The coronavirus crisis is having a very negative impact on people’s daily lives as well as on markets, the economy and politics. A recent report by Arcano Economic Research explains the consequences of this disease in these areas, and the scenarios that can occur afterwards. According to the entity, the biggest challenge for governments is to reach a balance between how to contain the pandemic, and how to avoid damage to economic activity.
Searching for balance
The seriousness of this epidemic lies in the fact that there is no vaccine yet. This causes infections to intensify rapidly, leading to the collapse of hospital systems. To measure their level of infection, experts use two ratios: the infection rate or Ro, which indicates how many people would be infected if no one, neither people nor governments, did anything. And the effective infection rate or Re, which measures this level once containment measures have been implemented. It serves to measure how effective they are.
Governments have set a goal of moving from 2.3 Ro to a level below 1 in Re. Because reaching this figure means defeating the disease with containment measures, which opens the door to resuming economic activity. China, Korea and Japan are reaching this scenario.
Impact on the global economy
The panic caused by the pandemic delays consumption and investment decisions sine die. This hurts supply, because companies slow down production, and demand, because consumers stop consuming. Between them they generate 80% of the GDP, hence the relevance of the disease. Therefore, Arcano Economic Research estimates that global growth will go from an average of 3.4% in the last 10 years to less than 2.5%, the worst since 2009.
By areas, the most affected will be China, which will suffer a very intense fall in GDP in the first quarter, and the emerging countries. The OECD area will be affected in the second quarter. The recovery will come in the second half of the year, but at different speeds: in China and the emerging countries in the form of a square root (a fall followed by zero or low growth in several quarters) and in the rest in the form of a U (a fall followed by flat growth in one quarter and a sharp rise in the next).
The reason: China will have to assume structural damage to its economy. The liquidity crisis in small companies and the bursting of the housing bubble will affect the banking system and cause GDP to fall by 2-3% in the first quarter.
The Chinese growth model, based on outsourcing for the supply chain, will have to change to insourcing, i.e. the use of own, not external, resources, which will threaten the Chinese industrial sector, which accounts for 43% of GDP. This will threaten China’s industrial sector, which accounts for 43% of GDP. In this tough environment, China will have to manage a high level of public debt, which will surely slow down the recovery of its growth.
As regards Europe and the United States, the impact in the first quarter will be zero because February’s data does not indicate that activity is falling. The ISM (Purchasing Managers’ Survey) indicators do show sharp declines in the second quarter, and we will have to see what this means for employment. Another data to be monitored will be the capacity of banks to inject liquidity into the system, especially SMEs, which generate most jobs.
In the emerging region, the worst capital flight in many years is taking place, due to the fall in the price of raw materials. This is a dangerous situation, which can lead to bankruptcies in countries that have abused their debt, as has been the case in Lebanon.
Impact on markets: volatility
As in 2008, the markets are suffering from a liquidity shock. However, at that time investment banks provided liquidity at the trading desks, which current regulation does not allow. The result is highly illiquid markets, a factor that drives volatility.
Thus, the American stock market has reached volatilities of 50%, when its historical average is 19%. Only during the Lehman Brothers crisis did volatility reach the record level of 89%, compared to 40% during the Second World War when Hitler invaded France.
There is another factor driving market instability, algorithmic trading or quantitative sales managed by robots. These are tools that replicate the behaviour of the stock market, both in sales and purchases, amplifying volatility. It is estimated that in just one week, the US stock market lost 50 billion dollars because of this, although when the epidemic is contained, the market will rebound more thanks to quantitative management.
Impact on asset classes
- Sovereign Bonds: Investors are seeking refuge in sovereign bonds, but they discriminate against and choose the strongest countries, so those emerging economies that are more fragile – for example, Turkey – may suffer.
- Currencies: The yen, Swiss franc and euro are rising at the expense of the dollar. The reason, investors usually put long (buyers) in currencies that pay returns, and finance themselves in currencies with zero or negative returns. To make profit on the spread.
In the current environment, you are selling currencies that have been long in the market, and buying back those you have financed: the yen, the franc, and the euro. As a result, the dollar is at record lows, and weakness is growing in emerging currencies. Therefore, if an emerging country borrows in dollars but collects in local currency, it has serious liquidity problems.
- Money markets: Money markets are experiencing a liquidity flood. In the United States, the Fed announced that it was increasing daily intervention to 150,000 dollars in the repo market, to give liquidity in the interbank market to banks that want to lend to other Asian or European financial entities. This scenario is not comparable to that of 2008, when the banking system had solvency problems, which was dangerous for the economy. Today the banking systems are more solvent, and have access to liquidity more easily. It is therefore a temporary situation.
- Credit market: The focus of the market is on the investment grade segment. In the US, the lack of liquidity can generate a problem if the recession arrives, and there is a reclassification of BBB- bonds to BB+ bonds; in that case, there would be no money to buy bonds with this rating. On the contrary, the situation in high-yield markets is devastating: no liquidity, huge price drops, closure of the primary, and increase in the default rate.
- Equities: We are in a bear market, with corrections of 30% or more. The market is anticipating recession, but of the last seven bear market situations, only two have confirmed recession. So, when this scenario is ruled out, the money will quickly return to equity.
- Commodities: The most cycle-sensitive commodities are in a weak phase, as is the case with zinc and copper. Oil discounts lower demand, due to a geopolitical issue. In the past, the OPEC production cartel tried to reach an agreement with Russia to continue production. However, Russia refused in order to raise the price and harm the United States.
In this situation, Saudi Arabia has decided to increase production in order to keep prices low and avoid bankruptcies in corporate bonds (high yield) of oil distributors, and to take Russia out of the market. An environment of nervousness accentuated by the coronavirus. In the short term this is bad news for countries like Mexico, whose income depends on a quarter of the price of oil.
Impact on the Spanish economy
The engine of the Spanish economy is tourism, because 12% of the Spanish GDP is generated by this sector. Half is international and half domestic, although the most relevant for our economy is the international one.
It seems reasonable to estimate a 50% drop in income from the Easter season. Easter represents 15% of the total income generated by international tourism. If the coronavirus is contained before summer, the summer season will not be affected.
Where there may be a more serious impact is on the fall in investment in the second quarter: less business spending, less consumption, frequent ERES and ERTES in small and medium enterprises, which account for 60% of GDP and 80% of employment and a decline in exports of goods. The case of China is worth noting, because we export 0.5% of GDP to this country and 500,000 Chinese tourists visit us every year. Finally, the real estate market will suffer delays in the purchase of homes due to the fall in demand.
But not all the impact will be negative. The fall in oil prices can benefit our economy, because we spend 2% of our GDP on crude oil and oil products. And as China recovers its production capacity and inventories – it is in a much more advanced stage of containing the epidemic than Spain – the beneficial effect on the Spanish economy will be greater.
In conclusion, experts from Arcano Economía Research predict a 0.6% drop in Spanish GDP due to the coronavirus. And a rise of 0.2% due to the drop in the price of crude oil. At the end of 2020, the estimate of growth is 1.3%, a level insufficient to create employment.
However, since our economy will recover in a U-shape, we will return to normal in the fourth quarter, laying the foundation for stronger and more stable growth in 2021.
On a global level, analysts discount a return to normal in the months of May-June and a second half of growth. In the markets, the reaction may be very positive at some point in the second half of the year, given the precedents. In 2008, world GDP fell -0.1%. Thanks to the signs of economic recovery that began to be felt in March, 2009 was the best year in the history of the stock market.
Financial Communications manager in Proa Comunicación