Four economic scenarios for the virus

Fears that the coronavirus will have a substantial impact on the world economy have taken hold in the last week, prompted by the sudden large outbreaks in Korea and Italy. Major stock markets have fallen more than 10% and the benchmark US 10-year bond yield has hit a new low below 1.2%. I will not attempt here to pinpoint exactly what is happening with the virus, but instead offer four scenarios for the world economy based on how bad the crisis becomes. The risk of a US and European recession this year has risen sharply, but there is a good chance that it is V-shaped, with a strong recovery once the virus retreats.

Scenario 1: Containment succeeds

Despite current fears, infection and death rates could tail off in the next 1-2 months due to containment and the typical seasonal flu decline. February is usually the peak for seasonal flu with cases dropping sharply in March and April. There is therefore a good probability that the coronavirus will also fade in the Spring, although the US Centre for Disease Control (CDC) has noted that this is not known for sure. In this scenario then, declining infection rates will take the virus off the front pages and people will start to return to normal as early as April. The virus might return next Winter but by then, we might have a vaccine, (though this is not certain either). The markets seemed to be running with this scenario until a week ago, with Western stock markets buoyant. Any impact on production, consumption and supply chains was thought to be limited, with really only China affected badly. Any loss in output was expected to be restored quickly in coming months with Chinese factories working weekends to catch up.

Scenario 2: Asian economy hit badly, supply chains severely disrupted.

Some combination of the virus spread becoming worse (before it gets better) and both demand and supply being severely hit by people staying indoors, not just in China but in other countries mainly in Asia, makes for a more severe impact. But in this scenario the virus still does not become widespread outside Asia so has little impact on consumer behaviour there. Again, it could fade in the Spring and a vaccine might prevent it recurring. Still, problems with supply chains as well as businesses holding back on hiring and investing means there is at least some hit to business confidence in the West as well as East. Investment falls bringing a slowdown everywhere (worst in China), but probably not a recession.

Scenario 3: The virus spreads globally and damages confidence.

In this scenario the problems in China over the last two months are reprised in the rest of the world, as increased fears about the virus keep people at home. As we have seen in China the effect on consumption and production can be considerable, even without many infections or deaths compared to the size of the population. The official figures from China likely understate both infections and deaths but at 79000 infected and 2800 deaths they amount to approximately 1 in 17000 people contracting the disease and about 1 in half a million in the population dying of it. Even if the true rates are 100 times these official numbers, that would still be less than 1% of the population infected and less than 0.0002% dead. But, as we have seen, this is enough to cause major economic disruption as people are asked (or forced) to stay at home. In this scenario there is a much more severe global economic impact and a recession becomes likely.

Scenario 4: Infection becomes widespread

Containment fails and a significant percentage of the global population contracts the disease over the next year. Probably anywhere from 25-75% of the world’s population could catch the disease eventually. Most people will recover quickly but the final death rate could be in the range of 0.5-1% of those infected, according to The Economist, mostly older people or people with prior health conditions (who are also more likely to catch the disease). A recession in Europe, the US and UK would be certain as people stay at home. Monetary loosening (where possible) can be expected and also fiscal stimulus. Already in Hong Kong the government is giving money directly to citizens (rather than planning tax cuts or investment spending which tends to take longer to enact) and such policies should be expected in the West too.

The impact on GDP

It is worth thinking through how the virus impacts GDP. If people don’t produce things because their place of business is closed (and assuming they can’t work from home) that production may still be caught up later, for example through overtime work. This is most obvious for goods production but can apply also to services like restaurants, hotels and entertainment since people may go out more often for a while once the threat has passed. It can even apply to airlines which might need to idle planes and pilots for a few weeks but then enjoy higher load factors and higher prices later in the year as everyone tries to catch up on their holiday or business trip.

But what if people are laid off without pay, or don’t earn because they stay at home (self-employed and proprietors)? Spending inevitably declines in the short-term as they pull back. But if others, constrained by staying at home rather than lower income, start spending again a few months later, people might make up in overtime and extra profits what they lost before. So there is a case for expecting any recession to be V-shaped once the virus threat goes away.

What is the risk of a bad recession?

Is there anything that could make the recession other than V-shaped? Ultimately this depends on whether or not confidence bounces back quickly. I can think of three areas to watch. One would be if the recession causes major financial distress somewhere. I have argued in previous posts that China is vulnerable after the debt binge of the last decade, though the government will move quickly to try to manage any defaults. US corporate debt is also a potential problem though the Fed will certainly cut rates in a recession. European banks are also still relatively weak and a re-run of the euro crisis is possible, though again, expect a government response. Overall though, the world banking system is much less exposed than in 2008.

Secondly, there could be major political fall-out. Some people would argue that if a US recession makes President Trump lose the coming election, that would be a good thing! But a Bernie Sanders Presidency would be viewed with trepidation by business and might damage confidence. There are also less predictable political events – for example an explosion of support for the Far-right in Europe. Elections are due in Germany in late 2021. Or an upset to the Chinese Communist Party which leads to anarchy and confusion.

The third concern is if stock markets fall particularly hard. Suppose we had a re-run of 2001-3 where the US and European stock markets fell by around half over 2 years or more. It might be difficult for confidence to rebound quickly in that environment. That said, while stock markets have looked expensive on some criteria (especially the US and especially growth stocks), very low interest rates mean that we should expect high valuations. So, arguably the situation is different to 2001-3.

The key is then is confidence. Recessions are usually caused by a collapse in business and/or consumer confidence either due to high interest rates or a shock. Plainly the coronavirus may well deliver that shock in coming weeks. Many people will fret that the limited scope for monetary loosening this time could make it difficult to recover from the recession. But in my view, the particular case of a virus could build an automatic V-shape into the downturn once the virus retreats, provided the other worries – financial risks, political risks and stock market risks – can be managed.