Unanswered Coronavirus Questions, Now Is Not The Time For Heroics

So the markets rallied in the last 15 minutes, and on Monday, they were due for at least a technical bounce. Hopes of monetary expansion and other economic measures seem to have been another driver.

Investors want to know whether we can all sigh with relief and assume most of the market damage is behind us, and this turns out to be similar to market reactions in previous endemics, where markets recovered after an initial scare.

While we don't claim to know this anymore than anyone else, we think there are enough uncomfortable truths and unanswered questions for investors not to get too comfortable.

South Korea

One of the situations we're least comfortable with is the evolving spread in South Korea. Much of the spread there seems to have been brought by a few persons from a religious sect.

It's true that their practices are especially conducive to contagion (forced attendance to mass services, even if you're ill, no face masks allowed, packed as sardines, secrecy, etc.) which aren't that common, but it still services as a reminder how fast the virus can spread given a chance.

And there are other examples of super spreaders for instance:

The takeaway from these cases is that when the number of infected people approach 100k (and these are the cases we know about, as they have been tested or screened), it can take only a few cases to produce new outbreaks.

China

We read reassuring assessments that the situation in China is getting under control. We're not entirely convinced, although it is certainly true that tens of thousands of the identified cases (45.5K at the moment of writing, which is more than half of known patients) have made full recoveries and that the number of new cases has been declining (with some daily variation).

But there are still some 100-500 new cases detected every day, numbers that would create panic in any other country. For comparison, look at the debate in the UK, where they have a total of just 51 cases (Tuesday morning), but are debating a whole host of China-like measures (one can follow live here and here).

Germany is a bit worse off with 188 confirmed cases and (The Guardian):

Several kindergartens and schools have shut, workplaces and even artists' studios have been closed, and increasing numbers of office staff have been told to work at home.

Italy (2,000+ confirmed cases) is of course the worst affected in Europe (The Guardian):

In a statement, Confindustria said gross domestic product would fall in the first quarter, with a "stronger contraction" between April and June due to the epidemic that has killed more than 50 people in Italy and heavily disrupted economic activity.

Given what we know about how even a single infected person or surface can infect many people, the Chinese numbers, while a big improvement, don't signal the all clear. Here is for instance the UK health secretary. From the BBC:

"Contain is about detecting the early cases, following up with close contacts, preventing the disease from taking hold in this country for as long as reasonably possible." This approach also buys time for the NHS to ramp up its preparations. "If the number of global cases continues to rise, especially in Europe, the scientific advice is that we may not be able to contain this virus indefinitely."

If in the UK they think containment might not hold with just 51 cases in total, the prospects for China with still 100+ new cases a day might not be much better.

What is good news is that data from China shows that contagion spreads mainly through family, that is close and perhaps prolonged contact are necessary conditions, the absence of which makes spreading much less likely (although not impossible).

While the PMI figures from China came in over the weekend were in uncharted territory (from Wolfstreet):

This is hardly a surprise for those who paid attention to events on the ground, but this will all soon blow over, supposedly.

Well, perhaps, but will it? Two-thirds of the Chinese workforce have yet to come back from their new year's holiday. When the majority has come back, we could say that things are turning back to normal, but when will that be?

More importantly, what will happen when they do? There is a considerable risk that normality could refuel the epidemic, given what we know about contagion. Here is BlackRock:

One key signpost to watch in the near term: How successful will China's effort to restart its economic activity be - and can it avoid another round of mass infection as workers return? This may provide insight on the potential duration of the outbreak - and its economic impact - elsewhere.

The Chinese authorities will also realize this risk, which puts them in an awkward dilemma, trying to salvage the economy and risking new outbreaks, or playing it safe and keep the economy in its near zombie state.

This is a bit of a Catch-22, and many more governments are facing similar trade-offs albeit in earlier versions. Take preventive measures now with all the economic damage these cause or risk a worse infection.

What's worse, this is far from a "perfect" trade-off. Even severe restrictions like lock-downs of entire cities are rather imperfect and more likely to just slow-down the spread.

People can get sick again?

Another disturbing news item is that at least some people seem to be able to get ill from the virus twice. From USA Today (our emphasis):

Li QinGyuan, director of pneumonia prevention and treatment at China Japan Friendship Hospital in Beijing, said a protective antibody is generated in those who are infected. "However, in certain individuals, the antibody cannot last that long," Li said. "For many patients who have been cured, there is a likelihood of relapse." Li urged patients who have recovered from COVID-19 to be vigilant in their hygiene, such as washing their hands often.

How common is this we don't know. Are people who are getting sick twice better able to withstand the disease, or worse? We don't know either. There is still a lot we don't know.

