One way to immunise your portfolio to Coronavirus

Coronavirus has thrown an ‘unknown unknown’ into the mix of the global economy, being both a demand and supply shock of significant magnitude. Importantly for Australia, it places pressure on our singular mega trade partner in China. We all know the Chinese financial system is highly leveraged, making it susceptible to nasty financial outcomes on large shocks.

China recently completed its annual banking stress tests, with last year’s exercise envisaging annual economic growth slowing to as low as 4.15% − a scenario which showed that the bad loan ratio at the nation’s 30 biggest banks would rise five-fold. 

Analysts now estimate that the outbreak could send first-quarter growth to as little as 3.8%, at a time when Chinese banking is already suffering record loan defaults, as the economy last year expanded at the slowest pace in three decades under the trade war.

Australia is entwined in the performance of the Chinese economy, with the virus already hitting the iron ore price (and that’s worth 4% of GDP) and heavily impacted Chinese tourism and education (almost 1% of GDP).

How long can Chinese businesses hold on with little cashflow as production capacities lay idle? 

Which other global businesses will be affected with significant supply blockages or eroded demand? The economic consequence of a disorderly credit environment in China has always been JCB’s biggest market black swan when looking at our own scenario analysis work. 

That prospect is very real as this virus sweeps through the Asian region.

2020 started as a year of optimism for the global economy, with the AUD above 0.70 US cents. Fast forward to early February and the AUD has hit an 11 year low versus USD, and combined with global sovereign bonds produced more than 7.00% return in January alone. 

Markets are concerned about the outlook for Australia in a global economy riddled with coronavirus impacts. JCB still expects the AUD to continue lower over 2020 (this has been our long-held view), and this material drawdown in the Chinese economy will likely expedite that outcome. 

Given the long incubation periods of coronavirus, we are only now seeing other cases pop up across the world. We might only be in the eye of the virus storm. 

One way to immunise your portfolio to Coronavirus

Finding protection to help balance portfolios is often the source of significant investor debate. Should that be bonds to ‘defend and protect’, or long volatility positions, maybe investors should own gold?

In current markets, investors could be forgiven for thinking owning dividend-paying stocks is good enough, given the enormous central bank support that is seemingly being unleashed at every material market problem.

We have previously written about using currency combined with bonds, noting a paper authored by Bank of England and European Central Bank staff looking at currency entropy (that is, which currencies slingshot under duress).

The finding of that paper suggests the AUD is the biggest underperformer in stress, something we have witnessed already during January this year. 

We noted that holding high-quality bonds in USD was one of the best allocations for Australian investors during the GFC, producing staggering positive returns around +70% (whilst equities drew down -39%).

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