• Arca Análisis Económico

The coronavirus, China and the others


Highlights


Mohamed El-Erian, Chief Economist of Allianz and next president of the Queen´s College at the University of Cambridge, argues that the latest health emergency happens at a time when the long-term growth expectations of the world economy are quite mediocre and the central banks in developed countries lack the tools to cope with an eventual severe recession.


Mr. El-Erian argues that this shock is strong enough to temporarily disrupt the forces that have driven the upward stock market of the last decade, so it would be prudent for most investors to minimize vulnerable flanks of their portfolio, that is, the assets with the greatest exposure to the performance of the Chinese economy and in particular illiquid stock positions.

Last week Mohamed El-Erian, Chief Economist of Allianz and next president of the Queen´s College at the University of Cambridge, wrote an article that, in our opinion, has been one of the most relevant opinion pieces on the recent coronavirus crisis and its impact on financial markets.


Mr. El- Erian argues that the latest health emergency occurs at a time when the long-term growth expectations of the world economy are quite mediocre and the central banks of developed countries lack the tools to cope with an eventual severe recession.

In the very short term, the US and Europe equity and fixed income markets have endured reasonably well the onslaught of the uncertainty caused by the epidemic outbreak, but as the days go by the managers of large investment funds are forced to place a strong bet on the outcome of this crisis.


Those who believe the virus will be controlled in a few weeks, will take advantage of the situation to buy with a certain discount those financial assets that have suffered the greatest corrections, that is, actions of hotels, airlines, casinos and related companies, and of course much of the public offering shares of Hong Kong and Mainland China. This group of actors follow a strategy that has been valid since 2009 and that is known under the name of buy-the-dip (purchase during the fall), this strategy assumes financial markets will remain robust and that any fall is nothing more than a break in a bull market.


On the other hand, there are those who believe that the coronavirus can achieve what the Chinese-American trade war and other crises of the last couple of years have not achieved before: produce a structural breakdown of financial markets. In other words, generating a profound change in the beliefs of opinion makers in the economic world, which until recently thought that central banks in developed countries wanted at all costs to minimize outbreaks of volatility caused by undesirable economic events, and especially that they had the resources to do it.


This second group of actors is concerned about the fact that China is, from a financial perspective, a highly leveraged economy that has been committed to generate a growth model based on a market of national consumers in recent years, consumers that during this crisis have had very limited mobility.


Some opinion makers have wanted to draw some lessons from the outbreak of the bird flu at the beginning of this century, which had a relatively minor economic impact on China. Unfortunately, this exercise is not very useful, since China in 2003 represented 4 percent of the world economy and it had a highly exporting economic model and low levels of indebtedness. Today's China generates 16 percent of the world's GDP, it does not have the resources to activate massive loans to the productive sectors, and its population will tend to reduce the consumption of goods and services in the coming months to compensate for unearned income due to quarantine and other related disruptions.


The impact of a contraction of the Chinese economy would feel very uneven in the rest of the world. A drop of 1 percent of China's GDP would induce a reduction of 0.35 percent in the GDP of South Korea, 0.30 percent in the GDP of Hong Kong, 0.12 percent in the GDP of Germany and 0.4 percent in the GDP of USA. This dispersion of results is not trivial at the time of rebalancing investment portfolios in response to the coronavirus.


Mr. El- Erian argues that this shock is strong enough to temporarily disrupt the forces that have driven the upward stock market of the last decade, so it would be prudent for most investors to minimize vulnerable flanks of their portfolio, that is, the assets with the greatest exposure to the performance of the Chinese economy and in particular illiquid stock positions.


Those who insist on the buy-the-dip strategy should buy shares of US companies with strong balances that allow them to survive the coronavirus and its even unpredictable consequences.

© 2015 Arca Análisis Económico

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