportunity to buy our favored themes in the United States and the U.K.
