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The deadly virus theme that has plagued global markets, devastating commodity prices and risk-sensitive currencies, seems to be calming down. The rate of infections appears to be levelling off, and Chinese media suggest scientists found a drug that effectively treats patients. If confirmed, that could ignite a fresh wave of risk-taking, helping the commodity-linked Australian, Canadian, and New Zealand dollars to rally in relief, as safe-havens like the yen come under selling pressure.
Is it a short-term thing?
Evaluating the economic fallout from an epidemic is notoriously difficult, as there are few incidents to compare with and each case has its own unique characteristics. For instance, comparing the recent coronavirus to the SARS outbreak in 2003 is not very helpful, as China now accounts for a far bigger share of the global economy and the interconnectivity of modern supply chains means that any shock in China can ripple into foreign economies much easier.
Moreover, the scale of this outbreak is far bigger than SARS and the economic impact is likely to be much greater. Several Chinese cities were put on lockdown during the busiest holiday period of the year, dampening demand for tourism-related activities, transportation, and restaurants, among many others.
On the bright side though, what these outbreaks do have in common, is a short-lived impact on economies and financial markets. Once there are signs that the spread of a virus is contained, investors tend to look through the already-inflicted damage on economies and instead focus on the better days ahead. In other words, the biggest impact is usually on investors’ sentiment, and that can turn around quickly.
This may be especially true this time, because while the scale might be bigger, Chinese authorities have enacted considerable stimulus measures to keep the economy supported.
Rays of light
While both the death toll and the number of confirmed virus cases have continued to climb in recent days, markets have taken heart by signs that the outbreak is slowly being contained. The rate of increase in new infections has slowed down, which suggests that the draconian quarantine measures taken by the Chinese authorities are starting to pay dividends.
In truth, the official figures might be underestimating the actual number of infections. Several accounts from Wuhan – ground zero of the outbreak – suggest that many patients are unable to receive treatment because hospitals are overloaded, and those people are therefore not counted as confirmed cases. Likewise, there have been multiple reports of test kit shortages in Wuhan, which likely deflates the official figures further as many carriers might not be diagnosed.
Yet, there’s reason for optimism too. This week, Chinese media reported that local scientists found two drugs that can inhibit the effects of the virus, and that clinical trials have already begun to test one of these drugs – Remdesivir – on coronavirus patients in Wuhan. To be clear, this is not touted as a ‘cure’ but rather as a ‘treatment’, the difference being that a cure completely removes a disease while a treatment merely improves a patient’s condition.
Still, a treatment might be good enough for financial markets. If confirmed, it would suggest that the economic impact in China may indeed be short-lived and that the largest quarantine in human history may be about to end.
Easy go, easy come?
In the markets, signs that the virus is gradually coming under control have already fueled an increased appetite for risk, and that might accelerate once there is something more tangible for investors to latch on to – like a confirmed treatment. Not least because trade and Brexit risks have faded off the radar, so virus disruptions are probably the biggest downside risk for the global economy at present.
In this optimistic scenario, the biggest upside reaction might be seen in commodity-linked currencies – the Australian, New Zealand, and Canadian dollars – all of which have been sold heavily as virus fears grew. This relief rally would likely be reinforced by a recovery in commodity prices such as iron ore, copper, and oil, that have been devasted by concerns about future demand. Remember that China is the biggest consumer of raw materials globally.
Stocks would also likely benefit, as the tsunami of liquidity unleashed by the major central banks lately (Fed, ECB, PBoC, BoJ) finds its way into equity markets.
On the opposite side of the risk spectrum, the main losers might be haven currencies and assets, most notably the Japanese yen, Swiss franc, and gold.
Or is this wishful thinking?
On the other hand, assuming the worst is over may be over-optimistic. Even if a treatment is found, there’s no telling how quickly the lockdown of cities like Wuhan will end, and how soon factories and other workplaces will reopen. Will it be a few more weeks, or a few more months?
The Hubei province – whose capital is Wuhan – is an industrial powerhouse with many supply chains running through it, so the longer it stays in quarantine the greater the risk of longer-lasting and more severe economic disruptions.
Yet more important is the risk of a surge in infections outside Hubei province, especially abroad. This could signal that the virus is not contained after all, igniting speculation for a much bigger hit to economic activity worldwide and by extension, generating another wave of risk aversion in the markets. In this case, commodity currencies could come back under selling interest, while safe havens shine.
A rebound, not a complete turnaround
Even in the best of scenarios, where the virus is contained or even better, a treatment is truly successful, the boost for commodity currencies is unlikely to be enough to wipe out all their virus-related losses.
Australia and New Zealand rely on China buying their raw material exports and no matter how you slice it, there will be a short-term hit to Chinese growth, meaning reduced demand for their exports. Not to mention that both nations will see their tourism industry take a severe hit from this, as inflows of Chinese travelers dry up amid travel restrictions.
The bottom line is that even once virus concerns subside, things are unlikely to ‘go back to normal’ quickly. That said, signs are accumulating that the worst may be behind us, and unless something negative enough happens to change this narrative, the soft recovery in risk sentiment might continue. Financial markets are certainly behaving as if this is the beginning of the end, for the virus theme.AUDUSDNZDUSDUSDCADUSDJPY
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