What sort of economic impact will the coronavirus and associated disruption have?
This year started so well for markets: the UK general election provided Brexit clarity, Presidents Donald Trump and Xi Jinping declared a trade-war ceasefire, and global manufacturing activity looked as though it was on the mend. All this after global central banks turned the liquidity taps on, encouraging investors to get stuck in to equity and credit markets across the globe.
But then came along the coronavirus. Now I’m not an expert in epidemics, so I’m not going to make any predictions about the disease. But here at LGIM, we do have a fair bit of expertise on economic growth and financial markets. Without passing judgment on the reaction to the outbreak, the facts are that China has extended holidays in a number of provinces, impacting hundreds of millions of people and countless factories, and many countries have cancelled air travel to China and restricted the ability of Chinese citizens to enter their country. What sort of economic impact does this have?
Here are a few observations:
• By looking at the relationship between infection rates and economic growth during the 2003 SARS epidemic, our economics team weighted different Chinese provinces by the severity of the outbreak, estimating that total Chinese GDP in the first quarter could be around 3% lower than last year. This assumes that the situation doesn’t materially worsen.
• A second method is to reduce the growth in our models of all provinces that are currently shut down by a similar amount. In doing so, we have estimated what activity is likely to have stopped and what might still be taking place. This method suggests that each week of closure is worth around 3% of GDP in the first quarter. So if things take two more weeks to reopen, then just double this.
• The two methods come out with similar numbers, so let’s put the range somewhere between 3% and 6% of GDP in the first quarter. At first glance this seems a lot, but we think it should prove temporary – this has generally been the case in recent years when natural disasters or epidemics interrupted economic activity. So, assuming there is a rebound in the second quarter, the impact over the whole of 2020 is likely to be much smaller, perhaps around 1% of Chinese growth.
• And then you have to consider Chinese policy support. Policymakers in the country have already announced interest-rate cuts and bank liquidity injections, aiming to avoid credit crunches and mass layoffs. And I wouldn’t be surprised if we see accelerated government spending in the form of new investment projects or targeted tax cuts in the coming weeks.
• We’ve also looked at the impact such a Chinese slowdown would have on the rest of the world. My colleagues will write about this in future blogs, but away from tourism and supply-chain disruptions, we’re not all that worried.
The major caveat is that the epidemic could get worse. We’re assuming things get back to normal in a couple of weeks, but if China shuts down for a lot longer, or if the disease spreads globally, then the disruption could become much more severe. You don’t simply add up the 3% GDP decline for each week; you have to compound supply-chain chaos as well as the potential for over-levered entities to get into trouble even if authorities try their best to help. So, like everyone, we’ll be watching the data on infections and how policymakers react very closely indeed.
What about markets? Again, I can make some observations:
• A few markets have already reacted, notably government bond yields, Chinese equity markets, oil, and high-yield credit (this is at least partly due to the number of oil companies within this index).
• Interestingly, global equity and investment-grade credit markets haven’t been much affected. Even emerging-market assets, away from certain Chinese sectors like travel, have been pretty resilient. Indeed, the fall in government bond yields has helped investment grade and emerging-market debt post positive returns over this period.
• Given the above economic analysis, I can see why broader markets have been robust, under the assumption that the disease is brought quickly under control and the global growth impact is small and temporary. But if things get worse, then I can imagine quite a bit of downside for global markets.
One option for investors is to reduce risk in assets that have thus far been resilient – you’re not losing much upside at these levels even if the virus is quickly beaten. Instead, you could add a bit of risk in those markets I mentioned that have already moved.
What I can say with relative certainty is that the next few days will prove critical in determining whether the coronavirus proves a transitory market risk or whether we need to recalibrate our base case of a supportive macro backdrop for 2020.