Last week equity markets concluded that the spread of coronavirus has major implications for economic growth and corporate profits. Last week’s sell-off in US equities was the sharpest correction since the Great Depression in 1933. It is a measure of the concern of markets that the immediate reaction of US equities was greater than when news of the bankruptcy of Lehman Brothers broke in 2008.
Markets face three related unknowns: the path and virulence of the virus, its effects on movement and on economic activity and the response of policymakers.
The world has plenty of experience of dealing with infectious diseases. The twentieth century witnessed three major flu pandemics: in 1918, 1958–59 and 1968. In a pandemic the disease spreads globally and a high proportion of the population are infected. The swine flu (H1N1) pandemic of 2009 is estimated to have infected in excess of 10% of the world population, but with relatively low death rates. Infections from avian flu (H5N1) since 1997 and severe acute respiratory syndrome (SARS) in 2002–03 have been on a lesser scale, though they have been economically disruptive, especially in some Asian countries.
The research into the impact of such outbreaks finds that the greatest economic effects come from reductions in movement, not from illness and deaths themselves. A 2009 study which modelled the economic effects of a UK pandemic concluded, “although the direct economic impact of disease is relatively small, school closures and prophylactic absenteeism, whether imposed by government or the result of fear of infection in the population, could greatly increase the economic impact” (British Medical Journal, November 2009).
This is partly about the decisions made by government, local authorities and employers – for instance Japan’s decision to close schools for two months, the cancellation of the Geneva Motor Show or the quarantine of 11 northern Italian cities. But it is at least as much about the judgements made by individuals and families as they assess the news. These decisions shape consumer spending and patterns of work.
The model of travel restrictions and quarantine followed in the last two months by China is not necessarily desirable or practical in the West. Here the authorities would need to balance the health benefits of such measures against the aim of maintaining a degree of business as usual.
The initial effects of reductions in mobility have been seen in leisure activities, travel and tourism. Last week Lufthansa said it was reducing short-haul flights by up to 25%. IAG, owner of BA, said the uncertainty meant it was unable to provide profit guidance for 2020.
In China travel and quarantine restrictions have limited the ability of workers to get to their factories and offices. Chinese growth in the first quarter will slow sharply and could contract. This makes a wider point. Even the regular seasonal pattern of change, such as the timing of public holidays, hot or wet weather, New Year sales and so on, cause significant volatility in monthly economic data. A shock, like coronavirus, whose path is unknowable, will make the economic data more erratic, clouding underlying trends.
Global activity is dependent on a web of cross-border supply chains, financial and transport networks. When things go wrong this interconnectedness amplifies and transmits stress globally, much as happened during the financial crisis. Last week the Financial Times reported that disruption to production at a northern Italian components parts manufacturer, MTA, could force closures at car plants across Europe. The car maker JLR has been shipping components from China by plane in suitcases to help keep production at its UK plants going. Last week Apple warned that its profits would suffer in the first quarter because of disruption in China.
Elevated levels of external uncertainty dampen corporate risk taking and spending. Brexit-related uncertainties have had a marked impact on corporate investment in the UK in the last three years. Rising protectionism, and the associated costs and uncertainties, have knocked manufacturing globally. Coronavirus represents a potent new source of uncertainty for business. Some are likely to react by shelving expansion plans and focussing on strengthening balance sheets.
The economic effects of coronavirus will depend partly on the response of the authorities. Some argue that coronavirus is a classic supply shock – one which limits the supply of goods and services due to supply chain disruption and workers staying at home. The argument runs that this sort of problem cannot be remedied by cutting interest rates, a measure which is designed to boost demand.
This rather misses the point. Of course central banks are unable to counter supply disruptions. Yet coronavirus is also likely to depress business confidence, reduce corporate cash flow and cause financial conditions to tighten. Cheaper money and more liquidity would help counter these problems. Financial markets agree. They are now pricing an 80% probability of the US Federal Reserve cutting interest rates four times this year – a massive easing of policy that would have been almost unimaginable two weeks ago. In an unusual move the chair of the Fed last Friday said the Fed was considering reducing interest rates in response to the spread of coronavirus.
Central banks will be watching financial conditions carefully. The Chinese authorities have pumped an additional $174bn of liquidity into money markets in the last month. After the 9/11 terrorist attacks the Fed flooded the financial system with liquidity and urged banks not to foreclose on borrowers with temporary liquidity problems. The Fed’s aim was to prevent disruption to the payments system and cash flow which could mutate into a wider financial crisis. This time round the authorities could help companies with cash flow problems weather the loss of revenues by extending loans and liquidity.
Hong Kong’s government last week unveiled an unorthodox fiscal response to coronavirus. It is giving each adult permanent resident just under $1,300 in cash and is cutting payroll taxes for 2m workers. Hong Kong’s economy is already in a fragile condition, growth having contracted by 1.2% last year due to political unrest and US-China trade tensions. Yesterday the Italian government announced it would spend an extra €3.6bn, equivalent to 0.2% of GDP, on tax measures to help companies suffering a sharp decline in revenues and on increased health spending. Other countries seem likely to follow suit and increase public borrowing and spending to boost growth.
Coronavirus will have significant negative effects on global growth in the short term. China’s economy will weaken sharply in the first quarter. The official Chinese purchasing managers index for February showed manufacturing activity contracted at its fastest-ever pace in February. The Italian economy, having contracted in the fourth quarter and with growth suffering now, is at risk of falling into a technical recession. Economists have been busy scaling back their forecasts for growth this year. Last week Bank of America Merrill Lynch cut its full-year 2020 forecasts for euro area GDP growth from 1.0% to 0.6% and for global growth from 3.1% to 2.8%.
The big question is whether the shock will be sufficient to knock the global economy into something worse. Much will depend on the persistence of the virus. But the evidence from past diseases is that some of the activity that is lost is pushed back later into the year, with a trough in activity followed by a bounce. Easier fiscal and monetary policy would help that rebound. External shocks, such as diseases, have significant economic effects, but they tend not to change the trajectory of the economic cycle.
In China the government believes that the epidemic is starting to come under control and that, where possible, people should get back to work. High frequency economic data, on coal consumption and car traffic, suggest that activity is slowly starting to pick up. A continuation of that slow recovery depends on containing the virus.
Then there are the longer term implications of coronavirus. It has the potential to become a major issue in the US presidential election, pitting an ardent advocate of private health care against supporters of greater government involvement. And the spread of the virus is another blow for global integration. The greatest economic effect of coronavirus could yet be to weaken globalisation.
PS: Previously we have commented on the research of Nobel Laureate Angus Deaton and Princeton economist Anne Case who shed light on the adverse effect of economic change and poor education on white working-class Americans. Last week Professor Sir Michael Marmot published his review of health equality in England over the last ten years. Although the nature of the study is quite different, there are some striking similarities. The report finds improvements to life expectancy have stalled, in part due to the legacy of the financial crisis. According to Sir Michael, “Austerity has taken a significant toll on equity and health, and it is likely to continue to do so.” The report shows that those living in the most deprived areas have significantly lower life expectancy than those in the least deprived areas of the same region. Where you live also matters. Living in a deprived area of the North East reduces your life expectancy by five years compared to a similarly deprived area of London. Ahead of the budget next month the report adds to the pressure on the government to deliver on its stated ambition of ‘levelling up’ activity across the UK.