Prior to the coronavirus, contagious disease hadn’t been high on the list of investors’ concerns. No disease in recent memory has threatened the global economy in the way coronavirus has. There are some outbreaks which because of their severity affected relatively small clusters of the population and didn’t spread globally. 1 1 Close Severe diseases such as Ebola often have short periods of contagion – they affect people quickly so they don’t have time to spread around the world. And there are also more common viruses, such as seasonal influenza, which infect large numbers of people around the world but have mortality rates which are low enough to make them part of our regular course of affairs. Sadly, the coronavirus falls in the “bitter spot” between these two, in that it is contagious, has a long incubation period and is more deadly than the ordinary seasonal flu. 2 2 Close There is no “sweet spot” here. Reports say mortality is around 2%, though it may turn out to be lower. “Coronavirus fatality rates vary wildly depending on age, gender, and medical history – some patients fare much worse than others,” MarketWatch, February 27, 2020. It has created significant challenges for health officials and governments, and less importantly for economists and investors.
There is no way to gauge its effect on economic activity with any kind of precision, so forecasts become uneducated guesses. The natural approach to analyzing an event like this is to look to past analogues. Fortunately, there have been few similar events in recent times. Initially, SARS was thought to be a guide, but the number of COVID-19 cases already far exceed what we saw with SARS or MERS. 3 3 Close “3 charts that compare coronavirus to previous outbreaks,” World Economic Forum, February 19, 2020. The SARS analogy led to some complacency among investors and was probably more misleading than informative. The Spanish flu occurred too long ago to draw close parallels. 4 4 Close And we hope was much worse than this strain of coronavirus will turn out to be. The best we can do is look for patterns in smaller regional events and extrapolate what they might mean in this case.
Initially the markets were slow to react, but a clear narrative emerged in early February. China had taken aggressive measures, and market participants for the most part thought the spread would be contained. It was thought that the economic effects would be limited to lost demand from Chinese consumers who were forced to remain at home. Countries with large export exposure to China such as Brazil and Australia saw their currencies underperform while countries such as the U.S. and Mexico, both of which run large trade deficits with China, saw their currencies appreciate. Some went so far as to make the argument that it could result in a flood of cheap Chinese imports to these countries which would cause lower inflation and monetary policy easing. After an initial sell-off, U.S. equities made new highs.
The sentiment changed quickly as cases have emerged around the world. It can no longer be considered a regional problem. The response from global health officials has been largely uncoordinated, and individual countries have been inconsistent in their approaches. Some governments seemed to make limiting the spread their primary goal, while others seemed to be more concerned with reducing mortality. 5 5 Close A cynic might argue that some governments have made hiding it a priority. There are merits to both approaches. Italy and China made great efforts to contain the virus via quarantines and shutdowns of businesses and schools. In China they have aggressively tested potential carriers but have found their health care system strained by the number of patients. Japan on the other hand initially decided to only treat patients with the worst to prevent their healthcare system from being overwhelmed. 6 6 Close Japanese authorities asked people with mild cold-like symptoms to remain home instead of rushing to the hospital. , 7 7 Close “Japan adopts basic policy to fight coronavirus outbreak,” Kyodo News, February 25, 2020. This week the Japanese government canceled school sessions and seems to be taking more effort on containment. 8 8 Close It’s not entirely clear which approach Iran is taking. There are some indications that China is easing its restrictions, and people are returning to work, so there may be some convergence in approach.
If all countries enacted strict quarantines, economic growth would come to a halt. You would see recessions around the world, but economies would quickly recover if the disease were in fact contained. If all countries went with a treatment approach, then you would see a longer, milder reduction in growth. As it is, we don’t really know which model will prevail. The lack of coordination and consistency may lead to an extended, more pronounced downturn.
The big question for longer-term investors is whether this is a supply or demand shock. In other words, whether it is inflationary or deflationary. Quarantines, travel restrictions and plain old fear of catching the virus have hurt consumer demand, but it is becoming clear that production will also be limited. Last week, markets were spooked by Apple’s announcement that it might not meet some deliveries. Investors now worry that supply chains have been disrupted and exports from China will drop significantly. If it is primarily a demand shock, it will be deflationary whereas if it is a supply shock, it will lead to higher inflation.
