The writer is a senior fellow at Harvard Kennedy School
I recently asked some investment managers how they might immunise their portfolios against fallout from China’s coronavirus. “I wouldn’t,” one scoffed, “the virus is temporary.” Another rattled off some ideas but added “no one is actually positioning their portfolio that way”.
Investors have been conditioned to believe that disturbances such as mad cow disease, Sars, and now the coronavirus are temporary blips. Even if that proves to be correct, interruptions to global supply chains may cause greater problems for growth and markets than investors are expecting.
Signs of complacency about the coronavirus abound. According to Bank of America’s February global survey of fund managers, cash comprises only 4 per cent of portfolios, the lowest since March 2013. When investors are worried, they tend to hold more cash. Instead, they’ve been putting their money into global equities, which keep hitting record highs.
Investors appear to view the coronavirus like a minor traffic jam: disruptive but, in economic and financial terms, something you get past quickly. They are making two assumptions. First, the coronavirus will be contained shortly, pent-up demand will be released and its impact is therefore transitory. Second, if the epidemic isn’t contained quickly, policymakers will step in to fix the mess with actions that send asset prices soaring. Either way, buy the dip.
Chinese authorities are already throwing the proverbial kitchen sink at their economy. The Ministry of Finance, People’s Bank of China, and regulators have all announced measures to reduce the burden for firms and households. If the drag on growth is sustained or market turmoil spreads, investors assume other central banks will also act.
But what if the coronavirus fallout is more like sitting in traffic hours after an accident scene is cleared? Demand may recover quickly, but the supply side is much more problematic. Chinese firms are integrated into complex, global supply chains and the enthusiasm for “just in time” manufacturing, which involves thin inventories, leaves little buffer for disruptions.
Bottlenecks could develop as production ramps back up. Say one of the parts for your product comes from Hubei, the province at the centre of the coronavirus. To resume normal activities, factories must reopen and workers must travel back to them after being forced by the virus to extend their Lunar New Year holiday. More than one-third of China’s labour force are rural migrant workers. Then truck drivers must transport goods to the coast and ports must reopen. If any one of those steps is hampered, the factories might as well still be at least partially closed.
Large companies will use airfreight for their parts, but this will eat into margins. If the supply chain disruptions persist, smaller firms may have to find new suppliers or risk going out of business. This isn’t easy; if western firms had a simple alternative to China for inputs, the US-China trade war probably would have led to supply chain shifts already.
Hubei is a cog in global supply chains in autos, healthcare, electronics, aerospace and defence and construction materials. The outbreak has already pushed South Korean firms Hyundai and Kia to halt production.
Finally, there is a problem with relying on policymakers to clean up the mess. Their tools are designed to stimulate demand, not fix supply interruptions. “I’ve only been at the Fed for two years,” Richmond Federal Reserve Bank president Tom Barkin told me. “But to my mind, central banks can’t come up with vaccines.”
Most investors assume the coronavirus will be contained by late March and that, as winter ends, so will the epidemic. But we cannot be sure the outbreak has a natural peak. If the virus becomes a full-blown global pandemic, growth and markets will be hit much harder than investors are assuming.
So what can you do? While there’s much we don’t know about this disease, we do know it has increased uncertainty, and if you think it may be worse than Wall Street is wagering, there are cheap ways to insure against a market decline. Uncertainty tends to breed volatility, so one strategy is to buy the Vix index, which goes up with volatility. Another is to buy the Skew Index, which focuses on options that make money if there is a big fall in the stock market.
Another way to immunise your portfolio is to invest in safe haven assets, including the US dollar, Treasuries and precious metals. Prices for these assets have risen over the past two months, but they could go higher still if investors decide their wait-and-see approach is wrong. Consider shorting the Japanese yen, traditionally a safe haven asset, given the country’s high exposure to the coronavirus.
If you want to stay in equities, look to utilities, internet, education and — no surprise here — healthcare. Sectors to short include commodities, particularly oil, airlines, entertainment and luxury goods.
Investors may be right that this will be temporary. If your time horizon is several years, then it could make sense to look past the coronavirus. But temporary can last a long time and get much worse before it gets better. For shorter horizons, remember that there are effective vaccines for your portfolio that sadly do not yet exist for the virus itself.