Until last week, a strange thing about the coronavirus was how little impact it had on global markets. After a –13% drop in the S&P 500, and a plunge in the US 10y treasury yield from 1.46% to 1.13%, complacency has been officially banished. Markets are now pricing in global recession. Have they gone too far?
As we noted when the epidemic first broke out in China, the answer hinges less on the disease than on the response. Uncertainty remains, yet the evidence so far suggests that while Covid-19 will spread widely, the vast majority of cases will be mild. Mortality, though higher than for seasonal flu, will mainly be an issue for older people with pre-existing medical conditions. In purely medical terms we are not close to a repeat of the 1918-19 Spanish flu. Given the vigorous public health response, it’s even questionable whether the aggregate impact of this outbreak will match that of the H1N1 swine flu of 2009-2010, which affected 60mn people in the US and was associated with 12,500 deaths there and somewhere between 150,000 and 575,000 deaths globally.
Aggregate health impact, though, is not what matters for the world economy. One reason the 2009 H1N1 pandemic caused so little damage was that within two weeks of the first reported US case, the CDC established that the mortality rate was unlikely to be much higher than for a seasonal flu. This time, demonstrably higher mortality, combined with the uncertainty caused by early obfuscations by the Chinese authorities and ongoing distrust of the numbers coming out of China, have thrown the world into a far stronger precautionary mode. To contain the disease, China has sacrificed the best part of a quarter’s economic activity. The questions now are
a) how much damage will the China shutdown cause in other countries;
b) how much additional activity will the rest of the world give up in the interest of public health; and
c) how big a policy response will central banks and government budgets deliver?
In the short run, we see three scenarios. The one in the market is that governments take severe measures to contain the virus, the Federal Reserve slashes interest rates, bond yields fall, gold rises and US growth stocks outperform. A second is that the Fed sits on its hands, deeming easy money an ineffective response to disease-driven dislocation. Third is that Covid-19 turns out to be less serious than feared, or the world learns to live with it. In that case the rebound in equities and bond yields could be sharp and dramatic.
Looking farther out, significant aftershocks are likely. With China-centric globalization now looking fragile and risky, multinationals will diversify supply chains into other countries. Populist pressure for tighter border controls will gain a boost. And the trust gap between China and the rest of the world will widen. The Communist Party’s domestic legitimacy is not at risk: the Party is already claiming credit for taming a major threat to global public health, and that story will resonate at home. But, thanks to mounting evidence that the government suppressed early information about the virus, China’s international credibility will take a hit.
The China Impact
The Traderinput team has been working overtime for the past month to document the effects of the Covid-19 response in China. Most available high-frequency indicators were down -30% to -80% YoY in February. Outside the coronavirus epicenter in Hubei province, the focus of government effort is shifting from virus containment to reactivating the economy. But this will be slow work, partly because much of the migrant labor force is still locked down in home villages and unable to return to work. Anything close to normal economic activity is unlikely until April. YoY GDP growth for Q1 will be negative, perhaps to the tune of -2% to -6%, though we shouldn’t expect Beijing to admit it.
Monetary and fiscal policy remain behind the curve, by design. Policymakers are still serious about the structural goals of de-risking the financial sector and disciplining local governments, so they have refrained from large-scale stimulus. The People’s Bank of China has yet to make a real rate cut and disavowed any broad credit boost. Local governments are getting authority to issue more special-purpose bonds; optimistically, this could push growth in infrastructure investment to 8% this year, from about 3% in 2019. By Chinese standards this is a modest response. Property policies have not been relaxed, so a bounce in housing starts is not in sight, and steel inventories are mounting.
A crucial variable will be liquidity in the corporate sector, which has tightened disastrously. We estimate that net business sector cashflows in Q1 will fall -87% from the expected pre-virus level, from RMB5.7trn to just RMB750bn. SOEs and large private firms can get by, thanks to tax breaks and special credit lines. But they will slash capex, and will also cut payments to small suppliers, who may not be able to tap into government support. The knock-on impacts on employment, wages and consumer spending could be substantial.