5 minute read
Jim McCormick, Global Head of Desk Strategy, presents an empirical framework to help provide some loose guidance in assessing the potential impact that the new coronavirus could have on global financial markets.
It may get worse before it gets better
I always hesitate to have too much to say when it comes to issues like today’s coronavirus escalation. There are too many unknowns, so best not to try and be too clever about the potential financial market impact. That said, if you accept the fact there will be an impact on global growth and that under most circumstances it will be big but likely temporary, there are some basic assumptions about how the virus could impact growth-linked assets. We use our Growth Asset Framework to help.
Putting the spotlight on growth-linked assets
As a refresher, our Growth Asset Framework looks at market valuations for a basket of 20 growth-linked assets against the 6-month rolling trend global manufacturing Purchasing Managers’ Index (PMI) data. With this in mind, we can estimate the impact on growth-linked assets by attempting to estimate the impact on the global manufacturing PMI from the coronavirus.
Step 1: Assess the impact of the 2003 SARs episode
To do this, we can use the 2003 SARs episode, given it is probably the closest comparison to what is happening today. Although, markets are in a very different place today, compared to 2003 – so it’s sensible to bear this in mind. Manufacturing PMI data were a bit more sparse back then, but we have data for Hong Kong as well as an aggregate for developed economy manufacturing. Hong Kong was one of the hardest hit countries during the SARS epidemic, so this is probably a reasonable proxy for what we might expect for the broader Asia region, China especially. As Chart 1 below shows, the Hong Kong PMI fell from above 50 in February 2003 to 38 in April – then returned to 50 by June. The developed market manufacturing PMI fell by 2.5 points during the same period and also recovered fully not long after.
Chart 1: Impact of 2003 SARS episode on Hong Kong
Source: NatWest Markets
Step 2: Plot the PMI trend for the coming months
Next, we can use our Global Manufacturing PMI estimate to try and build a profile of the trend in the coming months. The assumptions we have made are meant to be simple – China’s manufacturing PMI falls by a similar amount to Hong Kong’s drop in 2003 (from just above 50 to 40). Other Asian countries fall by 5 PMI points and the rest match the developed markets trend in 2003 (down 2.5 points). Based on these simple assumptions, the global manufacturing PMI could fall from just above 50 today, to a level near 46 in the coming 2-3 months.
Assuming as with the SARS episode the impact on global manufacturing is temporary, we’d expect the PMI to resume its modest upward trend above 50 by late spring. I’d emphasise again that these assumptions are purposefully simplistic – they are only meant to illustrate would the global manufacturing PMI would look like if the current coronavirus closely followed the 2003 SARS script. The reason today's decline looks so significant is China is nine times bigger as an economy then it was in 2003.
Chart 2: Global Manufacturing PMI estimate using the 2003 SARs impact on Hong Kong and DM PMIs
Source: NatWest Markets, Markit, Haver
Step 3: Implications for growth-linked assets
Finally, we can look to see what our global manufacturing PMI estimate implies for the trend in growth-linked assets in the coming few months. Using this model process, the results don’t make for great viewing, at least in the near term. At first look, the Growth Asset Basket could fall toward or even below levels last seen in late 2018, during the major risk-off episode at the time – if our estimates are kept in line with the PMI estimates outlined above.
That said, I’d be hesitant to take this at face value, especially given the failure of our Growth Asset Basket to respond to the weak manufacturing cycle last year. I’d also strongly emphasize that, like in 2003, our framework assumes the economic and market impact this time is temporary. Still, there are two reasons to be at least a little concerned about the downside risk from today’ s coronavirus episode.
Chart 3: NWM Growth Asset Basket and the 6-month rolling trend in the global manufacturing PMI (including est for next 3 months)
Source: NatWest Markets, Bloomberg, Markit, Haver
2 reasons to be a little concerned about the downside risk from coronavirus
First, the reason markets outperformed the business cycle last year was the aggressive response by central banks. But as we have discussed many times, central banks are running low on ammunition, so the response this time around may not be as aggressive. Moreover, last year’s manufacturing cycle weakness was centred in developed markets – today’s weakness will be mostly in Asia, China especially. The US Federal Reserve (the Fed) certainly has room to cut further and we think they ultimately will this year – but we’d probably need to see large spill over effects into the US economy and the S&P500 for the Fed to be back in play quickly.
A second reason for caution is markets were ill-prepared for an escalation is the coronavirus epidemic. Market implied volatility hit an all-time low two weeks ago, according to the core volatility indices we track - this is not a market that has been placing much value on the risk of another lurch lower in the manufacturing cycle and risk assets.
It’s only loose guidance
As I said at the start, issues like today’s coronavirus episode are difficult to assess. What I have tried to do here is present an empirical framework that can at least help provide some loose guidance. The best I can say is that it may get worse before it gets better. Although, keep in mind that markets today are very different from markets in 2003, which we have used to anchor our empirical model. But it’s the closest thing we’ve got today to help give us any sort of firm grounding to assess market implications. So I guess we just need to wait and see.
And remember – the market decline during the SARs episode was temporary and it all cleared up after a couple of months. Stay tuned for more updates as we monitor the situation.