Coronavirus: will there be a global recession?

A key question for investors tackling market volatility triggered by the Covid-19 outbreak is whether the impact will be short-lived or will mark a longer-term inflection point for the global economy - perhaps even a recession.

The good news is that, unlike natural disasters such as floods and earthquakes, capacity should bounce back once things return to normal: factories and offices remain untouched and most people who fall sick recover. However, the downside for investors is this may cause governments to wait and see how the virus spreads before turning on the fiscal taps.

The Fed cut rates this week and other central banks will probably further monetary stimulus, which may stabilise markets but - with policy already loose - have less impact on the real economy.

Estimates vary as to the global GDP growth impact. A 2013 report by the World Bank estimated that a mild flu pandemic would shave 0.7 percentage points off growth, and a severe one 4.8 per cent.[1] The OECD believes an escalation of the outbreak could cut 2020 growth of 3 per cent by almost half to 1.5 per cent. So far, consensus global GDP growth estimates for 2020 appear complacent even as the virus takes hold, declining just 0.1 per cent since the end of 2019.

While impossible to predict with high conviction, our current base case (at roughly 60 per cent likelihood) is a 30-50 basis point hit to a 3 per cent global growth projection for 2020; our best case is 10-20 bps (at 20 per cent probability) and our worst case is around 1 per cent (15 per cent probability - with a 5 per cent chance it could be even worse).

Our earnings estimates have also changed since January (Chart 1), although our analysts caution that many company managements themselves still don’t know how bad the impact will be. The ultimate outcome depends on how long the virus persists, the size of the policy response and how far the knock-on effects extend - from more people working from home and buying online to cancelling the Olympics.

Our investment teams observed - before the virus emerged - that while growth was picking up at the start of 2020, the magnitude of any rebound would be subdued. Central bank action in 2019 had stabilised the fall in activity due to trade tensions between the US and China, but the expected recovery looked fragile as inventories were high. With the virus affecting first China and Asia and now Europe and the US, some - but not all - economies may slide into recession. We explore the possibilities below.

Beyond economics, the investment implications will differ across regions and sectors. Long-term investors with well-diversified portfolios and flexibility can move tactically to mitigate these risks, and take advantage of pricing dislocations if volatility persists.

Production at many Chinese companies continues to run far below usual levels and a third of small and medium-sized enterprises expect revenues to halve in 2020.[3] In response, the government has introduced a range of stimulus measures and could do more. Despite a policy of trying to reduce borrowing in China and having triggered some stimulus measures before the crisis even hit, the authorities appear determined to support the economy.

Our portfolio managers in the region report that outside Hubei province, the centre of the outbreak, economic activity in China has returned to around 50 per cent of normal activity[4] and is likely rise to 70 per cent in the next few weeks. Inside Hubei, activity is around 30 to 40 per cent of normal levels. China’s disciplined handling of the crisis means that, unless it has urged a return to work too soon, it could emerge first, even as the rest of the world gets to grips with containment and mitigating the economic impact. Sectors such as healthcare and online gaming may even be long-term beneficiaries.

Economies in Europe, such as Italy, are more at risk. Growth was already sluggish, and many countries rely on tourism and are part of complex global supply chains disrupted by the virus. Signs of green shoots in Germany in January are expected to vanish in the first half, given its reliance on Chinese industrial demand.

Meanwhile, the European Central Bank is expected to respond to any changes in the inflation outlook, but has less monetary ammunition to counter any significant downturn. The European Union’s deficit rules also limit large fiscal spending plans. While the rules have emergency clauses that allow them to be broken in extreme situations, getting agreement could take time given political differences across the region.

Despite the announcement that California is monitoring thousands of people for Covid-19 and further cases are expected across the country, the US economy appears better placed to withstand disruption, meaning a mild slowdown is more probable than a recession if the virus is contained.

The Federal Reserve cut rates earlier this week. Markets are pricing in a total of three more cuts during the year, when previously the Fed had been expected to hold rates into the run up to the US election. The outbreak could trigger a fiscal response, but this may be complicated by politics as the November poll draws closer.

While infection rates will stabilise and economic disruption will eventually subside, it is too early to say whether the recent market sell-offs mark the bottom or not. Markets had been expecting a poor Q1 followed by a rebound in Q2. But the peak of the bad news for earnings and GDP growth is now likely in Q2, potentially persisting into Q3.

Market expectations for central bank and government intervention remain high, even where monetary stimulus has limited impact and fiscal stimulus, which can be much more effective, will take time to materialise. However economic and market impacts are rarely synchronised - so as evidence of stabilisation of the virus spread comes through, markets are likely to rebound (even if the economic effects have yet to play out).