This piece updates my earlier analysis (late January) on Covid19 and is accompanied by a short note that looks in more detail at some longer term trends. My January analysis highlighted the importance of the policy response including the quarantines and travel cancellations in driving economic impact, making the impact unprecedented. The global economic impact began with a demand shock especially for raw materials (oil, copper), as well as tourism and transport services and shifted into a supply shock dampening intermediate and finished goods.
It is now clear that the short transitory, China-focused scenario is unlikely, meaning that the economic impacts for the global economy will likely involve even more geographies beyond the East Asia value chain, and may prompt a more modest recovery. Meanwhile the weaker earnings outlook has prompted a tightening of financial conditions, which will stress the balance sheets of vulnerable actors especially in affected sectors, and limit the benefits of the very low interest rate environment. In the United States, the financial shocks are potentially most important, particularly if there are further dislocations in the financial markets that go well beyond the sell-off of the last week.
The policy response will be key in determining the economic impact and eventually the pace and dynamics of momentum ahead. Many market actors are looking to the Fed to provide support. While more cuts are likely coming, they are unlikely to address the underlying issues, and moreover are likely to be later and less extensive than markets are pricing in. Fiscal policy, especially in some Asian economies is likely to provide some offset, and also help in crisis fighting, but overall is likely to only partly offset the drag. The persistence and extent as well as policy response will be key to the economic impact.
Markets Woke up: Following the sharp escalation in infections in Italy and Iran, global markets and U.S, policymakers have moved from being complacent about the risks from Covid19 to scared. Risk assets have sold off, bonds have rallied (though they were doing so even before the scare) and volatility spiked as actors realized that the benign swift recovery containment scenario for Covid19 to be contained by early March was no longer possible. This suggests that the global economic impact might shift into a new phase where output slowly revives in China but demand remains depressed and tourism flows remain much more restrained – ie a modest recovery. Europe, where economic momentum just started to pick up in late 2019 and early 2020 (see German and EU PMIs for example), could well fall back into stagnation and weak growth, while US growth downshifts.
The economic impact will depend on the extent of the outbreak, the degree of quarantines and trade disruption, which in turn depends on the waves of infection. A negative demand and supply shock for some months, which could put additional pressure on some geographies in Europe and Asia which only starting to grow in early 2020. Beyond these, a number of oil producing countries and companies look vulnerable, especially as weaker demand amplifies the impact of financial shift to lower carbon portfolios. That said, few countries are likely to impose the degree of quarantines and work stoppages as China, suggesting that that macro impact may shift to being a drag (lower than potential) rather than the acute shock from Q1.
The macro scenarios are based on the duration and depth of the crisis and the policy response which drives local demand and balance sheet impact. Most consensus estimates initially focused their scenarios on a China output shock. It is now clear that the impact is somewhat broader than that.
The benign scenario was based on several factors:
- The outbreak’s demand hit would be transitory and focused on east Asia and energy. the view that aggressive containment efforts in China would limit the spread globally. These would have a macro impact and some supply chain disruption but might be transitory, hitting Q1 and early Q2 growth mostly in China.
- US economy would remain relatively unaffected, with limited shock to corporate profits offset by inflows. Safe haven and yield seeking flows in US assets could support select risk assets.
- Demand shock for oil and energy as well as other commodities might bottom out around 1-1.5mbd for early 2020 before stabilizing (though a warm winter complicated this also).
- A combination of monetary support, mostly from the U.S. and China and some fiscal support would lead to a rebound.
Even this benign scenario was not a good outcome – it still assumed a weak start to the year, an demand shock, a broader consumer shock and supply chain disruption especially for a range of goods. Several companies already reported that they would miss their earnings. While some China analysts highlighted a relatively greater restart of capital intensive industries (lower workers) and automated factories, nonetheless there would be a major drag for the beginning of 2020.
At this point, scenarios include a more protracted demand and supply disruption as key activity in China’s hubs remains restrained, the output picks up slowly and several other hubs reduce activity. Service sector remains less exposed globally particularly services that can be delivered remotely. Some food and manufactured goods shortages are possible. A prolonged tightening of financial conditions might lead to some dislocations and debt exposures. Other countries are unlikely to impose the aggressive quarantines experienced in China, but border closures and boycotts are likely to add supply chain disruptions.
Macro and market momentum were mixed at the start of the year: At the start of the year, there were signs that some European and Asian countries which slipped into or near recession last year might be exiting as evidenced by early 2020 PMIs. While economic growth was unlikely to be strong, a little less fiscal austerity especially in Europe and a very modest. Meanwhile ample central bank liquidity was pushing valuations more expensive especially across US assets and global bonds. While equity valuations looked very pricey, the search for yield continued. The extended lunar new year and closures could make it difficult to disentangle the impact of covid19 from the broader cycle and underlying growth. It could thus take a significant amount of time to identify demand.
What might reverse the market sell-off?
Market selloffs can end on their own and can have multiple causes and ends. Typically a new macro catalyst can prompt a reassessment of fundamentals that already changed or a valuation story that looks more attractive.
