01 April 2020
What could the coronavirus mean for the global economy?
By Philip Carlson Zlizak, Martin Reeves and Paul Schwartz
March 03, 2020
After Covid-19 was largely ignored as it spread across China, global financial markets reacted strongly last week when the virus spread to Europe and the Middle East, raising fears of a global pandemic. Since then, the risks of Covid-19 have been priced so aggressively across various asset classes that some fear a recession in the global economy is a foregone conclusion.
In our conversations, business leaders are questioning whether the market slump is really indicative of a recession, how bad the Covid-19 recession is, what the scenarios are for growth and recovery, and whether there will be any lasting structural impact from the unfolding crisis.
In truth, forecasts and indicators will not answer these questions. Hardly reliable in the quietest of times, GDP forecasts are questionable when the course of the virus is unknown, as are the effectiveness of containment efforts and the reactions of consumers and businesses. There is no single number that reliably captures or predicts the economic impact of Covid-19.
Instead, we should take a closer look at market signals across asset classes, recession and recovery patterns, as well as the history of epidemics and shocks, to glean insights about the future course.
What the markets are telling us
The brutal decline in global financial markets last week may seem to indicate that the global economy is on its way to recession. Valuations of safe assets have risen sharply, with premiums on long-term US government bonds dropping to a record low of minus 116 basis points – that’s how much investors are willing to pay for the safe haven of US government debt. As a result, mechanical models have raised the risk of recession.
However, a closer look reveals that stagnation should not be seen as an imposed consequence.
First, take valuations of risky assets, as the impact of Covid-19 has not been uniform. On the benign end, credit spreads rose significantly, indicating that credit markets are not yet anticipating funding and financing problems. Stock valuations are clearly down from recent highs, but it’s worth noting that they are still high relative to their long-term history. On the other end of the spectrum, volatility signals the biggest pressure, intermittently putting next month’s implied volatility on a par with any of the major disruptions in the past 30 years, outside of the global financial crisis.
Second, while financial markets are a convenient indicator of a recession (not least because they can cause it as well), history shows that bear markets should not be confused with a recession. In fact, overlap is only about two out of every three bear markets in the United States — in other words, one in three bear markets is not a recession. Over the past 100 years, we have counted seven such cases where bear markets have not coincided with recessions.
There is no doubt that financial markets are now attributing significant disruptive potential to Covid-19, and those risks are real. But the differences in asset valuations underscore the great uncertainty surrounding this pandemic, and history warns us against drawing a straight line between selling in the financial markets and the real economy.
What would a recession caused by Covid-19 look like?
Although market sentiment can be misleading, the risks of a recession are real. The weakness of the major economies, including the US economy, has increased as growth has slowed and expansions in various countries are now less able to absorb shocks. In fact, an external shock to the US economy at a time of weakness has been the most plausible scenario for a recession for some time.
Recessions usually fall into one of three categories:
- real stagnation. Traditionally, this is a capital expenditure boom cycle that turns into a crash and derails expansion. But severe external supply and demand shocks — such as wars, disasters, or other disruptions — can push the real economy into recession. Here Covid-19 has the greatest chance of infecting its host.
- stagnation of politics. When central banks leave policy rates too high compared to the “neutral” rate of the economy, they tighten financial conditions and credit intermediation and, with delays, stifle expansion. That risk remains modest – outside the US, prices are already at low or even negative levels, while the Fed has made a surprise 50 basis point cut. Outside of the monetary policy response, G7 finance ministers also pledged financial support.
- financial crisis. Financial imbalances tend to build up slowly and over long periods of time, before quickly dissipating, disrupting financial intermediation and then the real economy. There are some notable differences globally, but in the critical US economy, the risks of the financial crisis are hard to point out. Some commentators point to the bubble in corporate credit, as evidenced by the large issuance and tight spreads. However, we struggle with the analogy of subprime mortgages to the recent recession, in that corporate credit does not finance a real economic boom (as mortgages did with housing), nor does debt held on banks’ balance sheets. Both factors reduce the systemic risk of a potential credit jolt, although this risk cannot be completely ruled out. It is difficult to see the contribution of Covid-19 to financial imbalances, but stress can arise from cash flow pressures, particularly in small and medium enterprises (SMEs).
Looking at this rating, and back to history, there is some good news in the “real economy” rating. Although real recessions are idiosyncratic, they tend to be milder than political recessions or those caused by the financial crisis, because they represent potentially severe but transient shocks to demand (or supply). By contrast, recessions in policy can be severe, depending on the magnitude of the error. In fact, the cause of the Great Depression was perhaps the biggest political blunder of all time. Financial crises are the most harmful type of crisis, because they introduce structural problems into the economy that can take a long time to correct.
What is the possible course of recovery?
Whether or not economies can avoid a recession, the path back to growth under the Covid-19 virus will depend on a combination of drivers, such as the degree to which demand is delayed or lost, whether the shock is really an uptick and whether there is structural damage, among others. other factors. It is reasonable to draw three general scenarios that we describe as VUL.
