Containment Fail

We want to share a few observations about the growing COVID-19 epidemic, based on what we have seen so far. It has been obvious for a while now that the attempt to contain the spread of the virus has essentially failed. Ever since case numbers started to soar in South Korea, Italy and Iran, it was clear that hopes that the outbreak would remain confined to China were misplaced.

Double-plus-ungood micro-organism COVID-19 looking for cells to infect

While it appears that the draconian measures taken by China’s government have managed to slow the spread of the infection in the country substantially (the caveat is that it is hard to say how reliable the data released by China are), the outbreak is accelerating everywhere else. It does not appear to be containable, we, therefore, expect governments will begin to adopt mitigation strategies.

At the time of writing the chart depicting total cases outside of China looked like this:

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Total cases outside of China; at first the growth rate seemed manageable, but not anymore. A comprehensive up-to-date collection of COVID-19-related charts and data.

Known and Unknown Problems

This is the situation as we see it:

1. it is now an out-of-control pandemic, regardless of what the WHO wants to call it since it is spreading quite quickly all over the world.

2. one cannot take comfort from the fact that some countries are still reporting very low case numbers, as this is often merely the result of a lack of testing. Particularly in the US testing has so far not been undertaken on the scale this situation demands (as reported by Mish here, actions taken by the CDC and FDA seem to have led to a delay in the availability of testing kits).

3. the biggest known problems with the virus are:

A) it is highly transmissible and people can transmit the infection even while they are still

B) the incubation period generally ranges from 2 to 14 days, but in outlier cases, it can last up to 27 days. This fosters the spread of the infection and suggests lengthy quarantines will be necessary for people suspected of being infected.

C) existing tests are not very reliable – false negatives appear to happen quite frequently and quite a few patients who initially tested negative were found to test positive in a second test.

D) worst of all: around 18-20% of the cases are serious enough to require hospitalization and presumably some form of breathing assistance (blood oxygen saturation levels of these severe cases are reportedly in the 60s; unless oxygen is administered this is fatal). Most if not all health care systems in the countries concerned will be overwhelmed.

As an example, England has just 15 beds for treating severe respiratory problems (i.e., for adult extra-corporeal membrane oxygenation) – at most 28 beds can be made available in a pinch. This was recently revealed during question time in the House of Commons. The conclusion from this is that many people will not get the treatment they actually need – medical assistance will have to be rationed (a term we will see popping up more frequently in the future is “triage”). This, in turn, will tend to push up mortality rates.

4. there are still many unknowns – we believe the most worrisome of these is that a second infection may well trigger a severe immunopathological response and as a result could be far more dangerous than a first-round infection. A 2012 paper that discusses a study of SARS vaccines (h/t Chris Martensen of Peak Prosperity) suggests that this problem may well rear its head. Here is a link to the paper: Immunization with SARS Coronavirus Vaccines Leads to Pulmonary Immunopathology on Challenge with the SARS Virus

We quote from the conclusion:

These SARS-CoV vaccines all induced antibody and protection against infection with SARS-CoV. However, challenge of mice given any of the vaccines led to occurrence of Th2-type immunopathology suggesting hypersensitivity to SARS-CoV components was induced. Caution in proceeding to application of a SARS-CoV vaccine in humans is indicated.

(emphasis added)

In a nutshell: once the immune systems of the mice were trained to recognize the SARS virus (a corona-virus closely related to COVID-19), they went haywire when encountering it again – to the extent that fatal complications in the lungs of the test animals were triggered. The vaccines proved effective against SARS, but the immune system response proved deadly.

If COVID-19 has similar characteristics, developing a safe vaccine may turn out to be quite difficult. Of course, we don’t know yet if that is the case, but information on how reinfections develop should be forthcoming fairly soon.

5. final remarks: one should not make the mistake of believing this to be “no worse than the flu”. Apart from the rather obvious fact that China isn’t shutting down completely every time the flu season comes around, here is a list of the main differences: COVID-19 is not like the flu. Also, the eventual mortality rate remains unknown at this stage. Even in a best-case scenario it is certain to be far higher than that of the flu, but we are not likely to get a best-case scenario. An excellent discussion of mortality rate calculations and forecasts can be found here.

Economic and Financial Impact

The economic impact of the epidemic is going to be temporary, but it is not yet foreseeable just how temporary. What is certain is that if drastic steps are taken to slow down or stop its spread, the impact is going to be severe.

This was just demonstrated in China. Below are charts of China’s most recent PMI releases (both manufacturing and services PMI) – file under “as bad as it ever gets”:

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China’s manufacturing PMI fell to 35.7 points, while the services PMI slumped to an even worse 29.6 points. Presumably, it would take an asteroid strike to generate even worse readings.

China is a rather important cog in global manufacturing supply chains, so this would have reverberated across the world even if the epidemic had remained confined to China. Alas, one must fear that similar economic disruptions will eventually be seen in numerous industrialized countries.

In the financial markets arena, the greatest problems are likely to emerge in credit markets, particularly in corporate credit. According to the BIS, so-called “zombie corporations” represent an estimated 12% of the world’s corporate debt issuers. These companies depend on gullible investors continually refinancing their debts in order to muddle on – during boom times, that is.

If we were to take a stab at guessing what investors (even otherwise gullible ones) are likely to do if/when half the world releases PMI data similar to those shown above, refinancing the debt of zombies will probably not be at the top of their list of priorities. It seems more likely that most of them will speed-dial “1-800-GETMEOUT”.

And while the stock market provided some relief to punters with its smart rebound on Monday after last week’s merciless shellacking, we caution that this rebound may be a limited affair. This is a richly valued market to put it mildly, and our warning from early February on US stock market sentiment and positioning should not necessarily be dismissed as being only of short term significance.

As a reminder, here is what we said in our conclusion:

“[…] current sentiment and positioning data strongly suggest that a sizable setback may be at hand. This does not depend on Corona virus-related news: in fact, if a short term advance coincides with an improvement in the news backdrop on the epidemic, the market will likely end up in an even more vulnerable position. We believe one should be very cautious in coming days and weeks, refrain from chasing rallies and think about ways to protect existing positions.”

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Dow Jones Industrial Average, daily – a rally to a new high in early February, followed by a veritable massacre. It remains to be seen how far the recent rebound will go, but it should be noted that such huge one-day rallies are often hallmarks of bear market conditions.

As it happened, the market did resume its advance in the short term (despite the virus-related news backdrop failing to improve) and “an even more vulnerable position” was the result. Many of the positioning extremes we showed went to even more extreme levels in the process – and such rare outliers are often associated with long term market peaks. We plan to post more on this subject shortly.

Conclusion

It seems to us that one would do well to consider the situation to be potentially quite serious and prepare on a personal level for possible supply disruptions and other unpleasantries. We hope of course that things will turn out better than we currently fear, but one can no longer blindly rely on such hopes.

Meanwhile, investors and traders should expect even more market turmoil in the weeks ahead, especially if the economic impact of the epidemic threatens to become more protracted and severe than is currently assumed. Caveat emptor definitely remains the watchword.

Charts by worldometers, Bloomberg, stockcharts