Mike explains the key uncertainties surrounding the coronavirus outbreak that has sent risk assets tumbling.
The coronavirus outbreak that started in China has sent jitters across global financial markets amid fears of a hit to the global economy. We think it is too early to assess the eventual impact on the economy, yet see potential downside risks posed by the outbreak – with its unknown magnitude and duration. This underpins our view that U.S. Treasuries provide a source of portfolio resilience.
The outbreak has sparked a classic risk-off response, albeit one of relatively modest magnitude to date. Emerging market equities, airlines and oil prices have declined since January 20, when the Chinese government confirmed the virus can spread from person to person. Perceived safe haven assets such as U.S. Treasuries, as well as their inflation-protected peers, have gained. See the chart above. The VIX index, a gauge of U.S. stock market volatility, shot up to the highest level since October. Yet, the risk-off sentiment has so far been relatively limited, with modest pullbacks in high yield credit and U.S. stocks, even after Friday’s sell-off. The impact from worries about the outbreak may have been partially offset by positive results in the current quarterly earnings season that so far are in line with our expectation for global growth to edge higher this year.
What can we learn from past global disease outbreaks? Economic growth and markets have historically responded with a V-shaped pattern. The temporary hit to economic activity results in pent-up demand, which eventually helps fuel the rebound in economic activity. This recovery is typically led by retail and manufacturing sectors, since lost revenues are harder to recoup in the services sector (think of tourism).
It is too soon to gauge the impact of the current outbreak, given the many unknowns related to the coronavirus. These include the duration and severity of the outbreak in China – and whether it remains largely contained geographically. The reduced flow of people and goods due to travel restrictions and quarantine measures are likely to hit demand in the short term, pressuring economic activity in the most affected areas. The extent of the policy response by Chinese authorities to any growth slowdown is another key uncertainty. We are likely to see a meaningful policy response from Chinese authorities to shore up growth, as we have after prior epidemics, though an ongoing desire to rein in financial excesses leaves open the question of how sizable China’s stimulus will be. Another potential difference from past episodes is China’s increased role in the global economy: the country makes up 15% of global GDP today in purchasing parity terms. This is three times its size in 2003, when the world was hit by the SARS virus.
We also see potential supply side disruptions. China is now a key component of global supply chains. Any sustained outbreak could disrupt the supply chains of certain industries, with potential for bottlenecks. This risk echoes one of the messages of our 2020 Global Investment Outlook – that investors should be on the lookout for potential shifts in the economic regime, such as a world in which growth slows as inflation creeps higher.
We still see global growth edging higher this year, given easier financial conditions, a lull in global trade tensions, and generally positive economic data. An encouraging start to the latest quarterly earnings season also underpins our moderate pro-risk stance. Yet, the coronavirus outbreak creates downside risks to the growth outlook and underscores our preference for U.S. Treasuries as a source of portfolio ballast against any growth scares.
This post originally appeared on the BlackRock Blog.
Editor’s Note: The summary bullets for this article were chosen by Seeking Alpha editors.