Analysing a possible ‘coronavirus recession’

It is possible that parts of the world economy may experience a “Coronavirus recession” in 2020. Hopefully it will be short-lived (and, with luck, it will not even happen). However, as a Company Director I have a responsibility to risk manage how it might unfold. As we are doing this work now at Craigmore Sustainables and Map of Ag I share my analysis with you, for what it is worth.*

* I’d be grateful to be sent any thoughts or links to useful articles you may have? If these lead to any substantial revisions of the below analysis I will collate and circulate.

My aim in this Commentary is to explore three questions:
1. Is the Coronavirus outbreak bad enough it may cause a Recession?,
2. What economic policy responses might we expect? and
3. How might it impact markets for traded goods?

1. Might Coronavirus cause a recession?

The first thing to say is that a number of economists have come out in recent days to say they expect a sharp slowdown but not worldwide recession in 2020.

E.g. in a helpful paper (which also outlines internal responses that companies should consider to protect staff and their families McKinsey argue the central case is a global slowdown but not outright recession – McKinsey & Company: Coronavirus COVID19: Facts, Insights, Crisis Response: Updated: Feb 25, 2020, Pg. 12. Meanwhile the OECD on 2nd March said that if the virus becomes widespread outside China it would halve their forecast for 2020 global GDP growth from 2.9% to 1.5%.

This would be troubling for many businesses, especially in directly impacted areas e.g. China, Japan and Italy (where schools are now closed) and Italy (which is considering closing them). But, even if these “social control” mechanisms are not adopted, which businesses operating outside the hotspot areas are likely to be affected? My view is, to answer this, we need to analyse the mechanisms by which economic shocks are transmitted:

Although recessions are by definition economy-wide and so will have multiple transmission mechanisms a key event associated with most recent recessions (1990, 2001, 2009 – see graph) was collapse of over-heated financial markets. In those three events this collapse led to withdrawal of finance from the economy, a consequent slow-down in investment and wider lowering of confidence.

Figure 1: U.S. Gross Domestic Product

Source: U.S. Bureau of Economic Analysis/fredstlouisfed.org

More generally, even in non-recession years, flows of finance have become a key facilitator of growth. Hence the close attention investors now pay to central bank interest rate and financing behaviours. Including QE.

In this financialised world it has been wise to follow the old market rule “don’t fight the Fed” i.e. to back the central bank markets to stabilise things when they get shaky.

In this type of economy, changes to trade flows, like the Trump trade wars of the past two years (clearly a “Supply Shock” as they have made imports more expensive) have been big news. But they have failed to cause a recession.

One needs to go back to the 1970s to find recessions that were triggered by changes in the real rather than the financial economy. These were the oil shock triggered recessions of 1974 and 1979 (again see above graph).

One reason for their resilience to real shocks is economies are less industrialised now. Even in China and certainly in the West services and consumption make up a higher % of GDP than manufacturing and primary industry. The shift to so many of us working in the service industries (and our associated consumption – again of services) have been contributors to economic stability.

In this context some economists and central bankers have announced in recent days that Coronavirus may become a “Supply Shock”. I.e. lead to a curtailment of production or rise in price of goods and services. Some have drawn analogies with the oil shocks of the 70s, which were inflationary. Arguing that shortages of key inputs and malfunctioning of supply chains is likely to lead to shortages of goods and so price rises. Others have argued that the disruption will lead to a consumer and business-led Demand Shock. However, what both schools are arguing is that we face a shock to the real economy, not the financial economy

Levels of economic activity are already tumbling in many countries. Obviously Greater China, Korea, Iran, Italy. Also in those sectors directly affected (e.g. aviation, tourism) in those (many) countries with so far low-level incidence (such as the US, UK, France, NZ, Australia). If Covid-19 spreads more widely in those countries leading to widespread quarantining and closure of schools and other institutions this will widen the challenge beyond impacted sectors to generalised economic activity. Impacting both Supply and Demand i.e. the real not the financial economy.

2. What may be the economic policy response?

How is government policy likely to address this? As Keynes pointed out, monetary policy may have some effect in addressing recessions that are financial in origin (since e.g. money printing or assistance to banks can address the root cause of such recessions). However, central bank action directly addresses the prime cause neither of supply shocks nor of shortfalls in consumer demand. Famously he described monetary stimulus in these circumstances as being as effective as pushing on a piece of string.

This has not stopped the Federal reserve announcing a 50 bps cut in interest rates on Tuesday this week (i.e. 3rd March, 2020), lowering their benchmark funds rate to a range between 1% and1.25%). This was one of the fastest moves – from new economic news to policy decision – in the history of the institution. Prompting some market analysts to ask “do they know something the rest of us don’t”? The reduction uses up 1/3 of the Fed’s remaining dry powder, and brings closer the prospect of the US yield curve, if things get bad, of following the European currencies into the bizarre world of negative rates (a place to which the Kiwi and Australian central banks may well follow, if necessary).

My point is the likely poor transmission mechanism of monetary stimulus in economies facing a shock to the real economy may make a Coronavirus slow-down, if it occurs, quite scary. The Fed was able to revive flagging asset markets by lowering interest rates. It is not clear how lowering rates (from levels that are already low) can really help or boost activity levels of businesses and individuals whose liquidity has been knocked by school closures, quarantines and resulting staff shortages and/or declines in revenue.

