Last week equity markets concluded that the spread of coronavirus has major implications for economic growth and corporate profits. The 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 20th 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 focusing 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.