Positive catalysts may be difficult to come for some time – these include macro data of continuing resilience or signs of stronger momentum. Signs of containment of the illness could take several weeks or months. The weaker earnings outlook and risk of lower guidance through H1 may imply more risk asset adjustments more savings.
Clear signs of restart of growth in China (might take a while), shift from the Fed and PBoC, though the latter would be hard pressed to be anywhere near as dovish as markets who might actuall move to price in even more cuts, doing the opposite of what is intended. The PBoC may be holding fire until activity begins to pick up rather than just juicing the economy, adding liquidity and putting pressure on the exchange rate. Credit demand has been relatively weak up to this point. Expect more targeted measures.
Longer term trends to watch:
Global tourism flows, especially from China. China has become a major source of tourism flows at home, in Asia and globally, to the extent that tourism imports by China have become a major driver of the services account (despite some data issues). It might take many months after the all-clear to restart official tourism especially when the Chinese authorities will be focused on restarting domestic growth. Moreover when global airlines reassess their flight itineraries, some might choose to scale up only slowly, not restarting all flights and possibly bearing greater costs of carrying airlines etc. Cruises in particular look vulnerable. While these trends might not be long-term and effect all jurisdictions, they are likely to be among the consumer services that suffer – and some of those trends may last well in 2021 exacerbating other challenge. Business travel too is likely to take a hit
One upside might be around remote work/e-learning: one major response to quarantines has been to step up e-learning capabilities, most effectively in higher education in countries like Singapore and to mixed results. Many key events and business travel have been curtailed, whether big tech meetings, oil conferences or policy gatherings. It will remain to be seen if this will lead to more remote events and cuts to travel budget. .
Reinforcing the role of government investment in key emerging economies: Efforts to restart activity in China will likely include targeted government investment and pump-priming that could focus on adding further overcapacity on infrastructure. These government led investments tend to be quick to scale up and are less demand-sensitive. It risks reversing some of the rebalancing trends, something that already began in 2019 as the role of the government increased. There is a key role for governments to play in providing bridge lending, providing clarity and building resilience – see the recent fiscal packages from HK and Singapore for example. The challenge will be to target spending to focus on near and long-term needs. Expect oil producers also to double down on government-led pump-priming and activity.
Exacerbating distrust of China in U.S.: Being tough on China is a popular bipartisan issue in the U.S. with not only some Trump administration officials but also key Democratic presidential candidates like Elizabeth Warren responding to the crisis by lauding plans for deepening U.S. supply chains to reduce supply chain vulnerabilities and add jobs. While there are legitimate security concerns, the distrust could undermine investment, scientific cooperation and other associated work and lead to unrealistic expectations on economic investment and job creation. As colleagues have noted cogently, focus on building up alternative infrastructure and strengthening our own house is key.
Trade tensions/decoupling and thicker borders: Its broad consensus that the virus has made it even more unlikely that China can meet its phase 1 trade deal requirements especially on commodity purchases and less likely that phase 2 talks will kick off any time soon. The timing of the phase 1 deal already allowed the administration flexibility until after the election, which buys time if they want to take it- but the Trump administration may not. I continue to think that 2020 will be a time of more trade threats to Europe than Asia, given the irritants with Germany, the negotiations with the UK and more.
border restrictions are likely to increase along with quarantines, which may last beyond the immediate response. This could be a logical public health decision, but may have significant ramifications on bilateral trade as well as political dynamics in affected countries. Europe is a key area to watch. Formal quarantines and school and work shuttering are likely to drive the economic impact. Should
Exacerbating of debt burdens: Weaker growth is likely to hit revenues across many economies, while corporations forced to shut down may face financial pressure. In China, there is a good chance that authorities will opt for forbearance to avoid a spike in defaults, adding to the pace of growth in debt and reducing quality of growth. While interest rates are likely to stay low globally, helping with financing, the efficiency of spending may have significant concerns. Governments might find it useful to provide some targeted funding for businesses most exposed and help them build out alternatives in their supply chains.
In the U.S. household balances might suffer if there is a wider spread outbreak. Should the number of cases increase, out-of-pocket costs for testing and treating the illness might put a significant pressure on individuals with limited insurance coverage and might even discourage testing and seeking treatment. There is likely a role for coordinated government programs to encourage quick testing and come up with cost-sharing rather than spread the illness. The U.S. and others might well also take the lesson of stepping up monitoring at key airports as Asian and European counterparts have.
Amplify pressure on oil producers: Oil producing companies and countries have been having a tough few years due to ample supply of oil and gas and slower/stalling demand growth due to structural growth challenges in Europe, Asia among others. Now lower Chinese demand might amplify the trend and could persist for some time, while there is pressure from institutional investors to weaken funding to fossil fuels. Countries with higher fiscal break-evens and higher debt burdens and debt service look most vulnerable. These include Iraq, Venezuela, Iran, Nigeria among others. Saudi Arabia has more runway than neighbors like Oman but the combo of lower production (as they bear the brunt of more OPEC+ cuts) and lower prices suggest they will need to issue significant debt (tens of billions of dollars) and put more pressure on the PIF to stimulate growth. Smaller open economies like the UAE will also face exposure to lower tourism flows, exacerbating the existing pressure on the construction and other sensitive sectors.