Past regional events may provide some guidance. In other surprise shocks caused by natural or man-made disasters such as the earthquake in Christchurch, New Zealand or the Fukushima disaster reveal a pattern. The initial effect is usually a steep drop in demand. Consumers do not make purchases and inventories of goods remain unsold. The initial effects are deflationary. But the disaster results in lost production, and it can take time to get production back up. Authorities often respond with stimulus measures, and it is much easier to stimulate demand with interest rate cuts and fiscal spending packages than it is to add capacity or investment. As a result, demand recovers while supply is still strained, and prices start to rise.
Right now, markets are focused on the deflationary impact around the world, and it will probably be a while before the more inflationary effects are realized. 9 9 Close People have different definitions of “a while.” In macrospeak, that means around two to three months. In macrospeak, “an eternity” is around a year. In the meantime, central banks may react with rate cuts. However, as we’ve argued, the Fed and ECB would prefer not to act, so they may have to see a material deterioration in the data before acting. Still, this is the kind of event that can force them into action against their better judgement. The problem is that the data is unreliable because there is a lag between the event and the timing in which it affects the numbers. Many of the releases tell us more about how things were going prior to outbreak. Other measures may come faster. Countries may start to run higher deficits either as a policy response or perhaps using the crisis as an excuse to enact spending they had wanted to anyway. In recent years, currency and equity markets have rewarded fiscal stimulus. So far markets have been reluctant to react to these measures, while uncertainty remains about the extent of the spread. We, along with everyone else, hope that the crisis ends up being resolved. Investors should be aware that this might not happen.
What We Are Watching
China Caixin PMI (Sunday) and U.S. ISM Manufacturing PMI (Monday)
China Caixin manufacturing PMI is expected to have plummeted in February as measures to contain the spread of COVID-19 led to factory shutdowns and labor supply disruptions in various areas. High frequency indicators of Chinese business dynamism such as coal consumption or inter-city traffic point to weak activity after the Chinese New Year. The extent of the weakness is still unclear but next week’s data will be key to shed light on its initial magnitude. A larger-than-expected decline in manufacturing PMI could exacerbate recent market turmoil. The same is true for U.S. ISM manufacturing PMI to be released on Monday. The index rebounded sharply last month, but investors may be biased to ignore “pre-virus” data and focus on more recent releases like that of next week. Should U.S. manufacturing sentiment point to renewed weakness in February, fears of a severe slowdown in the U.S. or even a recession could prompt further declines in U.S. equities, bond yields, and the U.S. dollar.
Reserve Bank of Australia (Monday)
Heightened concerns about the new coronavirus have led markets to expect a more dovish stance from the Reserve Bank of Australia in 2020. Even though the RBA had recently placed domestic labor markets in center stage for future policy decisions, it will be hard for the central bank to ignore the effects of COVID-19 in its outlook. In addition to this rising public health risk, the data that the RBA had highlighted as key came weaker than expected in the inter-meeting period with the unemployment rate rising more than expected in January. Given external and internal factors weighing on the outlook for the Australian economy, next week’s meeting is expected to deliver a dovish tone, the extent of which will determine whether the Australian dollar and bond yields could face further downside pressure.
U.S. Democratic Primaries (Saturday and Tuesday)
South Carolina will hold its presidential primary on Saturday, followed by fifteen states and territories on so-called “Super Tuesday.” Left-wing Senator Bernie Sanders has emerged as a clear front-runner for the Democratic presidential nomination following strong performances in Iowa, New Hampshire, and Nevada. However, South Carolina and several of the Super Tuesday states appear more favorable for centrist candidates such as former Vice President Joe Biden. If Biden or another centrist wins these states, it could turn the primary into a two-person race. Conversely, if Sanders outperforms broadly, his odds of being the eventual nominee would go up significantly. While policy changes under a hypothetical Sanders administration would likely be constrained by a more moderate congress, equity market sentiment could be negatively impacted by expectations of a less business-friendly regulatory environment.
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