Pricing the coronavirus

| February 28, 2020

This document is intended for institutional investors and is not subject to all of the independence and disclosure standards applicable to debt research reports prepared for retail investors. This material does not constitute research.

Pricing the coronavirus has required weighing things known and unknown, with unknowns winning so far. But the base of knowns is getting better. The World Health Organization’s regular briefings continue to clarify the course of the illness, and its recent joint report with China indicates the epidemic there is abating. If recent knowns hold for countries with new coronavirus cases, risk premiums in the market should fall. The biggest risk may be from public and private measures taken before the course of the illness becomes clear.

Some key things known so far about coronavirus

The new WHO-China report shows the epidemic there peaked between late January and early February and started to decline even though the virus continues to spread to other countries. In recent days, China has reported as few as 10 new cases outside of Hubei province, where the epidemic began. Private companies also report signs of falling risk. Starbucks, for example, has reopened 85% of stores closed earlier because of the virus. China as of February 28 reported 78,959 cases to WHO including 2,791 deaths. In a population of more than 1.4 billion, that represents an infection rate of 0.0056% with a mortality rate of 3.5%.

Outside of China, WHO reports 4,351 cases with 67 deaths in 49 countries. That includes a recent surge of cases in Italy, Iran and Korea. WHO has sent a joint team with the European Centre of Disease Prevention and Control to Rome to assess the situation in Italy, and WHO is also sending a team to Iran. WHO sees the risk of coronavirus spreading as very high, and efforts to contain the virus outside of China may not match China’s experience. In a population outside of China of 6.3 billion, the current infection rate stands at less than 0.0001% with a mortality rate of 1.5%.

Understanding of the virus, its transmission and detection continues to improve. WHO recently reported no significant change in the DNA of the virus, addressing concerns about difficulty in developing a vaccine. WHO also reports that transmission comes from close unprotected contact with an infected person. WHO noted no reports of airborne infection and said it “is not believed to be a major driver of transmission based on available evidence.” WHO has also started helping countries worldwide develop lab capacity to test for the coronavirus.

The US has seen person-to-person spread of the coronavirus among close contacts of returned travelers from Wuhan, a city in Hubei province, according to a recent briefing from the US Centers for Disease Control and Prevention. But at this time, the virus is not spreading in the US. The CDC considers the immediate health risk for the general American public to be “low.”

Some key things unknown so far

Rates of infection and mortality can vary significantly if the numbers leave out patients without symptoms. Even though the recent WHO-China report included those patients, many may not have shown up at doctors’ offices or hospitals. Final estimates of mortality also usually involve weighing other contributing factors.

Even if the WHO-China report proves conclusive for China, rates of infection and mortality could be higher or lower for other countries depending on population density, poverty, public and private prevention and health systems. WHO studies of mortality from the flu shows significant differences across geography with rates in sub-Saharan Africa, for instance, 3.7 times higher than Europe and rates in South-East Asia 2.4 times higher.

Bounding the economic impact

Market response to the virus should reflect the economic impact, among other things, although that is highly uncertain for now. The World Bank in the past has tried to estimate the GDP impact of a broad person-to-person pandemic (Exhibit 1). Part of the impact comes from mortality, which the World Bank study assumed matched the Spanish flu epidemic of 1918-1919 with the death of 1.08% of the world population. Part of the impact comes from people staying home from work, which the study assumed included 35% of the world population out for up to three weeks depending on severity of illness. The biggest impact comes from efforts to avoid infection such as reducing air travel, mass transit, tourism, dining and retail shopping. With estimates for infection rates and mortality much higher than current data show for the coronavirus, the World Bank study estimated a loss of 3.1% of annual world GDP.

Exhibit 1: The World Bank in 2006 estimated a 3.1% GDP loss from pandemic

Source: Burns, A., D van der Mensbrugghe, H. Timmer (2006), Evaluating the Economic Consequences of Avian Influenza, Table 3.

Apart from the absolute potential loss, the World Bank study highlights the impact of public and private efforts to avoid infection.

Reflecting a readily available narrative

The market seems to reflect an easily available narrative of epidemic. Search Google for “movies about…,” and the first choice is “movies about pandemics.” It is an often and easily imagined storyline. Absent good information on the course of the coronavirus, the market should trade to worst imagined case. Briefings by the WHO, the CDC and other credible sources start to fill in detail.

The arc of epidemic in China suggests it could take another three months to six months for market risk premiums to materially fall. The epidemic started in December, according to WHO, peaked in late January or early February and now shows signs of receding. A similar pattern could play out in other countries.

Relative value

Rates and spreads both reflect flight to quality and liquidity. MBS will have to manage a wave of refinancing triggered by the move to lower rates. Corporate credit will have to manage new elevated risk in sectors most exposed to falling commodity prices, disrupted supply chains and default risk in borrowers affected by these factors.

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The view in rates

The narrative of contagion keeps forcing US rates down to worst-case levels. The current 1.17% rate on 10-year Treasury debt implies an average real rate of -0.26% and inflation of 143 bp. Futures now imply a better-than-even chance of a 25 bp Fed rate cut by March and three more through 2020. Both the Fed and fundamentals are likely to be different, but global flight to quality is likely to keep rates low until the market gets better information about the course of the coronavirus

The view in spreads

Investors have clearly stepped back at times to watch the coronavirus play out. The US economy looks healthy enough to keep credit concerns at bay for investment grade companies and even most high yield companies, so spreads have room to compress further once uncertainty around the virus drops. Prepayment risk should keep pushing MBS spreads wider, and MBS should underperform credit.

The view in credit

The immediate risk in credit is from companies with high fixed costs and a sharp drop in revenue from current efforts to avoid coronavirus infection. Companies with the highest leverage are first in line. As for the consumer, that is a story of generally continued strength with low unemployment, strong income, rising net worth and low debt service as a share of income.

john.killian@santander.us 1 (646) 776-7714

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