*By Christophe Barraud, Chief Economist & Strategist at Market Securities
*See my tweetstorm.

 Executive Summary:

  • The economic impact on Chinese activity has been significant since mid-January. Downward pressures quickly spread worldwide (through tourism and auto supply chain) while the lagging (second-round) effect of disruptions in other sectors should be felt from March, especially for foreign companies dependent on Chinese SMEs.
  • Elsewhere, the situation has deteriorated quickly in other areas such as South Korea, Japan, Italy and Middle East, raising concerns that traders and investors have been too complacent. Focusing on earnings and global GDP forecasts for 2020, expectations of both analysts and economists remain highly optimistic.
  • On the positive side, politicians look ready to intervene in order to partly offset the negative impact on the economy in 2020. Yet, they need to focus first on healthcare situation. Then, they will likely try to stimulate domestic consumption (when disruptions normalize) and support SMEs through fiscal stimulus. In the meantime, central banks should be under pressure to ease their monetary policy soon.

Nearly two decades have passed since a lethal virus known as SARS emerged in China before spreading to other countries. The virus infected about 8,000 people, claimed almost 800 lives worldwide and cost the global economy about $40 billion. The virus (CoV-19) now rampaging across China (and more recently worldwide) will be much more damaging.

Focusing on China, the country became an indispensable part of global production since the 2002/2003 SARS outbreak, not only churning out low-cost goods like T-shirts but also high value products including iPhone. Beijing is now driving demand for commodities like oil, steel and copper while it also boasts hundreds of millions of wealthy consumers who spend huge amount on cars, tourism, luxury products, etc. According to latest IMF calculation (PPP weight), China’s economy accounted for 8.270% of world GDP in 2002. It now makes 19.709% of global output and contributed to ~40% of global economic expansion in 2019.

1- The economic impact on domestic activity has been significant since mid-January. According to a New York Times analysis of government announcements in provinces and major cities, residential lockdowns of varying strictness covered at least 760 million people in China by mid-February (more than half the country’s population, ~10% of world population). Therefore, passenger travel decreased by more than 50% YoY during the 40-day travel season that ends on February 18. In this context, household consumption was under heavy pressure with restaurant chains such as Yum China (KFC, Pizza Hut and Taco Bell) reporting significant sales decline in early February (same-store sales at restaurants that remain open fell 40%/50% YoY). Meanwhile, new apartment sales dropped 90% YoY in the first week of February, according to preliminary data compiled by China Merchants Securities Co. Lastly, CPCA reported that automobile passenger car sales were down 20% YoY in January and 92% in the first two weeks of February. Chinese investment (both private and public) have also been hit dramatically with production in key raw materials (copper, gasoline, etc.) falling like a knife. As an example, according to industry consultant SCI99, operating rates at independent refineries in China’s Shandong province collapsed to 41.8% in the third week of February (down from 67.4% in late December). Outside raw materials, damages have also been significant especially in the auto sector. As a reminder, Hubei province where the outbreak began is a major car manufacturing hub responsible for nearly 9% of China’s automobile

2- The economic impact of the coronavirus has quickly spread worldwide (through tourism and auto supply chain), making significant damages in Asia. According to the World Tourism Organization, since 2014, China has been the largest source country of international tourism expenditure (~18% according to latest data). As a result, the first victims have been areas heavily reliant on Chinese tourists such as Macau, Honk Kong, Singapore, Thailand, Vietnam, etc. These countries also suffer from a sharp decline in tourists coming from western countries as the fear linked to the coronavirus pushed people to reorganize their holidays elsewhere than in Asia. As an example, Hong Kong will probably face a prolonged recession to that extent that preliminary numbers for February suggest that visitor arrivals could plunge by more than 98% YoY. The drop in Chinese shoppers is also reverberating all over the world with France flagging a 30% to 40% YoY fall in tourists. As a result, Luxury brands will lose up to €40 billion in sales and €10 billion in profits to the coronavirus outbreak in 2020, with little chance to return to normal trading conditions before the beginning of 2021, according to a survey conducted by Italian luxury brand committee Altagamma in collaboration with consulting firm BCG and asset management firm Bernstein. Another key transmission channel is the auto industry. Major disruptions in Hubei and other Chinese provinces have resulted in plants’ closure or production slowdown in South Korea (Kya, Hyundai), Japan (Nissan), or Europe (Fiat)

3- The lagging (second-round) effect of disruptions in other sectors should be felt from March, especially for foreign companies dependent on Chinese SMEs. Several indicators confirmed that trade flows between China and other countries (South Korea, Russia, etc.) have slumped since late January. As a matter of fact, according to my calculation, South Korea average daily imports from China were down 34.6% YoY in the first 20 days of February. In the meantime, both freight stocks and indexes have crashed. It reflects delays in resuming production especially for Chinese SMEs and implies that foreign companies with low inventories could face disruptions soon. To that extent, Lars Jensen from SeaIntelligence in Copenhagen said the loss of traffic is running at 300,000 containers a week. This will cause a logistical crunch in Europe in early March even if the epidemic is brought under control quickly.

Elsewhere, the situation has deteriorated quickly in other areas such as South Korea, Japan, Italy and Middle East, raising concerns that traders and investors have been too complacent. In Italy, the outbreak in Lombardy and Veneto was a very bad news given that the two regions combined account for ~30% of Italian GDP. It also means that other Eurozone countries could be hit soon while it will add negative pressure on tourism (from outside Eurozone) in the coming months. In the meantime, I see the outbreak in South Korea as a real source of concern for the technology supply chain. The fact is that global market share of South Korean semiconductor manufacturers reached 23.6% in 2018. Despite this critical situation, expectations of both analysts and economists remain highly optimistic. As of writing, analysts covered by Factset are projecting S&P earnings growth of 7.7% for 2020 while the Bloomberg consensus of economists still expect global 2020 GDP to accelerate to +3.0% (up from +2.9% in 2019). It implies that the drag from coronavirus on global GDP is expected to be close to 0.1%. By using a bottom-up analysis and summing the expected impact in several sectors such as luxury (see above), tourism, etc., it’s easy to see that the drag on global GDP will be larger. In addition, risks appear clearly skewed to the downside given that it’s very difficult to estimate what could be the potential cost of the third-round effect namely defaults. It could be limited in China as officials will increase the tolerance for non-performing loans (NPL) for local branches of financial institutions and encourage them to write off some bad loans to lower the NPL ratio. However, it’s not guaranteed to be the same elsewhere.

All in all, even if the number of deaths (compared to world population) would probably be limited, the economic damage linked to the coronavirus should be elevated in 1H 2020, reflecting residential lockdowns, fear effect and disruptions. On the positive side, my feeling is that politicians are completely aware of the situation and are ready to intervene in order to partly offset the negative impact on the economy in 2020. Yet, they need to focus first on healthcare situation. Then, they will likely try to stimulate domestic consumption (when disruptions normalize) and support SMEs through fiscal stimulus. First measures coming from China, Macau and Hong Kong could be a framework for other countries. In the meantime, central banks should be under pressure to ease their monetary policy soon. It can explain why investors are still accumulating government bonds despite very low rates. As a matter of fact, TrackInsight data show that cumulative inflows into “Government Bonds” ETFs reached a YTD high on Feb. 24.