Coronavirus uncertainties destabilize global economies
The novel Coronavirus has caused significant suffering and major economic disruption on a global scale. As the virus continues to spread, it can be expected that it will continue to drive market turbulence and bring a material impact on the near-term global economy.
According to the Organization for Economic Cooperation and Development (OECD), the expected global GDP growth rate in 2020 has been downward adjusted to 2.4% from November 2019 projections of 2.9% and could further plummet to as low as 1.5%.
The outbreak of the virus has impacted the global economy in two major ways:
- The slowdown in consumption or, in some markets, complete shutdown of the hospitality, tourism and retail industries. While it is thought that the spread of the virus may slow during the summer months, extraneous activities and consumer spending will undoubtedly be curtailed to minimize the risk of infection. While the slowdown in consumption may affect certain industries, retailers, and businesses more than others, the overall economic impact will be staggering. Those influenced by the slowdown are likely to react with cutbacks to investment, implementation of cost controls, and postponement of expansionary plans, thus further exacerbating the economic depression.
- The breakdown of the supply chain. In January when China was most impacted by the virus, widespread factory shutdowns caused significant headaches for global supply chains. For example, approximately 50% of automobile industry components are manufactured in China, while China, South Korea, and Japan comprise over 40% of global supply chains for consumer electronics. Disturbances to these and other supply chains have certainly inhibited business operations across the globe.
The OECD also cautioned that, amid the backdrop of already weakened GDP growth, the economies of Japan and the Eurozone could slide into a recession this year. Additionally, a breakdown in the UK’s post-Brexit trade talks with the EU could also represent further downside risk to the global economy.
China has already begun to feel the economic impact. The restrictions that Chinese authorities placed on the nation to limit the spread of the virus, while effective, resulted in a significant decline in domestic economic activity. The Caixin manufacturing PMI in February crashed to historical lows of 40.3, primarily due to production shutdowns that lasted for over one month.
Caixin China Manufacturing PMI
Sources: Bloomberg
The global economy is highly interconnected, and the fallout from a downturn in a market as large as China’s will inherently spread to other economies. The past two months of Chinese output contractions have impacted growth figures across the globe, showing the integral role that China plays in global supply chains, commodities markets, and the global retail industry.
The Coronavirus has impacted both supply and demand within the global economy. As MNCs struggle to restore normal operations after significant disruptions to their supply chains, weakened production levels have crippled economies around the world. Many companies are realizing their significant exposure to Chinese supply chains and, as a result, have begun to transition production lines to other emerging countries like Vietnam, Indonesia, and Cambodia. However, it will be a lengthy process to re-establish the same level of production capacity that these organizations currently have in China. Furthermore, as China supplies much of the world’s raw materials, component shortages and factory shutdowns will continue to weigh on global deliveries for some time.
Emergency Fed rate cuts
On March 3, 2020, the Fed surprised markets with an unplanned interest rate cut. The Fed announced that it lowered benchmark interest rates by 50bps to a target rate of 1.00-1.25% and, on March 15, 2020, it further lowered interest rates by another 1% to 2008 crisis levels of 0.00-0.25%.
Federal Funds Target Rate Upper Bound (%)
Sources: Bloomberg
US vulnerable to external shocks
As of mid-March 2020, the US economy has been comparatively insulated from demand shocks and supply chain-related issues. Strong employment, rising wages, and a relatively low debt burden has supported the US consumer sector. However, we expect economic indicators over the coming weeks to begin missing consensus projections.
According to the Fed’s Beige Book report, there are indications that the Coronavirus has not only caused delays in supply chains, but also impaired travel and tourism in the US. Furthermore, many businesses have cancelled work-related travel and Americans are beginning to stay at home due to the risk of infection. Given the consumer sector is a critical driver of US economic growth, with an increasing portion of the population reducing consumptions and companies implementing cost-cutting measures, the economy may begin to show cracks. As a result, we can expect that a rapidly spreading Coronavirus will bring further disruption – particularly within the US services sector.
US corporates will need to prepare for mounting cash flow pressures. Corporate credit lines may be affected first as banks consider pulling back loans in response to escalating economic uncertainties. We anticipate the Fed’s recent rate cuts as intended to project confidence in the banking system and coax institutions into continuing their role as financial intermediaries.
The Fed has been much more active in the face of the Coronavirus as compared to the 2008 financial crisis, despite stronger overall household leverage ratios and cash savings. Consumer spending is at risk while trips are being cancelled and corporates are beginning to reduce costs. Account receivables are piling up while banks are being more selective in loan reviews. Securities market volatilities have triggered margin calls while stop-loss and algorithm-spurred selloffs have created a vicious cycle leading to market-wide liquidity issues.
While the Fed’s response has undoubtedly maintained bank confidence and liquidity pools in the market, corporate CDS rates and interest spreads among various currencies are both widening. With markets and currencies across the globe manifesting differently, markets will likely remain fragile and suffer from significant volatility for a time to come.
It is difficult to predict how long the Coronavirus will continue to plague markets. While global markets think back on lessons learned from the 2008 financial crisis, it is understandable that banks and investors have quickly become risk averse. That said, household debt-to-income ratios are much healthier now than in 2008, and the overall US economy is much stronger compared to pre-2008 levels. While the effectiveness of the Fed’s monetary easing policy is disputed; however, its commitment to market stability has helped ease institutional worries. With consumption as the main driver of the US economy, it will be imperative for both the Fed and the US administration to consider how to maintain healthy employment levels and drive business confidence for continued investment.
As market volatility runs rampant and economic uncertainty drives systemic fear, it is important to remember the age-old adage in finance, ‘where there is risk, there is also opportunity.’
