The Coronavirus: Distinguishing Short-Term Tumult from Long-Term Impact

Markets have sent a clear message in recent days: investors are afraid of the coronavirus. The disease’s global progression and containment measures are seen as impediments to global economic recovery.

The toll on human lives has indeed been unnerving and regrettable. However, fear can lead investors to make irrational choices. We acknowledge that the virus is a global growth risk, and the situation will probably get worse before it gets better. But we suggest focusing on fundamentals and distinguishing between short-term tumult and long-term impact.

Read on for our assessment of developments, likely implications and what we are analyzing to test our outlook.

Economic impact

The economic and financial panic comes mainly from the unknown. A new virus like the coronavirus can only be contained and eradicated at the very beginning of an outbreak. That’s why the WHO and other health authorities have taken great emergency measures to contain the virus, such as restrictive quarantines, which can do severe, short-term economic damage.

We had been witnessing early signs of exiting the global manufacturing recession of 2019. But emergency efforts to contain the coronavirus are smothering these green shoots. These measures also increase the palpable anxiety about the virus. At some point, if containment efforts are ineffective, we will have to go on with our daily routines, taking necessary precautions. Economic activity would likely return toward pre-coronavirus baseline assumptions.

The economic impact of pandemics is typically a sharp V-shape, where activity drops hard and fast for a quarter and then bounces back to recover most, but not all, of the lost output. Looking at China, by our initial estimates, the loss to the Chinese economy will be approximately 0.5% to 1% of GDP from 2020 baseline growth. That may not sound like much, but that is a full-year 2020 estimate. The quarterly impact could see GDP growth fall from 6% in the fourth quarter of 2019 to close to zero in the first quarter of 2020 before a sharp rebound. As we see it now, annual growth in 2020 will likely be in the low 5% range instead of closer to 6%.  

As new clusters of infection occur outside China, the V-shaped recovery might look more like a U-shaped recovery. We have no idea how far quarantine efforts will go to contain the virus in the US and Europe, hence the uncertainty around the potential downside to growth.

But the economy does recover from pandemics. Using China’s recent experience, infections typically rise for two to three weeks before peaking, while the quarantine and economic loss continue for another three to five weeks. Hence, the economic impact of a pandemic usually lasts one quarter. But every time new clusters of infection occur, recovery is delayed. At this point, without knowing the spread of the virus in North America or Europe, we are initially assuming a net loss of around 0.25% to European and US GDP. That would place US and European GDP growth around 1.7% and 0.8%, respectively, for 2020. That is our current virus-related baseline loss estimate for all of 2020, and it is certainly subject to change.

The markets appear to be discounting a worse outcome. Our US recession probability model, which incorporates financial data, has risen from 16% at the end of January to 46% currently. So markets may be a coin flip away from a virus-led recession. Also, asset prices have been hitting downside targets that we modeled using our scenario-analysis framework at the beginning of February. Of course, things can get worse, but these moves indicate a lot of bad news is currently discounted.

Fed actions and yields

Globally, we expect the number of people infected with the virus to peak within a quarter or two, allowing growth to begin to normalize again. The fed funds futures market is pricing in a 25 basis-point cut by March, 60 basis points of easing by June, and nearly 90 basis points through year-end. But for now, we need to wait and see how far the virus might spread in the US. The US economy has been resilient and has solid support from consumption and services.

The drop in US Treasury yields has been spectacular, as they have been a relatively high-yielding global hedge for risk assets. In our view, the inverted yield curve reflects the flight to relative safety and is not signaling imminent recession fears. 

If the economic outlook deteriorates much further, we would expect more coordinated policy easing globally. This would likely include central bank rate cuts and more fiscal spending. Additional policy support would help the global manufacturing recovery.

Credit view

Investment grade and high yield values had been fairly resilient relative to recent downward pressure on equity prices, at least until the past few days. We see several reasons for this. Investment grade corporates have benefited from their long-duration profile and grab for yield. Within high yield, maturities have been extended at low rates, raising the hurdle for earnings to fall before default risks rise. High yield indices tend to have less multinational exposure than major equity indices. In addition, we have seen a decline in new issuance despite investors’ persistent demand for yield.

Going forward, credit spreads are vulnerable, but we would welcome better valuations.

Foreign exchange

The US dollar is considered a relative safe haven and has been at the upper end of its trading range. We would expect the dollar to be resilient. EM currencies are most vulnerable. They have been hit hard in this global deflationary shock where commodity prices have come down. We have seen the euro and yen rally as they have been funding currencies for carry trades that are being liquidated due to market stress.

What are we watching?

We expect the follow-on effects of the virus to undermine a near-term pickup in global growth. While the manufacturing recovery we forecasted will likely be delayed, we still think it will take root by summer 2020. In an effort to affirm or challenge our view, we will be closely watching developments in the following areas:

• Profits (highly correlated with PMIs): So far, the number of companies decreasing their forward earnings estimates has not been significant. We expect more negative announcements. Our analysts are closely parsing company data to reveal any flaws in profitability assumptions and revenue pressure. We expect more companies to either suspend earnings expectations or guide them downward. Reduced earnings and cash flow will lead to higher leverage metrics, at least in the near term, until the virus' impact on economic activity diminishes.  
• Service sector: This sector has underpinned economic strength while the manufacturing sector lagged. It will take on even more significance given the potential earnings hit from a likely reduction in tourism and travel spending.
• High yield financial companies: In our experience, spreads on high yield financial companies are strong indicators of financial system strength, and we are monitoring them.
• Proprietary Risk Premium Models: Our quantitative team has developed models to help us measure how far prices typically depart from fundamentals during times of market stress. When this divergence goes too far, it signals a potential buying opportunity.
• Virus contagion patterns will help shape our risk expectations.

Authors:

Michael Crowell, Co-Director of Macro Strategies

Tom Fahey, Co-Director of Macro Strategies

Craig Burelle, Macro Strategies Research Analyst

Saurabh Lele, Senior Commodities Analyst

Commodity, interest and derivative trading involve substantial risk of loss. 

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