Might, therefore, the virus stimulate some innovative “fiscal” policy responses? Such as the US$1,200 cash hand-out given to every Hong Kong citizen (and some HK residents) over the age of 18 last week.

Meanwhile Italy has announced EUR 3.6 bn of economic assistance to e.g. companies whose revenues have fallen by more than 25% as a result of the virus. Delivered, we gather, via cash advances against taxes. Unlike in Hong Kong where the government are spending reserves these Italian subsidies will almost certainly be funded by printed money (Italy is also talking about tax cuts). Will we see more examples of such “helicopter money” being handed out i.e. direct demand stimulation using unfunded deficit spending in response to economics shocks? The market seems to think so as gold (the only truly scarce currency we have) has risen sharply in value.

Since most things economic are correlated it is worth noting that a global slowdown may tighten financial market conditions, making Coronavirus an issue more appropriately addressed by Central Banks. Indeed, this may be the reason the Fed has already acted so quickly. I don’t want to argue against the stock market. Many stocks are real assets and some offer both yield and growth in a world where other financial assets do not. They can be a worthy rival to farmland as an investment! However, stocks have had an amazing run (see graph below) and are well ahead of corporate profit growth. Therefore, there may be risks of the stock market normalising downward, especially if profits are challenged. This would (on past behaviour) be a cue for very substantial monetary policy stimulation. I.e. don’t be surprised if you see central bankers talking about negative interest rates.

Figure 2: U.S. Corporate Profits and S&P 500 (Jan 1990-Dec 2019)

Source: Federal Reserve Bank of St Louis, Bloomberg
Note: Corporate Profits After Tax (without Inventory Value Adjustment and Capital Consumption Adjustment). Last reported data September 2019.

3. How may Coronavirus impact goods markets?

In New Zealand, the sectors likely to be hardest hit are tourism, education and, within the export sector, seafood (see table from NZ Herald, below).

Figure 3: New Zealand Key Export Sector Risks

Source: NZ Herald

Meanwhile, it is likely that NZ’s major agricultural exports (e.g. dairy, infant formula, fruit and lamb) will be reasonably resilient. This is partly to do with falling exchange rates (the NZD is down 7% against the USD year to date – dragged down by the Australian currency – whose exports of coal and ore to China have been sharply curtailed). Meanwhile the Chinese are determined to keep the population nourished. For example, in recent weeks the Chinese Government has advised its citizens they should consume the equivalent of 300 ml of milk per day in dairy products to help with their immune systems (a significant lift from current average consumption in that country of under 100 ml per day). For those of us worried about health and environmental impacts of the increase this rise in consumption would still not begin to approach the approx. 700 ml equivalent consumed daily by Europeans. Given such sources of demand for such staple foods the main area for concern for NZ agriculture is logistics, with up to 7 days logistics delays within China, and numerous cargo restrictions to and from China (especially for non-perishable items like timber, also affected by a slow-down in construction).

Generalising we can predict that, if consumers rein in consumption, this will particularly impact discretionary goods and services. During economic shocks consumers are far less likely to reduce consumption of basic food, heating and communication services than discretionary items. Each sector and company will need to do their own risk management. For the farm-food sector we are discovering that e.g. seafood (often eaten in restaurants) has a higher “coronavirus sensitivity” than fruit or dairy (where kiwifruit, apples, cheese, yogurt, infant formula etc are often eaten at home). Meanwhile NZ forestry, as noted, has been impacted as scarce on-shore Chinese transport has been allocated to perishables. Anecdotally, two months of timber will soon be piled up on Chinese wharves and a further 1 months’ worth is at sea, anchored offshore, waiting to be discharged. Fortunately, we are now hearing reports of staff returning to work and some of these backlogs starting to be cleared. China’s travel restrictions have eased, and businesses are starting to reopen. But schools remain closed, which suggests they are not confident the outbreak is truly under control. However, the more general point is that different parts of e.g. the NZ export economy are being differently impacted.

Not all national economies have the same exposures. Some are more exposed to discretionary or investment related purchases than others. China and Germany, the two leading export nations on Earth, have both often achieved 10% annual growth in exports during buoyant years. However, amidst the world-wide trade slow-down of 2009, both saw their exports fall 9%. In that year New Zealand, over half of whose exports are food staples, saw its exports fall 1%. That said, consistent with the above table, 2020 damage to NZ exports to China alone may exceed the 2009 “hit” (as e.g. Forest product and Tourism exports are curtailed).

This economic analysis must not supplant the equally important steps (for which I refer you to the McKinsey Coronavirus Facts and Insights article) which management teams should now be putting in place to respond to risks to their staff and their families as well as clients. However, while we are all hoping and praying that the Coronavirus will be contained , we are also wise to analyse its possible impact on our own and our team’s health and ability to function, as well as risks to the revenues and costs of our enterprises. In the hopeful event this issue is found to be manageable, we can treat preparedness as an “insurance premium” we paid for an accident that did not happen.

If as is likely, the spread of the disease continues to be sporadic then, as predicted by McKinsey and the OECD, the world faces a disappointing but not disastrous economic year. If things get really bad then look after your colleagues and family, invest in consumer staples (and the farmland that grows them!) and expect more helicopter money and other unprecedented innovations. Including the spread of negative interest rates to countries that would never have expected to see them.

Forbes Elworthy