Timing the Coronavirus

How should investors factor the latest China crisis into their strategies?

Sébastien Galy, Sr. Macro Strategist at Nordea Asset Management

We positioned cautiously ahead of the crisis and foresee bouts of volatility in equity markets in the very near future. We continue to recommend portfolio diversification including Covered Bonds, Listed Infrastructure and Listed Real Estate.

1.There are several ways of exploring the growth and financial consequences of the corona virus 1. Event studies, e.g. looking at SARS 2. Looking at financial contagion from China to Emerging Markets and the West in light of levels of volatility and tail correlation. 3. Assessing how much of the hit on global growth is priced in. 4. Assessing the policy response in China and abroad, how much is expected and priced early or late, such as in the great financial crisis. 5. Estimating the point of maximum pain by calculating when specialists will have certainty that the crisis is contained. This point has now been reached. 6. Estimating the impact of the noise. There are a few doctors and health economists specializing in viral spread, but many commentators. Indeed, a live map of the crisis can be found on the following link: https://gisanddata.maps.arcgis.com/apps/opsdashboard/index.html#/bda7594740fd40299423467b48e9ecf6 

2.Event studies look pretty but help little. Event studies are an interesting way to look at the data provided you have over 22 time series, the rest is blowing in the wind — particularly so because we are talking of extreme exponential events, not normal ones. We simply don’t have enough time series, though it can be a tad informative if misleading. Those with more solid methodology will look into ancient history to get a better understanding. While this is a sound approach, the structures of the economies have changed so fundamentally that it makes analysis difficult. The Black Death, for example, killed 75 to 200 million people as the disease was misunderstood and authorities were slow to close their towns.  

3.The question is whether the V shape recovery in equities and implied V shape in growth are warranted. Such paths are a function of systematic strategies, a buy on dip mentality borne out of years of equity market performance and studies of natural disasters. A natural disaster generally is a rapid and brutal affair whereas a pseudo-pandemic is closer to the policy of shutting down stores in African cities in protest. The impact is large but also persistent through time, workers become more uncertain of their earnings, consumption is depressed. Then comes China. The PBoC can direct liquidity to Wuhan at subsidized rates avoiding some of the sharp contraction from rising credit risk. The government’s infrastructure program is likely delayed and more fiscal easing is likely on the way, so why should we worry with such efficient authorities? What the government can’t stop is the shock from rising uncertainty known as precautionary savings. It is an overwhelming crisis which has depleted savings of the young courtesy of some lack of a social net and it is a psychological shock that leaves consumers more cautious for years to come. Hence, we expect that consumption after an initial forced splurge (as evidence by a spike in the reliable inflation), fades as inventories were depleted and then recovers with them but not at the same trend growth as before. That should take another two months to pan out.

4.Noise has an impact. Facts play into narratives that are motivated sometimes by balance sheet considerations. The consequence is either Cassandras or Buy on Dips comments. Cassandras have had a hard time as it is exceedingly difficult to call the top of a liquidity fueled carry trade – see the losses made shorting Tesla. As economic data rolls in, along with earnings, we suspect they will eventually have their day though not for long. We suspect that the persistence of the economic shock means that we have another two to four weeks of volatility in equities.

Implications
We continue to recommend caution and a diversified portfolio including Covered Bonds, Listed Real Estate and Listed Infrastructure.

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