Financial markets are banking on the economy recovering quickly and completely as soon as the virus peaks like SARS or Ebola…but models aren’t accounting for some key info they don’t have. Why China’s economy will likely not going to recover 100% when this is all over as predicted.

by DontMicrowaveCats

I’ve been posting a lot about the serious economic effects COVID is having on the global supply chain across virtually every major industry. I’ve also predicted world equities markets will likely begin responding to the hit to global GDP in the near future.

For now, markets continue to surge higher, including in China. Even the stock price of companies with idling factories and closed stores across the country now keep climbing. How can that be?

TL;DR Markets are currently being priced by analysts based on financial models of past outbreaks, while central banks prop them up through monetary intervention. I think most of these financial models are wrong. Due to an unknown volume of companies poised to pull out of China once this is over, combined industries being hit exponentially harder than the SARS outbreak, their economy will likely not recover fully as predicted..and world markets will deal with a longer-term downturn. This is a true Black Swan event


Money Supply

Short economy lesson.

As discussed in past posts, a primary factor to the world stock markets continued growth right now despite the guaranteed negative economic effects is central bank intervention. Esp in US and China , governments are pumping cash into their economies via “Repo” operations.

You may have heard that China’s GDP growth rate (an indicator of the strength of their economy) has slowed to a 25 year low. Although the growth rate has been trending down for years, the US-China trade war accelerated the decline. The Chinese government has been fairly desperate to stop the bleed.

Repos & Reverse Repos are complicated…essentially these are financial instruments that central government banks (such as the Fed in the US) can use as a tool to control the money supply within their economy. They do this by buying back securities (like government issued bonds) from large banks & financial institutions at set “discount” rates. In times of high risk and tight lending, the goal is to stimulate the economy by making sure those financial entities have enough liquid cash to loan out to 3rd parties at reasonable rates.

The US Fed as been pumping cash into the economy via repurchasing treasury bills and overnight Repo operations since September 2019…months before the first virus cases. This started in response to a sudden cash shortage in US banks (exact reasons for that are too complicated to go into…but basically the system fucked up, government stepped in to make sure it didn’t collapse).

China has also been injecting cash for months in response to the trade war. However, over the last couple of weeks they have increased these measures a massive scale (to the tune of $242.74 billion USD). Right now they are desperately enacting measures to keep the economy from crashing.. such as implementing tax relief measures for businesses and slashing interest rates. www.reuters.com/article/us-china-markets-rates/china-central-bank-unexpectedly-cuts-reverse-repo-rates-to-help-economy-as-virus-spreads-idUSKBN1ZX05X

Takeaway from this. As long as governments keep pumping cash into the economy, markets can continue to rise even in time of uncertainty or turmoil. In the current situation it would seem as if the only thing keeping China’s economy, and by association the US economy, afloat…is government intervention.

The question is, how long can that hold up?


Modeling Past Outbreaks

As you may know, the US economy & stock market has been on a non-stop rocketship growth trajectory for the last 10 years. There hasn’t been a real downturn since the 2007/2008 recession. Many people have gotten very rich. But for years investors and economists have questioned how long this continuous growth can last. Many have long predicted we’re “overdue” for a recession. Especially as growth has accelerated in recent months, they’ve questioned whether we’re in a “bubble” that could burst at any moment.

Currently, most financial analysts are modeling the economic fallout of this virus based on lessons learned from outbreaks such as the SARS epidemic in 2003 or Ebola in 2014. Like those outbreaks, they are assuming the effects COVID has on the economy will look like a “V” shape… a sharp decline followed by a swift recovery as soon as the virus peaks. In the eyes of financial analysts, outbreaks are single events which don’t cause long-term economic downturns. So, institutional investors look towards the other side of the “V”, and invest as if the negative effects never occur.

Right now, it seems the markets are moving based only on the most optimistic news out of China that falls in line with these expected models. Any mention of a possible “vaccine” breakthrough, or “coronavirus shows signs of slowing”…the markets surge. The current widespread expectation in the financial world is that the virus will peak in the next 2 weeks, be contained by April, and the economy will make up all or most lost growth in Q3 and Q4 of this year.


The Reality

Analysts & quants build models based on actual data available to them. Unfortunately in this case, there is no truly comparable scenario to build from. And they can’t model accurately the movements going on behind the scenes.

  1. The world has never been so invested & reliant on a single economy as they are with China right now. Unlike during SARS…they have become an essential keystone for both Imports and Exports. They also account for a larger percentage of foreign retail sales and tourism than ever before in history.
  2. US companies have already been under immense pressure from Trump’s trade war with China for nearly a year. They have been burdened by huge tariffs on Chinese goods coming into the US…as well as Chinese tariffs on US exports. With an uncertain end to the trade war, many companies started the process of diversifying supply chains out of China to other South East Asian countries months ago.
  3. Nearly every company has been caught off guard by this virus. This has lead many US companies to further push forward plans to source outside of China. Even if this is over quickly, this experience has been a wakeup call for companies about the need for supply chain diversity across multiple countries. Even if the virus ends tomorrow, China has officially lost its single-player advantage.
  4. China’s economic growth…its rising wages…the retail spending…tourism…investment….all rely on companies staying in China. Financial analysts & economists all have 0 idea the scale & scope of this outbound movement, and could not accurately price it into their models.

    When foreign companies pull out of the Chinese supply chain, their economy cannot recover completely

  5. Companies pulling out of China means there will be a rise in layoffs, unemployment, and reduced wages. This ripples through the rest of the economy for an extended period.
  6. Compounding the issue, tourism within China (both inbound foreigners and domestic travel) accounts for 11% of their GDP now. Even once the virus slows to a moderate level, travelers will still be wary to go to China, and countries will still be wary to let Chinese travelers in. This could last over a year.
  7. The entire world now relies on Chinese outbound tourism. China spends more on foreign tourism than any other country in the world (Nearly $300 billion in 2018…compared with $10 billion in 2000, just 3 years before the SARs outbreak). And Chinese travelers are typically among the biggest retail spenders while abroad.

    Even if companies do not pull out of China en masse, Chinese businesses & citizens have taken a large hit to their earnings during Q1 2020. Many of them may forego travel completely for an extended period of time while they recover. This is lost income that the industry will likely not recoup in Q3 & Q4.

  8. During SARS, global retail did not have nearly as large of a presence in China as they do now. Many global industries and companies have grown a reliance on Chinese domestic spending. As with tourism, due to reduced earnings and potentially layoffs/wage reductions….They will likely forego spending until recovered as well. Again, money that won’t be coming back into the economy.
  9. Chinese investments in foreign housing markets have caused prices to skyrocket in many cities around the world. If there is an economic downturn in China, it could lead to a widespread housing price collapse as those investments dry up.

There is more. A lot more that economic models cannot possibly predict at this stage.

Analysts already know growth will be slowed in Q1 and possibly into Q2. But the market is only staying up right now with the expectation it won’t be effected into Q3/Q4. By my assumptions, even if the virus stops 2 weeks from now, the snowball has already began rolling for companies pulling out of China.

Conclusion Taken all together….combine markets propped up on government-intervention, a high potential of partial or mass exodus of foreign industry from China, and a looming US election..there is a high chance the economy cannot bounce right back as hoped. There will be a slow bleed out through the end of 2020 and beyond.

On the bright side, I could be full of shit, the models could pan out, and everything is all good by Q3 2020. I hope I’m full of sh*t.

 

 

Disclaimer: This information is only for educational purposes. Do not make any investment decisions based on the information in this article. Do you own due diligence.