e believe that the Coronavirus is having a devastating impact on economic growth in China and its trading partners. The effective quarantine of major regions of China and severe international travel restrictions will depress earnings growth far more than what is currently built into analyst expectations, in our opinion. As shown in the chart below, analysts have only slightly reduced their earnings expectations for 2020.
The drop in earnings estimates is well below the typical earnings revisions despite disappointing news on Boeing 737-Max production (more software problems) and much lower than expected capital investment data coming out of the US oil patch. Incorporating the impact of the Coronavirus pandemic is likely to require earnings estimates to fall much further.
Hundreds of millions of Chinese workers travel to their parents’ villages each year during Chinese New Year. According to the Wall Street Journal’s February 18th “Daily Shot”, travel restrictions have meant that less than 40% of these workers have been able to return home.
Worker shortages have prevented factories all across China from restarting after the traditional New Year’s holiday break. Apple is likely to be only the first of many companies to announce a significant hit to earnings due to these supply chain disruptions.
Plummeting earnings estimates may not disrupt equity markets too much in the short run. Equity prices are currently being supported by aggressive central bank money printing, and investors probably expect a quick bounce back in economic growth and earnings once the pandemic has passed. However, we believe that China’s growth prospects will not be so easily restored.
President Trump’s trade war alerted companies operating out of China that sole sourcing from such a politically contentious country is extremely risky. Companies suddenly recognized that heavy reliance on Chinese production puts them at risk of being effectively shut out of the US market with the stroke of a Presidential pen.
The Coronavirus outbreak and associated production interruptions provide these companies with an even greater incentive to diversify out of China dependent supply chains.
The resulting drop in Chinese private investment and employment could weigh on China’s growth prospects for many years to come. Europe and Japan, with their dependence on Chinese demand, could suffer along with China.
The logical beneficiary of China’s loss should be India, since it has the population and educational base to assume some of China’s capacity in global supply chains. Unfortunately, India’s President Modi appears to be increasingly focused on a policy combination of Hindu nationalism and trade protectionism.
These policies raise the risk of political instability and trade protectionist retaliation. Global companies are unlikely to risk jumping out of the frying pan and into the fire.
The new trade agreement between the US, Canada and Mexico positions Mexico to benefit from the need to diversify out of China. The sharp rally in the Mexican peso in recent weeks suggests that foreign investors are positioning to increase investments in the Mexican economy.
Mexico is likely to be hampered by its ongoing problems with crime and the drug cartels, and by the decided leftward swing in economic policies taken by Mexican President Lopez Obrador. These concerns could prevent Mexico from benefitting from the move out of China to the extent that its low labor costs and proximity to the US might indicate.
Instead, the primary beneficiaries of shifting global supply chains are likely to continue to be Indonesia, Vietnam and the rest of Southeast Asia.
Australia is likely to lose in the short term as demand for its commodity and educational exports drop in the face of weaker Chinese demand. However, if Southeast Asian countries aspire to provide a viable supply chain alternative to China, they will have to emulate China’s outstanding infrastructure and educated elites.
That could eventually mean more demand for Australian commodities and college degrees. Australia might find a new source of demand just as their traditional markets in China are losing steam.
Global equity investors have thus far largely shrugged off the potential consequences of the Coronavirus epidemic. The Fed is priming financial markets with $100 billion in additional liquidity each month and most other major central are similarly accommodative.
This wave of liquidity creates a tailwind for equity prices that no amount of bad news has thus far been able to overcome. Provided the Fed continues printing money and buying government bonds for the balance of 2020, as we expect, then we believe that global markets can continue to rise despite the blow to earnings that we expect from Coronavirus.
Longer term, the Coronavirus epidemic will likely be one more motivation to topple China from its perch atop global supply chains. Chinese growth will face long term headwinds despite a short term bounce back that we will probably see once the epidemic has been contained.
Southeast Asian economies will likely gain the growth that China loses. Although these equity markets have proven resilient thus far, their currencies have fallen sharply. Cheaper currencies make Southeast Asian equity markets a relative bargain for international investors when compared to global equity alternatives.
Australia could be an eventual beneficiary of the infrastructure and educational needs of Southeast Asian economies, and we believe that Australian equities also present a good investment option in light of recent currency weakness.
