Coronavirus: the height of uncertainty
This year is off to an eventful start with several market-moving uncertainties already, such as the US attack on Iran. The coronavirus epidemic adds a new layer of uncertainty, with little indication of how long it will persist and cloud financial market sentiment.
From an economic perspective, it is impossible to assess the impact of the coronavirus as long as it continues to expand globally. While loss of life is a human tragedy, it is not directly the virus which causes the economic damage but rather the measures put in place to stop it from spreading.
China added an extra week of holidays to its lunar new year annual break and most factories were shut for longer than that, especially in the Wuhan region where the virus outbreak started. With China representing almost 20% of global gross domestic product (GDP), the hit to the economy will have an impact on world GDP.
In addition to the first-order impact, the shutdown of factories in China also affects companies relying on China’s production as part of their supply chain. Numerous businesses have already warned that the disruption will lead to a cut in their production elsewhere as essential parts are no longer available.
With the virus spreading outside of China, governments are warning of potential measures, such as quarantine and lockdown, which would hit production and consumption in a similar fashion to that seen in China in recent weeks.
Recession or not?
At this point it is too early to speak of a recession. Countries exposed to global trade, such as Germany, Japan or South Korea, are likely to be the most affected with south-east Asian countries also affected due to their ties to China. When thinking about recessions, it is important to make a difference between three types: structural, cyclical and event-driven.
We define a structural recession as when there are large imbalances in the economy, for example large debt on the private side or supply/demand imbalances in large parts of the economy, which require adjustments to rebalance the economy. This type of recession is long-lasting and usually triggers a severe downturn as it takes time for the economy to get rid of the excesses that created the imbalance in the first place.
A cyclical recession is usually triggered by central banks tightening monetary conditions to slow down an overheating economy. This type of recession is usually less severe and shorter than the structural recession. Finally, event-driven recessions are unforeseen slowdowns stemming from wars, natural catastrophes and the like. These tend to be sharp but short-lived.
A recession caused by the coronavirus epidemic would be an event-driven one. The impact on production would be abrupt as any confinement measures usually lead to no production and very little consumption.
However, once the epidemic is under control and measures hindering production and consumption are lifted, the ramp up to normal production should be relatively fast. Except in some particular sectors, notably commodities, there is not a pre-crisis period during which the economic slowdown gradually leads to an inventory build. Equally, if the slowdown is short-lived, there is little time for unemployment to rise massively, as it would in a structural recession, and consumption should resume at the pre-event pace.
But the longer the disruption lasts, a recession becomes more likely. Considering the exceptional nature of the event and the lack of a need to correct an imbalance, it makes sense for governments to fill the gap with fiscal stimulus. We have seen governments across the globe (South Korea, Italy, China and Hong Kong) already announcing measures to provide support to the part of the economy most affected by the virus outbreak. We would expect to see more such moves if the impact on the economy becomes more prolonged.
The spread of the virus and the uncertainty it conveys has taken its toll on most asset classes. The 10-year US yield touched an all-time low in February while equities gave back their year-to-date gains and are now in negative territory.
As we have warned in recent months, the risk of a correction has been increasing with valuations starting to look stretched across most asset classes. As mentioned previously, the impact of an event such as the coronavirus tends to be short-lived and history suggests that markets recover in the following few months.
In any event, in a year when equity markets were up, there has been a 10% correction, on average, at some point during the year. It is too early to draw firm conclusions on the final impact the epidemic will have on the global economy and financial markets. We think that it will be a short-lived event which will affect markets in a transitory way and is not the start of a structural bear market.
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