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Alibaba CEO Daniel Zhang described the epidemic and resulting widespread quarantine as a Black Swan event. Is he right?
And if he is, what can you as an investor do about it?
A black swan event is one that is difficult if not impossible to predict. In addition, it strikes out of the blue and it takes markets and investors time to even realize its impact.
What is a Black Swan Event?
A black swan event is a term used on Wall Street that refers to a rare and unpredictable occurrence that is beyond what is expected and has severe consequences to economies.
It's derived from European explorers who had previously thought that all swans were white. They were overcome with shock and confusion when Dutch explorer Willem de Vlamingh discovered the existence of black swans in Australia.
Let’s take a closer look at how you can get better at seeing black swans, assess the potential downside of the 2019 novel coronavirus (or Covid-19) virus in China and look at a few strategies to hedge this growing risk.
The great value investor Howard Marks points out that most people are first-level thinkers and that applies to most investors and the majority of the financial gurus and pundits.
This has nothing to do with intellect. Rather, most people are either just too busy or not interested in going deeper.
And the people that do have a keen interest in foreign relations have strong career and economic incentives not to rock the boat nor get out of their lane.
First-level thinking is simplistic and superficial. After all, the first-level thinker needs only an opinion about the future.
Regarding the Chinese economy, stocks and most recently the coronavirus, first-level thinking is not worry; this is just another bump in the road.
Or alternatively, Chinese stocks are going to crash and burn, so sell everything now.
Both approaches miss the mark by a wide margin.
This brings me to second-level thinking, which is deeper, more complex, and more helpful and challenging in navigating this age of US-China rivalry.
"What is the range of likely future outcomes?"... "Which outcome do I think will occur and what’s the probability I'm right?"... "What is the consensus opinion?"... "How and why does my thinking differ from the consensus?"... “What are the potential strategies and tactics?
These are the kinds of questions the successful second-level thinker asks but this is only worthwhile if the thinking is backed by history, facts and personal experience.
From the business angle, Clayton Christensen, the Harvard Business School professor who regrettably passed away in early 2020, saw China as a disruptive force.
Christensen’s brand theory was how great leading companies often get killed by competitors who come in on the low end in terms of price and quality and then move up the food chain to beat the leader.
Doesn’t this sound like China to you?
Another key ingredient to seeing through the China fog is a sense of history. Not just reading history but the ability to apply history to gain insight on likely future outcomes.
John Dos Passos put it well in his timeless “Use of the Past” essay:
“In easy times history is more or less an ornamental art, but in times of danger we are driven to the written record by a pressing need to find answers to the riddles of today.”
Thucydides noted that “the events of future history … will be of the same nature—or nearly so—as the history of the past, so long as men are men.”
This brings us to a crisis, which emerged in Wuhan, China in 1911.
Protestors opposed to foreign control of China’s railways charged a military garrison, easily defeating imperial army defenders and exposing the fragility of the ruling Qing dynasty.
Known as the Wuchang Uprising, this protest virus quickly spread.
Just three months later, the Chinese Revolution toppled the Manchu rulers leading to the establishment of the Republic of China.
A century plus later, Wuhan is at the center of the coronavirus outbreak, and while the probability of total pandemic remains low, it has the potential to be just as revolutionary.
The rapid spread of the virus is exposing weaknesses in the Communist Party’s hold on power as well as tarnishing China’s global brand.
But the impact of the spreading coronavirus has to be viewed against the backdrop of a host of other trends that are going the wrong way for China.
Here are just some of the troubling signs that keep appearing about China’s weakening economy and rising political turbulence:
economic growth is slowing
Hong Kong unrest is weakening confidence in Beijing
Wuhan virus is spreading
the Yuan is weakening
manufacturing is weakening
wages and debt are soaring
competitors are rising
export margins are shrinking
property bubble is popping
trade wars are brewing
protests are spreading
investment returns are falling
capital flight is increasing
financial system is cracking
political infighting is rising
widespread corruption is being uncovered
consumer inflation is rising and underestimated
China’s seeds of success have turned into millstones. Its success formula is not working anymore.
Textile manufacturing is moving to places like Bangladesh and Sri Lanka where labor costs are much lower.
Western multinationals are also looking at cheaper manufacturing bases like Vietnam, the Philippines and Indonesia and also are moving some production back to America to be closer to markets.
Kirk Yang, Managing Director of Barclays Capital comments that “The so-called cheap labor model has created a lot of problems and is not working anymore.”
Peter Chen, sales manager at Hua Hai Toys stated that for the first time, buyers are asking for the right to return unsold products.
A recent survey by New York consulting company Panjiva found that more than half of American importers interviewed were interested in new suppliers and in particular, those from India, Thailand and Vietnam.
China’s attractiveness as a low-cost base for global manufacturing is also less compelling given all the logistical issues that go along with supply lines spanning the Pacific.
AlixPartners studied five manufacturing segments over a five-year period and found that China’s pricing advantage for exports arriving in Long Beach, California relative to domestic prices have declined from a 22% advantage to a sizable disadvantage relative to North American competitors.
Taking everything under consideration, Mexico is now a better manufacturing hub than China for companies selling into North and South American markets. And Bangladesh and Vietnam offer manufacturing wages 30-50% of Shenzhen China.
This week, Niall Ferguson, author of the international bestseller The Ascent of Money stated that he's long America, short China… and shared his insights on why China represents the epitome of this massive debt bubble.
Mandarins in Beijing are desperately trying to quarantine major cities, including Wuhan, as more people already have died on the mainland from the coronavirus than from the 2003 SARS epidemic.
The death of the martyr Dr. Li Wenliang, who tried to warn about the outbreak but was threatened by authorities, has infuriated many, threatening the social stability and the party’s control.
