HOW WILL SARS IMPACT MARKETS? - THE WORST AND BEST CASE SCENARIOS

A special update from Shane Oliver, Chief Economist and Head of Investment Strategy at Henderson Global Investors - 24 April 03

It seems that no sooner has one problem resolved itself (ie. Iraq), another appears. If it is not contained soon, the SARS (Severe Acute Respiratory Syndrome) crisis has significant potential to disrupt global growth and equity markets.

The economic impact

So far the main economic impact has been through public panic. For example, in Hong Kong and Singapore people have been staying home and not spending on non-essential items. Travel to affected areas has also collapsed. As a result retailers, restaurants, hotels and airlines are being hit hard. Tourist arrivals to Singapore are down 60% for the first two weeks in April while hotel occupancy rates are down to 20% and are even lower in Hong Kong. Compared to other Asian countries, Singapore and Hong Kong are particularly vulnerable. Their economies are highly reliant on tourist spending and consumers' discretionary spending is normally high (as suggested by their high per capita GDP levels). Importance of tourism and discretionary consumption.

The impact on China has been less noticeable - partly because the epidemic has received less publicity (so spending is less affected). It also reflects that discretionary and tourist spending is far less important than in Hong Kong and Singapore. The contrast between China and Hong Kong is partly reflected by moves on their equity markets - Hong Kong is down 7.5% this year while Chinese markets are up 10% to 15% (though China's relatively stronger economic growth accounts for the bulk of the difference).

Getting a handle on the future economic impact of SARS is not easy given it will depend on how long the epidemic continues. We therefore, prefer to think in terms of two scenarios - either it ends soon or it doesn't!

1. Base case - worst is over within a few months
Under this scenario, containment proves successful and the number of new cases starts to decline. The crisis therefore, remains largely confined to China, Hong Kong, Canada and Singapore where there will be a temporary slump in demand as consumers stay at home and tourists stay away, followed by a recovery in the second half of the year. The impact on the major global economies and equity markets would be insignificant.

In Asia, the epidemic comes at a bad time as growth was already faltering in response to tenuous global conditions. Hong Kong was also suffering from an overvalued currency and loss of business to China. Within Asia, Hong Kong and Singapore are most affected both in terms of the number of cases and their vulnerability to weaker tourist and consumer spending. We have revised down our 2003 economic growth forecast for Hong Kong by 0.75% to 2.5%. Singapore will also see slower growth but hopefully less so. We have reduced our 2003 growth forecast to 2.7% (from 3%). Reflecting its size and less dependence on discretionary spending, Chinese growth is likely to be little affected. Overall, growth in Singapore and Hong Kong would likely recover in the second half of the year once the epidemic and related panic abates.

2. Worst case - containment is unsuccessful
Under this scenario the number of cases continue to grow spreading panic. The impact would be more than a temporary slump in demand. Supply lines would also be affected. The global economy would be knocked back into recession and global equity markets would lurch lower. The precise impact though, is open-ended and not worth even bothering to quantify.

Numerous variations are possible around these two scenarios. One possibility is that, while the epidemic is contained in most countries, China - which lacks the resources to deal with it - suffers a big outbreak. This could cause a major slump in Chinese growth (currently the one big source of strength globally) and impact Chinese goods production and hence global supply lines. Fortunately, while it is easy to dream up nightmare scenarios they rarely come to pass so we will stick with the base case for now.

SARS and Asian equity markets

Equity markets in Hong Kong and Singapore have already been affected by SARS and provided it is contained, are unlikely to fall a lot further. Looking at the region as a whole (and assuming the epidemic is successfully contained), Asian economies and equity markets remain highly geared to the US. With the US economy expected to continue its mild recovery and the US equity market likely to move higher, Asian markets look well placed. Over 2003, we expect non-Japan Asian equity markets to outperform other global markets modestly. They remain undervalued relative to the US and Europe, their economies should grow faster and a reduction in risk aversion globally should eventually see capital flows to the region pick up.

Conclusion

Analysing the likely impact of SARS is difficult given it is hard to get a handle on the ultimate duration and reach of the epidemic. The risks are clearly high. However, providing containment is successful, the economic fallout will be minimal and the impact on hard hit countries (notably China, Hong Kong, Singapore and Canada) will be a temporary slump in demand for a quarter or two rather than anything permanent. Once the epidemic and public panic abates demand is likely to quickly recover as life goes on.

For equity investors, SARS seems like just another link in a long chain of negative news. Provided the epidemic is contained soon, it should have minimal impact on global equity markets. The key remains the US equity market where we expect a further modest recovery this year.