Risk assets have been remarkably robust, with some equity markets touching new highs, even as the Delta variant of COVID-19 has spread worldwide. But we are increasingly anxious about the threat that Delta poses in China, which markets do not appear to be anticipating.
The country has adopted a zero-tolerance approach to coronavirus and has a relatively low rate of vaccinations. As the government is focused on using vaccines developed in China, which local authorities believe have fewer side effects but whose efficacy is yet to be proven, it has a strong incentive to keep fighting the virus with hard and potentially economic-disruptive lockdowns.
Although it’s early days, unfortunately the variant seems to have spread too far in the world’s second-largest economy to be easily contained with regional measures. Delta cases have now been reported in over half of China’s provincial-level regions*, including Beijing, and over 90% are now warning against unnecessary travel. Airline capacity in China has fallen by 10% over the past week as virus concerns started to spread.
This raises the prospect of the following scenario, modelled by our China guru Erik: the authorities come down hard and contain the virus within one quarter, just as we observed in early 2020. This could lower Chinese growth from a seasonally adjusted annual rate of 5% to zero over a three-month period, implying that full-year growth would fall from 5% to below 4% with the following knock-on effects:
• World and US growth would slow by 0.6% and 0.2% respectively. Note we took the 2015 China slowdown as the template here. The main reason US growth slowed a bit in this period is because oil prices more than halved in a short space of time, which led to an immediate collapse in US domestic shale-oil investment that previously had been booming. The benefit to the consumer took longer to come through.
• Emerging markets would probably be worse affected than the US and Europe, slowing by about 0.6-0.7%.
• Those in Asia would likely be the hardest hit, followed by Latin America and CEEMEA.
It’s worth noting that given the time lags, we would not expect an immediate policy response outside China.
All this could then be translated into global markets through the traditional channels of a slowdown in the world’s largest commodity consumer. The principal market impact would be via weaker commodity prices, in our view: that’s good news for Western consumers dealing with higher inflation, but bad news for corporates whose earnings are linked to the commodity cycle. We worry that the market will demand a higher risk premium, particularly on commodity-linked credits, if global growth slows in this way.
As a result, we are lightening our bullish stance on risk assets. With the S&P 500 close to an all-time high, we think this is a prudent step against the threat of this scenario playing out. Because we are reacting to a developing risk that only has the potential to be significant, this view change may have a relatively short shelf life. Six weeks from now, we will probably know whether the risk has crystallised or not.
Against our view, one could reasonably ask: why might stock markets panic over this variant in China when they are relaxed about its presence in the US?
We cannot say for sure how the market narrative will develop, of course. Delta risk in the US is unlikely to lead to lockdowns, in our view. The worst impacted states are also the most reluctant to impose restrictions. Florida is a good example. Hospitalisations there due to COVID-19 are now running at their highest rate since the pandemic began, but the state’s governor refuses to even consider a mask mandate. Markets can continue to focus on the light at the end of the tunnel given the pace and, just as important, the proven efficacy of vaccines in the US.
All this said, we are not turning completely neutral or even bearish on risk assets because our case for a medium-term bullish view remains in place: the global economy is in mid cycle, consumers have excess savings to spend, and central banks are still extremely supportive. While growth momentum is fading, research by our equity strategist Lars has suggested that this does not necessarily mean lower equities.
*China consists of 22 provinces, 5 autonomous regions, 4 municipalities under central government control (Beijing, Shanghai, Tianjin and Chongqing), and 2 special administrative regions (Hong Kong and Macau).