In response, Secretary Xi has ordered the lockdown of 50 million people.
On February 13th Hubei province, with Wuhan a city of 11 million at its center, announced 14,840 new confirmed cases, a sharp rise due to including scans.
In contrast with the post-1978 era of “reform and opening up” under Deng Xiaoping, Mr. Xi’s China was becoming more repressive, secretive and nationalistic even before the epidemic.
All this calls for a much more-measured assessment of China’s strengths and weaknesses as a rival to America both in Asia and the world. If this virus continues unchecked, it may have more damaging effects than many expect.
Below are some data points and anecdotes regarding the extent of the economic impact of the virus.
The Economist reports that provinces accounting for more than 90% of Chinese exports have kept factories either shut or running at low capacity since January 31st, when the lunar new-year holiday was due to end.
In addition, coal consumption is more than a third lower than the average and property sales are down by more than 90%.
After the holidays, roughly 200 million people usually leave their hometowns to return to work. This year the returning trains have been nearly empty and city officials have warned that returnees might face 14-day quarantines.
Nine out of ten companies surveyed by the American Chamber of Commerce in Shanghai have employees working from home and Starbucks has shut half its 4,500 cafés in China.
It should also be noted that the global economy has changed since 2003, when SARS hit the Chinese economy hard. China now accounts for 16% of global GDP, up from just 4% back then.
And China is now the world’s largest exporter and second-biggest importer, and its manufacturers have also become entwined in supply chains of staggering complexity.
Plus just-in-time production leaves little room for delays and many firms cannot trace all their suppliers, making it hard to predict the impact of work stoppages in China on their output.
Because of parts shortages, Hyundai (KSE: 005280 / OTC US: HYMTF) has halted some car production in South Korea as has Nissan (TSE: 7201 / OTC US: NSANY) in Japan. Nintendo (TSE: 7974 / OTC US: NTDOY) has delayed shipments of new gaming devices.
Foxconn (TWSE: 2354), which makes smart phones for both Apple (NASDAQ: AAPL) and Huawei (SZSE: 002502), has re-opened some its factories but with minimal staffing. And these are just the brands you have heard of.
Recruitment site Zhaopin said this week that around 10% of firms they surveyed were “on the verge of death,” with around 30% planning job cuts and another 30% saying they could not pay their employees on time...
In 2003, which included the severe acute respiratory syndrome (SARS) outbreak, around 8 million people lost their jobs, according to official Chinese data, although real job losses may have been much higher because government data did not cover most migrant workers (290 million).
According to Caixin, even before the outbreak, many small businesses were already struggling with shrinking sales as China’s economy logged some of its slowest growth in decades. Many must be facing liquidity issues, and large numbers say they are having difficulties just paying salaries.
A survey of 995 small and midsize companies conducted by Tsinghua University and Peking University after the outbreak began showed the vast majority couldn’t survive for more than three months with their current savings. About a third said they could survive for only one month, and another third said they could survive for two months.
Then there is the potential impact on China’s banking system, already under pressure before the crisis.
The Financial Times reports that a prolonged crisis in which factories and shops are unable to do business could treble non-performing loans, according to S&P Global Ratings, as companies struggle with repayments.
Bad debt across the banking system could rise from less than 2% at the end of last year to 6.3% of total assets, S&P research shows — a level not seen for two decades.
Bloomberg reports that Alibaba Chief Financial Officer Maggie Wu told investors that the company’s China retail and local consumer businesses would be hit hardest by the impact of the coronavirus.
Both will bear the brunt of lower demand and the high challenge of delivering products. She also stated that revenue and commissions will likely decline.
So what should global and China investors do with this potentially black swan event looming over their portfolio?
The worst thing you can do is to go out and sell all your stocks.
Rather, I suggest you take the following steps.
First, and this is directed to active investors, take some profits off the table by selling a portion of your more aggressive stock positions that have done well over the past couple of years. This locks in some profits and raises some cash for flexibility down the road.
Second, to hedge your China exposure, why not add to your portfolio a small position of ProShares Short FTSE China 50 (NYSE: YXI). This exchange-traded fund (ETF) moves opposite the China index.
These inverse ETFs, which move up when the index declines, act like a portfolio shock absorber.
Third, shift into the highest quality China stocks such as Alibaba (NYSE: BABA), which just released its most recent financial report.
Revenue for Alibaba's core commerce business revenue increased +38% while Lazada (Southeast Asian e-commerce business) posted a +97% year-over-year increase.
Taobao (China's consumer-to-consumer platform version of eBay) increased monthly active users by +100% year-over-year and Alibaba's cloud segment increased revenue by +62% year-over-year.
Tmall Global, which imports products from international brands, saw growth of +45%.
On the other hand, the company’s view is that the outbreak of the coronavirus over the past three weeks has affected BABA in two ways:
For a company of its size, BABA is a remarkable growth stock and is a great core holding for those looking for exposure to the rising Chinese consumer class. I would be a buyer even in the wake of the current coronavirus scare.
In closing, I advise you to keep calm but to avoid panic by taking action to hedge against potential Black Swan events. The goal should always be to both protect and grow your portfolio.
Carl Delfeld, Contributor
for Investors News Service
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DISCLAIMER: Investing in any securities is highly speculative. Please be sure to always do your own due diligence before making any investment decisions. Read our full disclaimer here.
Wall Street Journal: https://www.wsj.com/articles/life-in-coronavirus-lockdown-we-can-make-it-through-this-11582194602
Financial Times: https://www.ft.com/content/cb8a2fca-5465-11ea-8841-482eed0038b1
Caixing Global: https://www.caixinglobal.com/2020-02-13/in-depth-epidemic-poses-existential-threat-to-small-businesses-101515049.html