Regina Chi is vice-president and portfolio manager at AGF Investments Inc.
The COVID-19 fear trade is in play. Global stock markets have been fluctuating between relief and fear along with positive or negative news about the coronavirus outbreak, which has spread from Wuhan, China, to South Korea (the country with the highest number of ex-China reported cases), Europe (including Italy, with hundreds of confirmed infections), the Middle East, the United States, Canada and South America. In fact, by the end of February, the number of new reported COVID-19 cases outside China was outpacing those inside the country – a sign either that China’s radical attempts to combat the virus within its borders are working, or that the coronavirus epidemic is fast becoming a pandemic.
It’s unclear how many people will ultimately be affected by COVID-19, or how many weeks or months it will take to run its course. If it holds true to similar epidemics, however, it will run its course. From an investor’s perspective, it is not too soon to look beyond headline-driven fear and ask what the long-term impact will be. Neither is it too soon to try to identify opportunities. In our view, those will most likely arise from the disruption of global supply chains that rely on China – a structural change that was already taking place, but to which the coronavirus event may add both momentum and permanence.
As grave as the COVID-19 outbreak has been in humanitarian terms, the response to it might have the bigger impact in economic terms. Compared with its handling of SARS in 2002-2003, the Chinese government’s efforts to contain this coronavirus have been restrictive and extensive. Wuhan and more than a dozen other cities are in quarantine, affecting about 50 million people and nearly 800 million people – roughly half of China’s population – are living under various forms of travel restrictions, according to CNN. Meanwhile, governments at all levels have introduced a raft of regulations, transport blockades, extended work holidays and mandatory factory closures.
These restrictions have put a tourniquet on supply chains. One Taiwanese company we spoke to has nearly 100% of its revenues originating in China, and according to management only 20% of its production is up and running; the CFO says that “there are so many new controls in place in various cities in China, preventing companies and people to resume normal activities.” At another company in which we have an interest, one executive told us that reopening its factory required seven government approvals. Depending on the success of the COVID-19 containment, unwinding the various restrictions affecting Chinese supply chains will take a significant amount of time, creating a bottleneck to the resumption of production.
Another will be labour. In much of China, manufacturers in cities rely heavily on workers from rural regions. In Wuhan – a major auto manufacturing hub – many migrant workers (no one can say for certain how many) returned to their homes for the Jan. 24-30 Lunar New Year holiday before quarantine was imposed on Jan. 23. Government controls and the fear of going outside have curtailed spending and many factories are not at full capacity due to a lack of staff with workers still in their hometowns or spending two weeks in quarantine. Even after the COVID-19 epidemic dissipates, we expect a large portion of these migrant workers will return to work in the second quarter, leading to labour shortages and lower than expected capacity utilization in the meantime.
For companies whose supply chains have relied heavily on China, this is a wake-up call. If they haven’t already, many will be forced to reassess their exposure to China and look elsewhere. Of course, this trend started long before the COVID-19 outbreak. Rising labour costs and an aging workforce have been two contributing factors; the U.S.-China trade war has been another. Other low-cost jurisdictions have been beneficiaries. For example, Vietnam, Taiwan, Singapore, India and Malaysia all gained export share in the U.S. market between December 2017 and the end of last year, as China’s share declined. Meanwhile, despite a generally stagnant economy, Mexico now has a current account surplus thanks to surging non-oil exports mainly to the United States.
Investment Opportunities
With COVID-19, global companies can now add the risk of a public health emergency to their list of reasons to diversify supply chains out of China. This will present opportunities for investors, especially in countries trying to take advantage – India, for instance, is aggressively trying to lure manufacturers with lower taxes– and in companies that have a head-start. One of those is South Korea’s Samsung Electronics Co Ltd., which moved its major mobile production site to Vietnam five years ago. As well, Samsung has low sales exposure to China – its smartphones account for less than 5% of mobile revenues– so any impact from contracting Chinese demand will be relatively limited.
Eclat Textile Co. Ltd., a Taiwanese garment manufacturer that includes some of the world’s biggest sportswear brands as clients, was also an early mover to Vietnam and closed its only Chinese manufacturing base in Wuxi at the end of 2016. It also has facilities in Taiwan and Cambodia and recently announced plans to build a plant in Indonesia.
Clearly, China’s importance in a globalized economy has grown significantly since the 2002-2003 SARS outbreak, the most obvious precedent for today’s crisis, that originated in the Guangdong province of China and spread to more than two dozen countries. Seventeen years ago, China comprised less than four percent global GDP; today, it accounts for more than 15%. Yet no trend lasts forever. China’s pre-eminence in global supply chains is eroding – and the COVID-19 outbreak will accelerate the shift.
AGF owns stock in Samsung Electronics Co. Ltd. and Eclat Textile Co. Ltd.
The views expressed are those of the author and do not necessarily represent the opinions of AGF, its subsidiaries or any of its affiliated companies, funds or investment strategies. References to specific securities should not be considered as investment advice or recommendations.