An Enquiry About the Influence of the Coronavirus in the Economy and the Financial Markets
First of all, I chose to talk about this topic because it is the most disruptive for our global paradigm today and because it is the factor that’s causing more turmoil in the different economies.
So what is Coronavirus? Coronaviruses are a family of viruses that cause disease in animals. Seven, including the new virus, have made the jump to humans, but most just cause cold-like symptoms. The vast majority of cases are in China but the virus has spread to 30 other countries. Compared to strains of the same type (Sars and Mers), Covid-19 is transmitted much more quickly however, the fatality rate is also much lower, currently at 2%. Also, compared to past outbreaks Covid-19 hasn’t infected that much. More than 81,000 cases have been confirmed since the outbreak started compared to 500 million infected by the Spanish flu. However, we can’t forget that we are in an initial stage of the infection and the strain is still being studied so we don’t have exact knowledge of the vast world of possibilities of how Covid-19 can affect the world.
Even if the number of infected is not so high compared to the overall population, markets are moved by expectations, fear, rationality also, and emotions. This made me remember an episode that occurred in Portugal where an expectation of low full supply caused an expectation of a long-term strike by the hazmat drivers made Portuguese citizens going crazy to fill the tanks; that led to a drop of short-term supplies, long hours queues, and made a big turmoil in the country where some people were selling fuel for up to five times the market price. This is where I learned that expectations could cause real effects in the world. At the end nothing happened, and all the turmoil was superfluous. This is the same thing I’m expecting it will happen with Covid-19 advent. Markets and the real economy will swirl a lot due to the phenomena of the expectation of the high spread of the coronavirus. The psychology, emotional and the mindset of people is very important to consider. We just must see that the revenue of Corona beer dropped significantly because people don’t want to buy a beer with the same name of a Virus even if there isn’t any correlation of contagious.
First, let’s see what happened where everything began, China. China is the country with most people infected by the Coronavirus with around 0.01% of the population being infected. It was the fast increase of infectious cases, the report of the first cases of death in China, and the spread of the strain to other countries that prompted the World Health Organization (WHO) to declare a global health emergency. In is essence prices are moved by two sides of the same coin: Supply and Demand. For and economy to work properly the supply of goods must match, more or less, the demand for them. The outbreak of the Coronavirus is affecting both demand and supply. In the demand side people are ruling themselves by emotions, namely fear. In the cities most affected by the virus people are afraid to go out with fear of catching this new disease, schools are closing, university as well, in general all institutions where people tend to be concentrated are closing, at the same time the tourism and the flow of people from place to place is sharply decreasing. This is causing a decrease in aggregate demand and economic transactions that will lead to a decrease in economic activity that will further lead to a deacceleration of GDP. An example of this is the city with most people infected, Wuhan, where we can see a drone footage of the city with no movement of people at all. Moreover, when people enter a state of fear there is a decrease in consumer confidence and people will prioritize the save of cash and liquidity instead of consumption further reducing the aggregate demand. In the supply side the first effect of the fall in demand is the accumulation of inventories and some companies will enter in overcapacity. Moreover, the fear of contamination of the workers is making factories across the country closing and workers are kept away from manufacturing centers. With factories shuttered and consumption stalled, multinational companies have been forced to shift production elsewhere. The South Korean electronics group Samsung, for example, has been closing Chinese plants and opening others in Vietnam. Mexico has benefited from some US corporations moving their supply chains closer to home.
No demand means no entry of revenue for the companies and this will pressure downwards their financial statements and as this outbreak is a systematic event most of the sectors will experience their earnings decrease. If the earnings decrease the investors will have to consider this in their valuations and the stock prices will fall in value.
The topic of my Master thesis “VaR Adjusted to Business and Financial Cycles” explores the possibility of existing different risk factors that are inherent to the state at the economy and where it is in the cycle, and it focus in adjusting this risk metric according to where in cycle the economy is. To assess when the economy is more at risk, I use economic and financial variables like the unemployment rate, the VIX, and the rate of change of debt. My proprietary indicator started to give red flags in September 2019 for the American economy. The indicator doesn’t tell certainly that something wrong will happened, it increases a bit the likelihood of something undesirable occur but more important it tells that if something wrong will happened in the red zone of the indicator the shock in the markets and the economy will be more sudden and violent (this can be observed recently in the S&P500 where the stocks fell around 13% last week, the worst week slump since 2008), this is why the VaR tends to be adjusted upwards when the risk variables are in the red zone.
One of the variables in my work is Debt and this can be very problematic for China. As the revenues of the companies falls by the reasons already exposed above the firms (small and medium-sized) will suffer a stress test to repay loans. The virus epidemic is mainly disastrous for bad debt. This will hurt the country’s banking system making pressure to the hundreds of billions of dollars worth of non-performing assets.
In the energy market, as China is responsible for good share of the oil worldwide demand the advent of the coronavirus plunged suddenly the energy demand in China making the price of oil follow the same path. As the virus spreads globally, I believe that more plants will shutdown leading to a further decrease in price with the Brent crude oil dropping to 40$ a barrel in the short term. One of the most important things to watch will be the response from OPEC towards this situation as they will leaning towards larger oil cuts to equilibrate the balance. Depending on the magnitude and the speed of their reaction they can sustain the price or even making it rebound.
