Equity markets face various challenges in 2020, the imminent threat being the coronavirus fears which continue to make the headlines. Fear is spreading outside China, fuelling volatility on financial markets. Kristian Camenzuli, investment manager at Calamatta Cuschieri, answers questions on what investors need to know about the challenges investors face in 2020.

What is the global economic impact of the coronavirus likely to be?

It is still too early to predict the full magnitude of the economic impact of the coronavirus outbreak on China and, by extension, on global growth dynamics with any reasonable degree of confidence. However, if the situation does take a turn for the worse, global GDP growth would most certainly take a hit.

Chinese demand for foreign products may falter and global supply chains could get disrupted. Apart from the economic drag, any further escalation of the coronavirus situation could also trigger distress in global markets through a retrenchment of risk appetite.

Investment banks started to put figures on what the damage could be. Citi has said it expects China’s 2020 growth to slow to 5.5 per cent, after previously predicting it to be 5.8 per cent, with the sharpest slowdown this quarter.

Morgan Stanley are predicting that China’s economic growth in the first quarter could fall to as low as 3.5 per cent if the spread of the virus outbreak is not contained fast enough for factory production to resume to normal levels.

The question is whether the shock is limited to the first quarter or extends into the second quarter. In the former case, the impact should be absorbed without too much damage thanks to a drop in inventories. In the second case, we cannot exclude a short-lived technical recession.

Why is the coronavirus such a threat for companies?

The coronavirus has translated into two negative shocks:  a demand shock, mainly through the reduction in Chinese imports and spending, and a supply shock through disruptions in the supply chains.

More and more western firms warn about lower-than-expected sales and earnings due to these disruptions.

Are companies issuing profit warnings?

Yes. Apple has drawn the first blood but it will be far from the last.  Tesla opened its Shanghai factory at the end of December. 

Nike and Disney are also heavily dependent on the Chinese consumer. There will be more such warnings in the weeks to come.

The coronavirus has also led to the temporary closures of international businesses such as McDonald’s and H&M across parts of China and prompted worries about the impact to the economy from curbs to consumer spending, business operations and travel.

Looking at history, election years were positive for equity markets

Why did markets take so long to sell off?

Accommodative policies by the People’s Bank of China is the main reason why equity markets have initially held onto their gains. Policy priorities have started to shift from containing the spread of the virus to restarting industrial and services activities.

However, once the market learned that the virus was spreading fast to other countries, particularly northern Italy, equities started to sell off at a faster pace, pricing in increased uncertainty on global growth.

What was the impact on the market when Sars broke out?

In March 2003 (one month after the Sars virus broke out in February), we saw a 10 per cent month-on-month average decline in share prices for HK cosmetics and jewellery companies, followed by a four per cent drop in April.

However, stock prices rebounded significantly after the Sars incident was deemed under control with a 38 per cent and 32 per cent jump in July and August 2003 respectively.

Is Sars comparable to the coronavirus?

The repercussions for equity markets from the coronavirus could be far wider because of China’s economic rise over the past 17 years and its greater integration with the global economy.

Also, the market backdrop to both outbreaks is very different. Sars happened at the late stage of a long bear market when global markets were trading at much lower valuations. By comparison, the present outbreak is happening in a risk-on period and at a time when China is much more integrated in global markets and economies.

Should investors add gold to their portfolio?

Gold is on fire due to both short- and long-term catalysts. Concerns linked to the coronavirus outbreak has triggered a powerful global hunt for safe havens. Investors fear the outbreak could damage growth, hurt risk assets and add to pressures for easier monetary policy.

As a result of these fears, long-term real bond yields have dropped further into negative territory. Remember that there is a negative relationship between real bond yields and gold prices, as gold is a non-yielding asset.

Over the long term, less globalisation (rising protectionism, rising risks) should translate into lower global growth and higher inflationary pressures. This global macro backdrop would be favourable for gold.

Moving on to other issues, is the trade war still an issue for the markets?

Although both the US and China struck a more constructive tone (China announced to halve tariffs on more than 1,700 US products), the tail risk of a sudden deterioration or breakdown of talks remains.

Even if the US/China trade disputes get conclusively resolved, it is entirely possible that the focus of the Trump administration would swiftly shift to Europe.

It is an election year in the US after all and protectionist measures are popular policies among a not insignificant part of the electorate.

What about the US elections?

Looking at history, election years were positive for equity markets as potential candidates come out with attractive propositions on how to boost economic growth. We don’t expect this year to be any different.

Are you confident about the strength of the US economy?

Leading indicators of S&P 500 forward earnings argue that they will continue to slow for several more quarters. This is the biggest risk the S&P 500 faces in the near term. The fact that the coronavirus is posing an additional threat reinforces this concern in the short term.

Are you concerned about negotiations between the EU and UK?

After the UK left the EUon January 31, the 11-month transition period has begun. The clock is ticking and, if there is no extension, only very little time remains to negotiate a comprehensive trade deal between both parties. The risk for the EU is, of course, that from January 1, 2021 onwards, trade with the UK will be conducted on WTO (World Trade Organisation) terms, which could disrupt supply chains and damped economic activity.

Is the European economy in a better state?

Lately, a growing number of indicators have suggested that the European economy might be out of the woods, heading towards a more robust recovery. For instance, while European inflation remains significantly below the ECB’s inflation target, of close to but below two per cent, it is worth highlighting that the year-on-year headline rate has, in fact, doubled from 0.7 per cent in October 2019 to 1.4 per cent in January 2020. Even the manufacturing PMI (purchasing managers index) for the euro area, one of the biggest causes of worry to European investors throughout 2018, seems to have bottomed out in September 2019 and is now back on a mild upward trajectory. Sentiment among European investors has also improved considerably.

The key question is, of course, whether Europe has genuinely turned the corner or not. I’d argue that it is way too early to give the all-clear signal. First of all, despite the recent green shoots, economic growth in Europe remains anaemic and fragile.

Which stocks do you recommend given the uncertainties at the moment?

Positions in defensive stocks should stand out in an equity portfolio. Names like L’Oréal and Unilever stand out.

Pharmaceuticals should also continue to do well. We like Sanofi and Astrazeneca. An investor can also get exposure to the sector ETF (exchange traded fund).

From the tech sector, we favour companies which are growing in the cloud business. Companies like Amazon, Microsoft and SAP come to mind.

In the 5G space, we favour ASML, which has a monopoly in its sector and which we expect will continue to do well in the years ahead.

What are your thoughts about equities for 2020?

Equities were priced for perfection, anticipating a strong economic recovery. Short-term profit-taking is likely and their magnitude may be significant should virus fears broaden, as these fears would put global growth into danger.

Nonetheless, in the medium to long term, we retain our pro-risk investment stance, as growth should edge higher in 2020, helped by easier financial conditions.

Although financial vulnerabilities are climbing, it is important to highlight that our overall gauge of vulnerabilities across the global economy stands well short of its peaks ahead of the last recession.

The information, views and opinions provided in this article are provided solely for educational and informational purposes and should not be construed as investment advice, tax or legal advice. This article was issued by Calamatta Cuschieri Investment Services. For more information, visit https://www.cc.com.mt.