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Easy money fights the virus

Stimulus measures by central banks are supporting equity markets, but the implications of the novel coronavirus outbreak could get more serious.

Stimulus measures by central banks are supporting equity markets, but the implications of the novel coronavirus outbreak could get more serious.

by
John Redwood

in Features

11.02.2020

Before we knew about the outbreak of the coronavirus epidemic, we were pessimistic about Chinese shares, expecting the economy to slow. The Chinese authorities were seeking to balance the need for stimulus to keep growth high with the need to avoid a big build of debt. They wished to tackle more of the bad debts in the system, close down more of the older dirtier industrial capacity whilst encouraging the new technology and service-based economy to flourish. It seemed to us they were in danger of tightening too much with adverse consequences for growth and share ratings. The interest rate cuts were tiny and the fiscal stimulus modest.

Today the position looks very different. The Chinese authorities are administering a large monetary stimulus through direct liquidity injections into the markets. The equity market fall has been braked by this action. The government may well spend more and tax less as it combats the consequences of the virus.

Meanwhile, Chinese business had to take a prolonged shutdown and New Year holiday. This week some are getting back to work but the position is patchy, with some companies telling staff to stay away owing to infection worries, with some cities and local authorities taking a prudent view and stopping or advising against commuter travel, and some individual workers isolating themselves in their homes for fourteen days in case recent contacts have given them the illness. Market estimates of how much damage might be done to Chinese output are being revised downwards.

Doubts rising

In the early days of the outbreak, markets tended to a relaxed view, thinking there would be a short period before we reached peak new infection, followed by a decline. On such an outcome the market downtick on the original news would soon be reversed and the economy would make up for lost output. Now there are more doubts. It appears we have not yet seen peak new cases or peak daily deaths. The infection has spread very widely through China, and many companies have good reasons to stay closed or to work below full capacity. It seems safest to assume this dangerous epidemic has more bad news to bring, with further revisions to how long it will take to get back to normal and gloomier views of how much output and profit will be lost in the meantime.

Whilst the effects will be most marked in China itself, there are two worries for the rest of the world. The first is the possibility that outbreaks will grow in other countries, as individuals arriving in other countries with the virus seem to infect a number of people each before their condition is known and before they can be cared for in controlled surroundings.

The second is the certainty that there will be knock-on effects of the interruptions to Chinese output which will hit international companies with Chinese components in their supply chains. The South Korean car companies have already announced shut down periods owing to a shortage of Chinese parts. Wuhan at the centre of the Chinese outbreak is a centre for cars and car components and for optical equipment and components. Conditions remain very difficult in Wuhan, with other Chinese cities also now taking more restrictive actions to prevent faster spread.

If the world is fortunate, the virus will subside as quickly as it came. This, in turn, will give a boost to confidence and there will be some efforts to make up for lost sales and output. If, as we fear, the epidemic drags on for longer, confidence will be damaged more and it will be impossible to make up for all the lost activity.

More stimulus

The authorities both in China and the wider world are likely to continue a response to the challenge based around low interest rates, more money being put into markets and more fiscal easing. Chinese prime rates are still at 4.15% as they concentrated before the health problems on seeking to boost things by cutting the reserve ratio for banks which controls how much cash and capital they need for any given amount of lending.

This will leave share markets with a quandary. Do they concentrate on the easier conditions and expect continued good performance of riskier assets? Or do they worry more about the impact all this will have on cash and profit generation by business and on the growing gap between what is happening to earnings and dividends and what has been happening to share prices? As world equities are still up a little this year overall, after a great year for performance last year, it seems prudent to reduce risks in portfolios that have been running with more equity exposure than they need to stay within their risk bands.

Nothing on this website should be construed as personal advice based on your circumstances. No news or research item is a personal recommendation to deal.

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