Expansions do not die of old age – they get murdered.
paraphrase of a 2019 exchange between former Fed Chairs Janet Yellen and Ben Bernanke
The outbreak of a new coronavirus in China poses risks to the rosy economic and market outlook that dominated at the beginning of the year. While public health risks appear manageable, the impact of the
disruption to China’s economy and global trade remains uncertain. Market have begun to price in a recessionary risk that had largely disappeared in last year’s rally. Although China’s financial markets will not reopen until Monday, US-based ETFs continue to trade. ASHR, an ETF which tracks China’s local A Share Market declined 14% from its January 17 peak while the iShares MSCI China ETF, which is dominated by the large Chinese technology companies, declined 11.2% over the same period. China comprises over 30% of the MSCI Emerging Markets Index. All of our emerging market managers have some exposure to China, but are all underweight relative to the index.
We can expect a coordinated policy response from Chinese financial authorities to support liquidity both in corporate and financial markets. However, this outbreak comes at a particularly challenging time. While the markets believed Chinese manufacturing bottomed in the fourth quarter, the economy still faced challenges from the trade war and global companies diversifying their supply chains to other Asian economies. The economy faces one of the highest debt burdens of any major economy – over 300% of GDP – and an aging demographic. Last year, African swine fever wiped out approximately a quarter of the country’s pig population, resulting in higher food prices. Discontent over General Secretary Xi Jinping’s autocratic policies led to widespread riots in Hong Kong and the expansion of anti-mainland DPP’s majority in Taiwan’s January 11th election.
SARS, a similar coronavirus that emerged from China in 2003, infected over 8,000 and caused 774 deaths. The outbreak resulted in a 200 basis point reduction in Chinese GDP growth. However both the virus and China are different in 2020. The coronavirus is both less lethal and more contagious than SARS. Whereas SARS had a lethality rate of nearly 10%, the Wuhan coronavirus has killed 2-3% of those infected. Similar to the flu, fatalities fell predominately on the elderly. The virulence of this virus creates the greatest risks. In the 2003 SARS outbreak, Chinese travel was a fraction of today’s level. China’s integration in global supply chains makes large manufacturing centers like the epicenter Wuhan critical to global trade.
Most past recessions have had an identifiable, if debatable, catalyst. In 2001, the 9/11 attack preceded the short recession of that year. Several economists point to the spike in oil prices in mid-2008 as the needle that pricked the housing bubble. Will this outbreak be the trigger that creates a messy unwind of China’s massive credit expansion? No US recession to date can be traced to a downturn in a foreign economy. Past foreign downturns, from the 1997 Asian Financial Crisis through the 2016 manufacturing recession in Europe and Emerging Markets, caused little impact on Main Street. All of our past recessions have been made in the USA. While this suggests that this outbreak presents little risk of igniting a US recession, the world keeps changing and past performance is no guarantee of future results.
As the market continued to rise last year, we reviewed portfolios to ensure adequate reserves of safe liquid assets to meet several years of distribution needs. We view the focus on quality from our equity managers as a second line of defense. While a slowdown in China and disruption of global supply chains will be felt, we remain focused on owning businesses with the resilience to weather economic downturns.