- V: This scenario describes the “classic” real economy shock, i.e. output displacement, but growth eventually rebounds. In this scenario, annual growth rates could completely absorb the shock. While it may sound optimistic amid today’s gloom, we think it makes sense.
- U-shaped: This scenario is the ugly brother of the V – the shock continues, and while the initial growth trajectory is resumed, there is some permanent production loss. Is this reasonable for Covid-19? Sure, but we’d like to see more evidence of the actual damage of the virus to make this case the base case.
- L-shaped: This scenario is the very ugly and weak relationship between V and U. For this to happen, you have to believe in the potential of Covid-19 to cause significant structural damage, i.e. break something in the economic supply side – labor market, capital formation or productivity function. It’s hard to imagine this even with pessimistic assumptions. At some point we will be on the other side of this pandemic.
Again, it’s worth looking back at history to place the potential impact path of Covid-19 empirically. In fact, V-shapes monopolize the empirical landscape of prior shocks, including epidemics such as SARS, the 1968 H3N2 (“Hong Kong”) flu, 1958 H2N2 (“Asian”) flu, and 1918 Spanish flu.
Will There be Any Lasting Economic Consequences of Covid-19?
To understand this, we need to examine the transmission mechanism through which the health crisis affects the economy.
If the taxonomy of recessions tells us where the virus likely attacks the economy, transmission channels tell us how the virus takes control of its host. This is important since it involves different impacts and remedies. There are three plausible transmission channels:
- Indirect hit to confidence (wealth effect): A classic transmission of exogenous shocks to the real economy is via financial markets (and more broadly financial conditions) — they become part of the problem. As markets fall and household wealth contracts, household savings rates move up and thus consumption must fall. This effect can be powerful, particularly in advanced where household exposure to the equity asset class is high, such as the US That said, it would take both a more bear market than correction) and sustained decline.
- Direct hit to consumer confidence: While financial market performance and consumer confidence strongly correlate, long-run data also shows that consumer confidence can drop even when markets are up. Covid-19 appears to be a potentially potent direct hit on confidence, keeping consumers at home, weary of discretionary spending, and perhaps pessimistic about the longer term.
- Supply-side shock : The above two channels are demand shocks, but there is additional transmission risk via supply disruption . As the virus shuts down production and disables critical components of supply chains, gaps turn into problems, production could halt, furloughs and layoffs could occur. There will be huge variability across and industries, but taking the US economy as an example, we think it would take quite a prolonged crisis for this to feed through in a significant way. Relative to the demand impact, we see this as secondary.
Recessions are predominantly cyclical, not structural, events. And yet the boundary can be blurred. To illustrate, the global financial crisis was a (very bad) cyclical event in the US, but it had a structural overhang. The economy rebounded, yet household deleveraging is an ongoing secular phenomenon — household willingness (and ability) to borrow is structurally impaired, and the collateral damage, structurally, is that policy makers find it much harder to push the cycle just by managing short-term interest rates today.
Could Covid-19 create its own structural legacy? History suggests that the global economy after a major crisis like Covid-19 will likely be different in a number of significant ways.
- Microeconomic legacy : Crises, including epidemics, can spur the adoption of new technologies and business models. The SARS outbreak of 2003 is often credited with the adoption of online shopping among Chinese consumers, accelerating Alibaba’s rise. As schools have closed in Japan and could plausibly close in the US and other markets, could e-learning and e-delivery of education see a breakthrough? Further, have digital efforts in Wuhan to contain the crisis via smart-phone trackers effectively demonstrated a powerful new public health tool?
- Macroeconomic legacy : Already it looks like the virus will hasten the progress to more decentralized global value chains — essentially the virus adds a biological dimension to the political and institutional forces that have pushed the pre-2016 value chain model into a more fragmented direction.
- Political legacy : Political ramifications are not to be ruled out, globally, as the virus puts to the test various political systems’ ability to effectively protect their populations. Brittle institutions could be exposed, and political shifts triggered. Depending on its duration and intensity, Covid-19 could even shape the US presidential election. At the multilateral level, the crisis could be read as a call to more cooperation or conversely push the bipolar centers of geopolitical power further apart.
What Should Leaders Do in Relation to Economic Risks?
The insights from financial markets and the history of analogous shocks can be operationalized as follows:
- Don’t become dependent on projections. Financial markets are currently reflecting great uncertainty. A wide range of scenarios remain plausible and should be explored by companies.
- Don’t allow financial markets gyrations to cloud judgment about the business you lead.
- Focus on consumer confidence signals, trust your own instincts, and know how to leverage your company’s data in calibrating such insights. The impact will not be uniform, and the conclusions will be specific to your industry.
- Plan for the best and prepare for the worst trajectories. Keep in mind that a V-shaped recovery is the plausible scenario conceptually and empirically, but don’t let that insight make you complacent.
- Begin to look past the crisis. What micro or macroeconomic or legacy will Covid-19 have? What opportunities or challenges will arise?
- Consider how you will address the post-crisis world. Can you be part of faster adoption of new technologies, new processes, etc? Can you eventually find advantage in adversity for your company, clients and society?
(Editor’s Note, March 6) : This piece has been updated to reflect the subtypes of the historic flu outbreaks.)
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