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Mid- March — First Direct Impact on U.S. Economy from China’s Shutdown and Coronavirus — Inflationary or Deflationary?

Date Posted: March 9, 2020

Normal—Lunar Holiday Shutdown for China

Each year Chinese production typically shuts down for the Lunar New Year. This year that holiday lasted about fifteen days — January 25th to February 8th. In anticipation of that shutdown, Chinese manufacturers ramp up pre-holiday production to bridge global inventory demands over the lunar holiday period. Shipments take about thirty days by sea before reaching American and European ports. Since pre-holiday production ended about February 8th, the last of those deliveries will likely reach the U.S. and Europe by mid-March.

Abnormal—Coronus Virus Shutdown—Creates U.S. Supply Gap Mid-March—Inflationary?

The lunar holiday shutdown would not create a delivery hiccup if production resumed right after the holidays. Unfortunately, the 2019 Novel Coronavirus (COVID-19) epidemic forced China to extend lunar holiday production, shutdowns another 10 to 14 days. With the lengthy shipping distances, that unexpected shutdown likely will leave a delivery gap beginning about mid-March for shipments to the U.S. and Europe. In January and February, China’s exports declined over 17% year-over-year (YoY). More importantly, in the same period, exports to the U.S. dropped nearly 28% YoY.

How long that delivery gap will last depends on the speed at which both Chinese production ramps up and container ships recycle to their regular schedules. In the short run, this potential supply shortage could lead to upward price pressures on critical parts and products. To close this supply gap, some end users may use air cargo to expedite critical parts deliveries to this country and Europe.

Sharp Decline Likely for Chinese Exports

Recent surveys show a substantial decline in China’s purchasing managers index (see Figure 1). According to the U.N. Division of International Trade and Commodities (UNCTA), this index highly correlates with changes in China’s exports. Therefore, this correlation would imply a two percent decline over the year for Chinese exports. Expectation surveys, such as this one, and future hard data can and will differ. The depth of the decline and, more importantly, its length will primarily reflect on the speed China can retool its production to meet critical demands from just-in-time manufacturing systems.

Figure 1

China’s Purchasing Managers Indices

Source: National Bureau of Statistics China, UNCTAD

Container Shipping—Slowly Recovering

This recent quote in the American Shipper from the founder of Sea-Intelligence provides some perspective on shipping cancelations, “we appear to be seeing a stabilization … the pace of new blank (canceled) sailings has clearly declined to suggest a belief from the carriers that volumes will slowly be brought back to normal levels” (see Figure 2). Rebalancing ship locations to meet cargo needs will importantly determine the speed at which trade can recover.

Figure 2

Impact of Coronavirus on Container Shipping

Canceled Sailings (Transpacific) Cancelled Sailings (Asia-Europe)

Source: Sea-Intelligence Note – Blanks Refer to Cancelled Sailings

Europe Most Affected by China’s Partial Shutdown

Figure 3 shows which economies will likely feel the greatest effect from China’s partial shutdown. Not surprisingly, supply chains feeding Europe and the United States followed closely by Japan could wind up with the greatest production bottlenecks in the near-term. Again, short supplies may lead to inflationary pressures on select parts and products, assuming the economy slows but does not decline.

Figure 3

Trade Impact of Coronavirus Epidemic by Country ($ U.S. Millions)

Sectors Most Impacted by China’s Partial Shutdown

For investors, determining which industries could experience the most disruptions from China’s partial shutdown will prove most critical. Figure 4 identifies those products most sensitive to China’s participation in the global value chains. The Grubel-Lloyd index used in this graph measures the intra-industry trade of a particular product. The higher the number, the greater the mix of both exports and imports for that product by China in trade. In one sector, automotive manufacturers announced production stoppages resulting from shortages of parts from China.

Figure 4

China Integration in the Global Value Chains by Sector

Source: Grubel-Lloyd Index

Virus Concern Impacts the Important U.S. Service Sector—Deflationary?

Services Dominate Manufacturing in the U.S. Economy

Manufacturing represents approximately 11% of U.S. Gross-Domestic-Product (GDP) compared to over 75% for services. As a result, understandable fear of the virus may affect demand for services more than delayed Chinese imports affect manufacturing. Fear could prove the biggest drag on the U.S. economy. (Please Google FDR on the subject of fear.)

Virus Sinks Travel Demand

Travel will be one major service sector where virus concerns will likely dampen demand. The International Air Transport Association recently doubled its estimated revenue losses for global airlines to between $63 and $113 billion. This loss would represent 10-20% of their revenues. Other sectors of the travel industry, such as cruise lines, would magnify those losses. The sharp decline facing the travel industry will bring deflationary industry pricing pressures. At the same time, intrepid travelers may find bargains.

China Declining New Virus Cases—What It Could Mean for the U.S.

Figure 5 shows a sizeable decline in the number of new people infected by the virus in China. If accurate, a similar expectation for this country could lead to diminished new virus cases by about mid-April. If that proves the case, it would likely reduce broader concerns about the virus and begin recovery for sectors of the service industry. However, until a vaccine can be widely delivered, consumers will likely remain cautious about travel, particularly outside this country.

Figure 5

Source: John Hopkins University, Worldometer, Dansk Bank, WSJ/Daily Shot

Investment Conclusions

The S&P 500 fell 12% from its all-time high on February 19th. In part, this decline reflects that the coronavirus epidemic creates a different form of uncertainty by providing less of a basis for determining macroeconomic economic forecasts and their resulting investment implications.

This uncertain environment, in our view, calls for a more selective investment approach. Rather than using broad-based ETFs, clearer investment judgments can result by limiting decisions to selected sectors and companies. Employ such selected investments within our recommended asset mix, which remains 40% equities, 35% alternatives, and 25% fixed income.

We continue to look to fixed-income investments primarily for capital preservation. Therefore, use shorter duration credits to meet that goal.

Overall, very accommodative monetary policies over the last decade encouraged increased borrowings by questionable credits. Therefore, balance sheet strength should prove key when considering both equity and fixed-income investments.