Does warm weather help containing the virus?

Optimists argue that the outbreak will subside when the weather gets warmer, just like the common flu and other coronavirus outbreaks. This might very well be true, but here too there are some uncomfortable truths.

What about Singapore? The last time we checked it was in the tropics and it has 108 cases. There are also several countries in the Middle East and others with mild weather like Thailand suffering from outbreaks, although we don't know whether all of these have just been imported by travelers or whether the virus is spreading inside these countries.

It seems too early for firm conclusions here.

Weakest link

Viruses know no borders, and on a world scale, the strength of our efforts to contain the outbreak is only as strong as the weakest link. There are numerous countries which are ill prepared for dealing with an outbreak, and one such a case is unfolding before our eyes - Iran. From the BBC:

At least 210 people in Iran have died as a result of the new coronavirus disease, sources in the country's health system have told BBC Persian. Most of the victims are from the capital, Tehran, and the city of Qom, where cases of Covid-19 first emerged. The figure is six times higher than the official death toll of 34 given by the health ministry earlier on Friday.

If correct, on the basis of a 2% mortality rate, this implies a 10K infection rate already. Perhaps they can cope with that; we don't know. But authoritarian regimes with crumbling economies lacking trust from large swaths of the population are far from ideal circumstances for containing such outbreaks.

There are potentially far worse countries, where there is hardly an acting state or functioning health system or where there is conflict and refugees.

You don't know what you don't measure

How many Irans are there? We don't know. What we do know is that there are a host of countries, including the US, which have for whatever reason done little or no testing. Up until last week, the US had performed less than 500 tests.

It now emerges that an outbreak was festering for perhaps a couple of weeks already. There could be more. We simply don't know. What we do know is that people who have a better understanding of the situation argued last week that community spreading was a matter of when and not if. That turned out to be the right call.

If we don't really know the extent of the problem in countries like the US, we have only a vague idea for a whole host of other countries where there is even less testing. This is hardly reassuring. In many countries we're only likely to see the tip of the iceberg.

Globalization

Globalization comes with great economic benefits (even though they are rarely evenly distributed) as they allow one of the driving economic forces, the division of labor, to expand on a global scale.

But with that comes dependency and multiple channels for disturbances in one part of the world to have negative ramifications in other parts. With respect to that, it's unfortunate that China is the center of the outbreak.

Not only is China the second largest economy in the world and (until recently) good for a third of world economic growth, but it's also the manufacturing hub of the world.

The longer the implosion in the Chinese economy lasts, the more the demand effects reverberate around the world for commodity producing countries, luxury goods, tourist destinations, capital goods, etc., and these cause secondary contractions elsewhere that spread.

Supply chains

China plays an important often even central role in many supply chains of many foreign firms, and supply chain disruptions tend to reverberate and magnify distortions downstream as regular patterns of ordering are disturbed.

To get an idea, from the FT (our emphasis):

Four of world's biggest carmakers will be forced to shut down European production, one of the sector's key suppliers has warned, after an electronics factory in Lombardy was forced to close by the Italian authorities amid the rapid spread of the coronavirus. Electronics manufacturer MTA said that if its 600 employees in the northern Italian town of Codogno were not allowed to return to work within days, production lines at Fiat Chrysler (FCA) subsidiaries would be brought to a standstill. "All the other FCA plants in Europe and those of Renault, BMW and Peugeot will close too," MTA said.

This is just one (recently!) closed plant and it's not even in China, the effect of which comes with a delay, according to Friedolin Strack, head of international markets at BDI (Financial Times):

"There have been no immediate breaks in the supply chain so far, but what we are receiving in harbours today was shipped four to five weeks ago, so the shortages will be coming in the next few weeks," Mr Strack said.

How big is the problem going to be? Well (Fortune):

Now, as coronavirus continues to spread, the region of China most heavily affected by the outbreak is a hub of global supply chains. A new Dun & Bradstreet study estimates that 163 of the Fortune 1000 have tier 1 suppliers-those they do direct business with-in the area. And 938 have tier 2 suppliers, which feed the first tier.

And (Financial Times):

Chris Connor, chief executive of the American Association of Port Authorities, predicted that his members could see cargo volumes fall by a fifth in the first three months of the year and warned that the economic impact of such a crisis "can easily run into the tens of billions of dollars".

Panjiva, the S&P-owned trade data company, reported that west coast ports are particularly exposed. The Port of Los Angeles, the busiest US port, saw cargo volumes fall by just over 5 per cent in January but expects a 25 per cent drop for February.

While longer term this could very well induce companies to reduce their dependency on Chinese sources, shifting supply chains itself isn't a cost-less process either.

