I’ve been contemplating how we should think about the stock market reaction to the virus. One possible way to contemplate the chaos of the last few weeks is to think about waves of reaction i.e the first order followed by the second order of reaction.

So, the first order of reaction was simply the immediate reaction to putting an economy into cardiac arrest. This triggered the first 15 to 25% reaction. The second order or wave was the realisation that the impact of the virus would carry on increasing as the weeks went by, piling on the agony. The market is now in this phase as it tries to work out the likely duration of the shutdown. In recent days investors have begun to sense that we are closing in on the peak and sentiment has steadied.

But the next wave, the third order, is about to hit us. This wave is the after effect wave as the ripples of distress move through the economy. We’re likely to see credit crises and liquidity crises, even after massive fiscal and monetary easing.  This wave, the third order of magnitude is only know being figured out and explains why we need to think through an additional second wave of selling, with possible 10 to 25% declines.

After this third wave we then encounter a penultimate wave, the fourth order effects. These are based around geographical knock on impacts. As I’m about to explain China is a good test bed. Its dealt with the first three phases (assuming there isn’t a credit crisis) but its not getting the blow back/washback from the wider global economy tanking. Our version of this will be when the virus cuts a swathe through the developing world, prompting all sorts of issues we can only worry about.

The last wave is the most dangerous. Its when the economic and social impact has played out largely but the political fall out intensifies. We’ve already seen a hint of this with the Saudi Russia oil standoff. But future – within 18 months – political knock on effects could be legion. Last week, on Friday, I mentioned Albert Edwards of SG worrying about the possible implosion of the Euro zone. My own concern is that revisionist powers such as Russia might try and push their luck with a military gambit against weakened Western powers. The stockmarket impact of this could be hugely variable and uncertain.

So, in my reckoning we are only just moving out of phase two into phase three, the third order effects. What impact will my others waves have? Some may happen concurrently, others consecutively. Or both.

One useful measure is to look at what’s happened so far, in that it is already pushing towards the fourth phase i.e its now suffering from the blowback of the rapidly collapsing Western economies.

In this analysis its useful to point o a short report out today from analysts at index firm S&P Dow Jones.  Priscilla Luk, Managing Director, Head of Global Research & Design, APAC notes that in China the first wave resulted in China A Shares falling by 14.2% between Jan. 20 and Feb. 3, 2020, when the number of new cases of coronavirus infections in China was on the rise. However, the market has recovered most of its losses since Feb. 3, 2020, as a result of government stimulus packages and improved investor sentiment due to a slowing domestic infection rate.

She’s also broken down that first and second phase decline (and recovery) by sector.

“During the market decline between Jan. 20 and Feb. 3, 2020, the vast majority of industries suffered losses; however there was a significant spread in industry returns, from 3.2% to -17.9%. Health care equipment, health care technology, and biotech were top-performing industries due to the threat of the outbreak; As cities in China were locked down and travel was restricted to control the outbreak, airlines, retailers, restaurants, and hotels took a hard hit, while companies in interactive media, internet retail, and food and staples retailing were least affected. Semis, software, electronic equipment, and tech hardware companies were also less hammered by the domestic virus outbreak and they were among the top performers during the market rally between Feb. 3 and Feb. 20, 2020, when coronavirus infection rates slowed in mainland China.”

Now though China is experiencing the fourth order effects I mentioned. Just as China is about to recover its economy is now being buffeted by collapsing international demand. Again, looking at S&P Dow Jones numbers based on companies in the S&P Total China Domestic BMI, electronic equipment, household durables, semiconductors, auto components, and tech hardware are the largest industries with the highest high foreign revenue exposure, ranging from 29.9% to 58.7%.

By contrast sectors such as interactive media, real estate management, and wireless telecom services have low exposure to foreign revenue, ranging from only 0.8% to 2.5%, and their revenues are dominated by domestic demand.

The chart below really nicely sums up the reaction of the markets in both the US and China to the stream of bad news about the virus.

US based fund manager Wisdom Tree have also put out an interesting note about the second and third wave as the Chinese economy takes a hit. Some useful stats here:

• Daily coal consumption is around 80% of the normal level, while 65% of migrant workers have returned to their place of work.
• Although mass transit journeys remain 70% below normal, strict quarantine arrangements are being loosened rapidly by local authorities across China.
• Overall consumption is at 85% of normal levels, while online spending is back to normal levels. However large ticket items like autos and home sales and travel related categories remain well below normal levels. Since auto retail sales account for 10% of total retail sales we expect to see further stimulus to help support demand.
• The economically important coastal province of Jiangsu is aiming for the full opening of all schools and colleges by April 13.
• Museums and some national restaurant chains that have been closed since late January are also beginning to re-open.
• After declining to a record low of 35.7 in February, the official Purchasing Managers Index (PMI) rebounded to 52 in March, according to National Bureau of Statistics, signalling that the world’s second largest economy is getting back to work.

This last chart above is I think really quite interesting. I’m particularly struck by how the relevant Chinese equity index moves (mostly) in sync with the China Manufacturing PMI. Bar one period, it almost moves in sync. Now that the PMI numbers have really bounced back maybe we have undervalued Chinese equities even after the bounce back? Then again maybe we should now be very careful about fourth and fifth order after shocks?