Unknown unknowns put recovery at risk

Sebastian Mullins

Sebastian Mullins

Portfolio Manager, Multi-Asset

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The strength in equity markets from 2019 flowed through into the start of 2020. Risk assets continued to rally on the removal of geopolitical risks (the US–China trade deal and the decisive outcome of the UK election), increased central bank liquidity (the US Federal Reserve’s standing repo facility and the European Central Bank’s resumption of quantitative easing), and signs of green shoots in the global economy (bottoming purchasing manager indices (PMIs) and earnings). However, once the market had successfully priced in the new geopolitical “known unknowns”, January reminded us that the true risks come from “unknown unknowns.”

The first of these unknowns erupted at the start of the month with a sudden escalation in tensions between the US and Iran, following the assassination of Soleimani. Despite intraday moves in equities and oil, the fear of World War 3 quickly subsided and the market marched higher. This was then replaced with a new unknown, originating from the province of Hubei, China. Home to the world’s largest dam, the province now boasts the world’s largest quarantine centre, with over 50 million people in lockdown to help stop the spread of 2019-nCoV Coronavirus. At the time of writing, this disease has already infected over 60,000 people in China and led to over 1300 fatalities¹.

Economic contagion raises recession fears

While the impact on the Chinese and global economy will likely be transitory, the current unknown is how substantial the slowdown will be and how long it will take to work through. China has spent enormous effort to pivot its economy towards consumption, which will be precisely where this slowdown will hurt. On the industrial side, factories remain shuttered and we still don’t know when they will restart.

The world is not immune from this slowdown either. Cyclical materials have plummeted – copper, iron ore and oil have all fallen between 10-20%, while shipping rates have fallen even more. Companies like Starbucks and Nike have been closing their stores and factories, which will have a negative impact on their quarterly earnings. Chinese tourism is collapsing internally and overseas. The risk is that the downturn could be enough to knock over the nascent recovery, potentially reviving fears of a global recession.

Australia may be particularly vulnerable. China accounts for 33% of Australia’s total exports and buys 82% of our iron ore. China accounts for 25% of all foreign students in Australia and the largest number of tourist arrivals at 15%. Tourism is already under pressure, as bushfires caused many visitors to cancel their trips during peak season, when tourist-oriented businesses typically earn the lion’s share of their yearly income and employ a large portion of temporary workers. The longer travel restrictions remain in place, either officially or psychologically, the further downside risk to the economy.

Record breaking stimulus may be just the start

The counter-balance will be that this crisis will ultimately force China to stimulate more aggressively than originally expected. Monetary and fiscal support has been muted as the country has been preoccupied with deleveraging. However, the outbreak will likely provide the trigger needed to support short term growth over longer term stability. Since the outbreak, the People’s Bank of China announced the largest single day cash injection since 2004 of over USD$170bn.

Perhaps even more important is their relaxing of the war on shadow banking, which will provide a lifeline to private companies who do not have access to traditional bank financing. On top of the immediate fiscal spend required to help curb the spread of the virus – such as building two hospitals in 10 days – it is likely that the government will be forced to do far more in the coming months to help stimulate the economy.

Our portfolio position

We added equities at the start of January, given the improving fundamentals and removal of geopolitical risk, but also added 0.25 years of duration as protection as the news of coronavirus unfolded. At the time of writing, developed equity markets are already back within a hair’s breadth of their all-time highs and credit spreads have resumed their tightening. We will use this as an opportunity to reduce risk while we wait and see how the shutdown of the world’s second largest economy affects global growth. Although we believe the impact will likely be transitory, we are looking for a better entry point to re-risk, which will likely occur when the first impact of the virus shows up in the economic data. Ultimately the stimulus from China should be supportive, but we prefer to stay defensive for now.

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¹ Worldometer, COVID-19 Coronavirus Outbreak as at 14 February 2020

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