We might also want to keep an eye on countries like Japan and South Korea, which suffer from growing coronavirus outbreaks as these could compound the supply chain problems, especially in sectors like electronics and automotive.

Consumer confidence

So far the US has been spared most of the epidemic itself (105 confirmed cases), but there is still economic damage imported from the rest of the world. However, there is a good chance things will get worse domestically as apparently the virus has been spreading undetected for weeks simply as the US has done little testing.

If it does spread further, which seems the assumption of the CDC people, this is likely to provoke measures like we're seeing in other countries (cancelling large gatherings, lock-downs, etc.), and with many consumers practicing "social distancing," this is likely to take a serious bite out of consumer confidence and spending, good for 70% of the economy. From MarketWatch:

That means discretionary activities - such as traveling, dining out or attending entertainment, sporting, religious and political events - would grind to a halt. Business travel and entertaining would dry up. Schools and day-care centers would close. Public transportation ridership would plunge.

This could affect 10%-15% of GDP with another 16% of non-food consumption that could also be easily affected if people don't go out shopping. The employment effects compound this given the labor intensive nature of retail.

So, in case of a more serious domestic outbreak, the resulting "social distancing" will quickly compound the damage imported from affected areas abroad and a recession becomes quite likely.

How prepared is the US?

In general, the US has a sophisticated healthcare system and the resources to deal with disease outbreaks, but there are some particularities that make the situation less than ideal. According to (Commondreams, our emphasis):

Lawrence Gostin, a professor of global health law at Georgetown University, told the Times that "the most important rule of public health is to gain the cooperation of the population."

There have been cutbacks and the amount of testing that has been done in the US (less than 500) is surprisingly little, which is why the official number is likely to understate the true nature of the outbreak and why recently detected cases have been spreading undetected for weeks.

It's also not reassuring that the CDC has stopped publishing testing data altogether since a few days (they say because it's done mostly at state level).

What's worrying is that many people who might experience symptoms face significant financial penalties for either self-quarantining and/or getting tested because of lack of insurance (or the likelihood of a host of surprisingly high bills even when insured) and a lack of paid sick leave and/or holidays.

What to think of the host of workers on zero-hours contracts for instance in the so called gig economy? If they feel under the weather and don't show up for work (which is highly recommended), they don't earn anything.

Policy reaction

The Fed reduced interest rates by 50bp to 1.25%, but the markets had already rallied strongly in anticipation, and it seems that it is taken as a buy the rumor, sell the news kind of situation.

That isn't surprising. Monetary policy is incapable of repairing broken supply chains or get people into airplanes to foreign destination, or should things deteriorate domestically, to get them into restaurants and shopping centers.

With interest rates already this low, there isn't much traction in further relaxation and the main transmission mechanism is actually through the wealth effect via financial markets.

Even rumored tax cuts would do little unless they're targeted at companies in distress or removing barriers for people to get tested or stay home if they fall ill (see above).

The longer the situation lasts, the more likely it is the state might have to bail out companies like they are doing in China already (for instance HNA airlines suffering with $75B of debt was taken over by Hainan Province).

Your portfolio

This is not the time for being all-in on stocks. If you're fully invested, we think one should use rallies to lighten up at least a little and go into cash unless you've bought extensive protection.

While we don't predict it, a really bad scenario can't be excluded and you don't want to be caught with your pants down if that happens. Cash is king here, not only as a hedge but also to be able to jump on chances that will present themselves.

Goldman Sachs has already predicted this year will see no earnings growth, so the market overall is likely to have limited upside; it looks to be a stock picker's market for the foreseeable future.

If there is an all-clear, it will be when additional bad news (if and when that arrives) doesn't produce further downward movement in stocks; it means that most bad news is priced in.

Conclusion

While drastic measures in China have enabled authorities to get the situation seemingly under control, it's too early to start rejoicing. A big test will ensue when they relax some of these measures and more of the factory workers return from their extended holiday.

From what happened in South Korea, we know that new outbreaks are relatively easy and we know there are countries which already suffer from a serious outbreak like Iran or are ill prepared to take one on.

On a world scale, we're only as strong as the weakest link so we see an extended period in which we'll have to deal with this situation. Warm weather may help, but we don't know to what extent.

Economically this is a Catch-22 situation. Experience shows that swift and drastic measures help contain a breakout, but this comes with a large price tag for the economy and even then full containment is still anything but ensured.

The longer these measures last, the more compounded the economic damage becomes. We think the stream of bad news will last for a while and the risk in the market is most definitely on the downside.

The situation in Europe as well as the US is concerning. There is a rapid rise in cases in Italy which is being met with increasingly stringent measures. In the US, a lack of testing to date might obscure a bigger problem. We just don't know yet.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.