What Wuhan pneumonia means for investors

Asian equity markets (MSCI Asia ex-Japan) gained more than 10% between early December and mid-January as uncertainty over the US-China trade dispute subsided. But the rally came to a halt last week over mounting investor fears that the pneumonia outbreak in Wuhan, China, might turn into a larger epidemic and negatively impact consumption, travel and tourism-related sectors.

Last week the MSCI AxJ index declined by 2.8% and China’s CSI 300 fell by 3.6% prior to closing for the New Year holiday. We believe the selling pressure in part reflects uncertainty ahead of a lengthy market holiday, with much still unclear over the severity of the virus and how fast it is spreading.

But we think past experience in the region offers some guidance as to the potential economic and market impact in China and Asia:

Macroeconomic impact likely to be limited.

• Given initial reports on the virus, we anticipate the economic fallout will be smaller than during the SARS epidemic in 2003. SARS lasted eight months as a health risk, but led to a sharp fall in China economic growth over just one quarter, followed by a swift recovery. MERS in South Korea in 2015 followed a similar pattern.
• We had expected 1Q 2020 to mark the turnaround point for GDP and corporate earnings growth in Asia. If the situation deteriorates, the turnaround time might be delayed by a quarter, based on our view that any potential outbreak takes time to contain. That said, one of the most positive legacies of SARS and other outbreaks is that governments and the public are more vigilant. The initial response by the Chinese authorities to this outbreak has been relatively swift, with Wuhan and neighbouring cities subject to a travel ban by 23 January in an attempt to contain the spread of the virus.

Market impact likely to be short-lived.

• Equities: The correction in the MSCI AxJ index has so far only pushed price-to-book valuations down closer towards their 10-year mean, but on a relative basis the index is now trading at an attractive discount to global markets. We expect Asia's corporate earnings to grow by 13.8% in USD terms in 2020, which is significantly faster than expected developed market profit growth. We also remain positive on Chinese equities, with a forecast for 12% earnings growth (USD), and have preferences for a number of sectors, including tech hardware and ecommerce.
• Bonds and currencies: Assuming the virus can be contained within a few months, any negative impact on APAC currencies should be short-lived. Based in part on the SARS experienced in 2003, we believe currencies sensitive to external demand (such as KRW,TWD, THB, SGD, MYR) would be relatively vulnerable, while domestic-demand-oriented currencies (IDR,INR, PHP) should be more resilient.
• In our FX strategy, our long exposure to the IDR and the INR, combined with our short exposure to the TWD in our high-yielding EM currency basket should benefit in this scenario. For bonds, a worsening scenario could lead to a marginal widening of yield spreads. We recently closed our overweight to EM USD-denominated sovereign bonds, but we still recommend a strategic allocation to the asset class despite this tail risk.

So while we remain alert for an increase in the severity of the outbreak, we expect the impact on the region’s economy and risk assets to be short-lived. Since the timing around the extent of the outbreak is difficult to predict, we do not recommend investors take directional positions or withdraw from financial markets based on news about the virus – instead we would be inclined to view the drop in markets as an opportunity to add exposure to emerging market and Chinese stocks. We remain overweight EM equities.

We remain overweight EM equities.

More broadly, disease outbreaks reinforce the importance of investing through a diversified portfolio to mitigate idiosyncratic risks. In the risk case of a more severe outbreak we would expect a drag on discretionary spending, with retail sales and visitor arrivals most affected, which would put pressure on related industries including airlines, consumer discretionary, and tourism. Past experience suggests trade growth would be relatively immune. Investors worried about deploying capital near record highs amid heightened uncertainty can, however, take advantage of relatively low volatility in the option market at present to make use of strategies that reduce portfolio volatility or add explicit protection.

Please visit ubs.com/cio-disclaimer #shareUBS