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In response to the outbreak of COVID-19 (COrona VIrus Disease 2019), the Chinese government has implemented a huge containment effort, closing public transport, schools and factories across the country and preventing any movement outside the home in the worst affected areas. At time of writing, around a third of all Chinese citizens, accounting for nearly 50% of GDP, are under some form of lockdown.
Outside China, major new outbreaks have appeared in South Korea, Iran and Italy, although so far containment is not on the scale of the Chinese response. Further outbreaks look likely, especially in the developing world where the capability to test for the virus is limited.
Comparison to SARS
Analysis of the impact of the disease focuses on the 2003 SARS (Severe Acute Respiratory Syndrome) outbreak. The economic impact of SARS was limited – Chinese growth ended that year about 0.5% lower than it would otherwise have done and equities saw only a temporary dip.
Source: Thomson Reuters Eikon
The greater virulence of SARS meant symptomless cases were rare, but these are much more common with COVID-19. Temperature screening at airports – a key weapon in the fight against SARS – has therefore proven to be less effective. COVID-19 has been able to spread more rapidly than SARS resulting in a higher number of cases and fatalities. As a result, the economic impact is likely to dwarf the impact of SARS, especially as China now accounts for nearly 16% of the global economy and a third of global growth, making the country many times more important to the global economy than in 2003.
The main economic effect of the virus has come from the containment measures put in place in China. This acts as a huge drag on the economy, with people unable to work, travel, or, in certain areas, leave their homes. As growth slows, China’s trading partners will also suffer. In particular, commodity exporting countries are vulnerable.
In response, President Xi Jinping declared that China “must prevent economic growth from sliding out of a reasonable range”. To this end, measures of credit and liquidity provided to the economy reached all-time highs in January 2020. China – as well as Hong Kong, Macau and Singapore – have employed “helicopter money” (direct payments to citizens) in order to boost their economies. In the rest of the world, markets now expect further support. The Federal Reserve is anticipated to cut rates three times over the course of 2020.
The main effect for the global economy will be the disruption in global supply chains. Closing factories to prevent the spread of the disease interrupts the role China plays in making parts for, or assembling, larger products. At present, people still demand the same products and would be willing to pay for them, but cannot get them because the supply is disrupted. This presents an unusual problem for policymakers, as supply shocks cannot be tackled with monetary policy, and only to a limited extent by fiscal policy. Only once people return to work and supply returns to normal will the full effects of the stimulus be felt.
The COVID-19 outbreak has already caused significant market volatility, but the ultimate outcome is highly dependent on the future path of the virus. If the virus is contained and China returns to work quickly, global supply chains will be restored and the monetary policy support could even lead to a positive outcome for markets. However, the longer the outbreak continues and the more restrictive the containment measures become, the greater the damage.
Source: Thomson Reuters Eikon
In the period between 19 February, when the Iranian and South Korean outbreaks were discovered, and 27 February, equity markets fell by 10%. This fall has been mirrored in high yield bond markets and other high-risk debt markets.
Equities may well fare better than other assets. Although they are subject to short-term volatility, their value in the medium term is dependent on revenue that falls years into the future. In comparison, short-dated, high-risk, fixed-income assets may suffer. For relatively highly leveraged companies, even a temporary loss of revenue could potentially lead to defaults.
Government bonds on the other hand have already seen strong performance as investors look for safe assets. US Treasury yields have fallen to all-time lows and UK and European yields are not far away from matching their September 2019 low points.
Inflation is another source of uncertainty. The loss of supply from China should cause prices to rise as producers and consumers compete over the remaining suppliers. However, with China locked-down, global demand is temporarily restricted, which should lower prices in other sectors. The balance between these two dynamics is unpredictable. If inflation rises too fast, the ability of central banks to provide support could be limited.
Over the longer term, the COVID-19 outbreak could add to pressure on the globalised manufacturing and trading system built up over the last 30 years which was already under pressure from the US as part of President Trump’s trade war with China. Global trade peaked in October 2018 and has been falling ever since. COVID-19 is likely to accelerate the change. Therefore, large manufacturers with global supply chains may be particularly vulnerable to this kind of disruption in both the short- and long-term.
Because of China’s huge contribution to global growth, COVID-19 could result in the first quarter of negative growth since the start of 2009. If the disruption in China continues into the second quarter of the year, we could already be halfway into the first global recession since the Financial Crisis. However, the consequences of a recession in 2020 are unlikely to be comparable to 2008. COVID-19 has caused a supply shock that is likely to be reversed more quickly than the demand shock that the world suffered in 2008, but the question remains over just how long it will take to do so.
The danger lies in the possibility that disruption is prolonged which could cause supply chains to 'break' and take a long time to rebuild. Any consequent reduction in demand could result in a more permanent economic loss. Policymakers and central banks remain acutely aware of this danger and in many cases have already shown their willingness to step in to provide support to demand throughout the outbreak.
It’s difficult to assess what the full impact of the coronavirus will be until the scale of the outbreak and the containment response becomes clear. Past evidence suggests that disease outbreaks do not leave a lasting scar on markets over the long-term. However, short-term disruption and volatility is likely to be far greater than some events commonly used as a comparison. Investors should be prepared to see through the volatility in the short-term and we would expect a well-diversified portfolio, with adequate consideration for managing risk, to provide more than sufficient cover against this outbreak.
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