The more interconnected and interdependent the economies are the more the risk tends to spread between continents. When the Coronavirus outbreaks was just in China in its initial phase the markets were not taking it seriously, it was just when the spread quickly increase in Europe, mainly Italy, that investors were finally raising awareness of the really extent that the outbreak could take. The problem is not the high number of infectious cases as we have seen previously that the number is still very low compared to major outbreaks but the reactions of the people towards it. The rapid surge of different cases in other countries and the constant and dramatic exposure of the virus in media is provoking a lot of fear in the citizens. This fear is creating emotional expectations that the outbreak will raise to the hundreds of million infected and cause a lot of death and pain in the world and this expectation is causing real effects in the world! In Europe a lot of institutions suspected of entered in contact with this pathogen are closing, the flow of people is falling, commerce is falling, and tourism is falling a lot. The north of Italy is feeling a lot this effect.
I suspect the countries that are most dependent of tourism, like Portugal, will be the ones facing a bigger impact in their economies. If the number of cases in these countries starts to increase just a bit the tourism will fall brutally and as these countries are dependent of tourism exportations, small and medium-sized companies will take a huge it in the demand side.
My main preoccupation is how the Covid-19 will behave in Africa and Latin America. The problem of this virus is its long incubation period and it is very hard to predict the extent it can take. While Europe as a strong health care system Africa and Latin America are much behind. If a virus that is highly infectious spreads towards these regions the outbreak can be much worse. Economically this would provoke a global economy slowdown of the and even if some countries like North America wouldn’t be much affected by the Covid-19 the global chain supply could hurt the economy of this country a lot.
Even if the virus doesn’t spread that much, the worst scenario would be that the slowdown of the economy in aggregation with loan repayments would cause an enormous chain reaction making the economy falling towards a downward spiral.
To conclude I believe the main factors that will drive the magnitude and extension of this outbreak in the economy are: the rate of increase of new infected cases, its duration, and the media response.
If the number of infected people stars to grow, as we saw, it will affect both the demand and supply side and depending on how the media report the news it will increase our not the magnitude of how people react towards the outbreak. The duration is one of the most important factors, the economy can handle a short-term shock of 1 or 2 months but the longer the duration the higher the likelihood of a chain-reaction.
Scenarios:
Best Case Scenario:
China is able to handle the outbreak, the number of new cases starts to decrease and eventually in mid-April the Covid-19 will be eradicated. Europe and the US are able to prevent a quick outbreak and the fear goes down. The virus will not spread neither in Africa nor Latin America will be completely eradicated worldwide in May/June.
People start to return to their normal lives and the economy activity stars to increase again while at the same time the loses incurred by the panic are small and the companies are able to run their businesses as before. Eventually the stock market will recover gradually as the earnings loss will not be as big as expected.
Average Scenario:
The Covid-19 continues to spread globally infecting between 30–55% of the countries worldwide. The numbers of cases in China will raise between 10 to 100 million and in Europe will not go above 1 million. The number of infected people will go up until May and the media will keep exposing and dramatizing a lot the facts. The fall of the aggregate demand and the decrease of economic activity will lead to a slowdown of the GDP for the next quarters and some countries that are more fragilized can enter in a technical recession. In the US the fed will drop interest rates to try to boost the economy activity but this strategy will only be effective if the cases of infection are low because if stores are closed and people are afraid to leave their home, even if it’s cheap to borrow if there isn’t demand there is no income and, by consequence, no earnings. With lower earnings the valuations of the companies will be priced lower. With the global chain minimally affected the overall business will take a hit and the most fragile and leverage companies will shut down. This will cause the stock indexes to fall between 15 to 30%. The investors and financial institutions will move towards safe haven assets and US Treasuries and metals will increase in price.
In Europe this will affect very differently its Countries. Nations that are dependent of tourism and have a high Debt/GDP ratio will be in trouble as the aggregate demand will deeply fall and they cannot use fiscal policy effectively. However, by mid-May the number of infection cases drop significantly, and people start to return to their normal lives. Some countries will have no problems to restart while others will feel more the effect of the economic slowdown.
Worst case Scenario:
The coronavirus infects more than 60% of the countries, the numbers that the Chinese Government are higher than expected and the number of infected people increase exponentially worldwide. People leave in fear to go out and the economy activity worldwide decreases sharply making a lot of economies enter in recession. Because of the huge number of infected people, the duration of the outbreak goes beyond June and the companies with bad debt will have more and more difficulty to pay causing. If more and more companies start to default this can cause a chain-reaction in the financial system that will lead to even lower demand and would ignite an economic collapse.
References:
https://www.telegraph.co.uk/news/2020/02/28/what-is-coronavirus-how-outbreak-start-spread-pandemic/
https://www.ft.com/content/ed3fb63e-41ce-11ea-bdb5-169ba7be433d
https://www.ft.com/content/fa003908-53a7-11ea-8841-482eed0038b1
https://www.telegraph.co.uk/business/2020/02/27/corona-maker-ab-bev-struck-coronavirus-outbreak/
