28 February 2020

Coronavirus: reasons to be cheerful

By James Sproule

As Coronavirus sweeps across the continents, causing death and panic in unequal measure, I thought it might be useful to provide a bit of perspective by looking at the economic impact the virus is having – and what might be coming in the next few weeks.

In the immediate term, data from the US Centre for Disease Control covering the period of 1982-2018 shows the peak of the flu season is Feb, with a degree of peak flu activity trailing over into March with – in exceptional cases –  it lasting into May. Looking at this year’s data for the US, the peak would appear to have been be in mid-Feb, and the decline in reported cases is following the historical pattern. While the influenza hospitalisation rate in the US is greater this year than that seen last year, it well below the record level seen in 2017/18.

Looking to the longer term, it has been noted by Matt Ridley that it took years to sequence the genome of HIV, weeks to sequence the genome of SARS, and days for Covid-19. Such a sequencing is seen as being the first important stage in developing a vaccine.

The bottom line here is that, while there seems to be evidence that the Corona virus is rapidly spreading, there is also very likely to be a natural falling off in any flu pandemic as spring approaches. Rapid advances in immunology would suggest that a vaccine will be available before the next flu season is with us next autumn.

What is the likely economic impact in China?

Official economic data from China has been notoriously unreliable. The Chinese Government is still predicting a slowing down to 4% growth in 2020 (from an expected 5.8%), however economic forecasts from around the world frequently have great difficulty in anticipating volatility, even where such volatility has been a prominent feature in the recent past. The IMF’s most recent forecast (Oct ’19, so after the initial slowdown in freight rates) see a slowdown in imports, but otherwise exports, investment and overall GDP all remain on trend. China has not had a recession since before 1980, so any negative growth will come as an economic, political and cultural shock. Anecdotal evidence from business in China suggests that many factories remain shut and economic activity has been severely curtailed, so a sharp downturn has to be a realistic possibility.

The key question for investors is what sort of recovery is China likely to have. Will the recovery be rapid, (or “V” shaped), meaning sell out positions now will simply crystallise losses? Will it be “U” shaped, meaning recovery from this downturn will take longer? Will it be “W” shaped, where any recovery in China is temporary and there is a second downturn as the Coronavirus moves to the rest of the world and impacts demand for Chinese products? Many investors have been willing to “look through” the crisis, essentially anticipating a “V” shaped recovery, but the more that the Coronavirus spreads, the more difficult it is to maintain this position.

Of it’s near neighbours, Hong Kong is China’s biggest export market (and second largest overall, after the US). Europe remains China’s third biggest export market, and Germany is the key market within Europe, followed by the Netherlands and the UK.

While there has been some media attention on the plight of car makers, parts for motor vehicles constitute a relatively small part of Chinese exports. Of far greater importance is electronics and computer manufacturing.

In trying to better gauge the accuracy of official Chinese government data, analysts for many years looked at figures for electricity generation. This was and remains a very good proxy to overall GDP growth given the Chinese economy’s dependence on manufacturing and their general stage of development. Such data also provided a timelier and more accurate guide to what was going on than Government reported (and massaged) GDP figures. Related to electricity generation figures are coal consumption figures (where the most up to date data exists); this data points to a significant slowdown and reveals consumption has not recovered as would have been expected post the lunar New Year celebrations. A clear indication that many factories remain idle, or certainly working at well below capacity.

As a result, there is likely to be a measurable downturn in the Chinese economy in 2020, but whether this is a “Chernobyl Moment” for China (a crisis so bad that people lose faith in their country’s political leadership) is a question for another day.

Global economic impact

So what is the likely impact of this on the global economy?

The 2007/08 financial crisis demonstrated many things. One of the most important, highlighted by the demise of Lehman Bros, was that there was a greater degree of connectivity in financial markets than anyone had anticipated. Indeed, it rapidly became apparent in the autumn of 2008 that the degree of financial connectivity was so complex that it was essentially unknowable – and where risk cannot be judged, investors and banks were unwilling to trade, not just with Lehman, but with anyone.

The lesson is that globalisation generally means the degree of connectivity of the Chinese economy, particularly in manufacturing, into the wider world is considerable and like financial connectivity extremely difficult to gauge. It is often cited that the Chinese economy accounts of 16% of global GDP, but this does not give great insight into the integrated nature of manufacturing. That said, unlike the 2008 global financial crisis, engaging in trade does not entail the same risk of loss of principle that ultimately underpinned concerns in the financial crisis.

What has been happening is a crisis in trading confidence and with this, there is a danger that this loss of confidence moves more broadly into effecting business confidence.

Looking specifically at the most recent trade data, according to the International Maritime Organisation over 90% of physical trade moves by ship. The Baltic Dry index – a global measure of dry (so not oil) shipping freight rates across a series of key global shipping routes – has suffered a sharp decline of 84% between Sept 2019 and Feb 2020, and the outbreak of the Corona virus in mid-Jan simply kept that trend going (although since mid-Feb there has been a minor correction). By way of contrast, the Baltic Dry Index suffered a 90% decline in the wake of the Global Financial Crisis of 2008. The highly responsive nature of shipping rates (bearing in mind the index often over corrects) and weekly data updates make this an indicator to watch.

So the bottom line here is that there is a reasonable likelihood of the Coronavirus being effectively contained and fading within the coming months, this means the wider economic impact on trade is going to be seen primarily in the emerging gaps in supply chains and the congested backlog of shipping.

Knock-on effects

It’s now more or less certain that the Coronavirus is going to have a significant impact on global growth in the first half of 2020. Even if the mid-Feb peak of flu did turn out to be the worst of the disease, there has been sufficient disruption to supply chains and shipping schedules, congestion in ports and delays in production, that there is going to be a measurable impact.

The bigger danger, so far unrealised, is that this crisis will be the catalyst for a wider loss in business and consumer confidence, and with loss in confidence comes a reassessment of asset valuations. Central Banks around the world have been pursuing a Zero Interest Rate Policy since 2008. The result was initially the world was saved from a dramatic economic depression, but in time this policy has also underpinned a steady rise in asset values. These asset values, in housing, in equities, and in bond and debt prices, have reached the point where a significant correction is highly likely.

A rapid correction of the scale necessary to return valuations to historic norms would trigger a recession similar if not worse than that experienced in 2008, as firms curtail investment in light of higher borrowing costs and consumers come to terms with the fact that their biggest assets, their home and their pension accounts, are now worth far less. What Governments and Central Bankers would do in response to such a reassessment in asset valuations remains to be seen, but the most likely path is the one followed by the Japanese: namely having the Central Bank purchase a wide range of assets. As with Japan, it does not necessarily follow that this will lead to any sustainable growth, although it may prevent a recession.

So, in short, the real economic danger of Cornavirus is not temporary supply chain disruption, which is likely to substantially slow global economic growth in the first half of 2020. The concern should be that this crisis triggers a panic in consumer and business confidence and in doing so sets off a wider reassessment of asset valuations.

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James Sproule has worked as a Senior Business Adviser to the Prime Minister, as well as a number of think tanks, management consultancies and investment banks.