The Four-Stage Impacts of the Coronavirus
(Bloomberg Opinion) -- When it comes to the impacts that the coronavirus could have on economic well-being and corporate profitability, it may be useful to think of four stages. The first two are currently in play and legitimately worry many, from households, companies and financial markets to governments and central banks. They don’t just overlap but feed on each other in an unsettling manner.
The third phase involves forming a market bottom and, subsequently, an economic one providing the basis for a sustained though far from full recovery. The final one is potentially longer-term and could have elements of de-globalization and, in the case of financial regulation and supervision, greater focus on liquidity risks among non-banks.
Phase 1: Economic and corporate damage
As I have detailed in earlier articles, the coronavirus is unusual in that it triggers at the same time large adverse supply and demand shocks that disrupt both the manufacturing and services sectors, while simultaneously involving multifaceted internal and external dislocations. It’s a dynamic that has been experienced in small developing countries, particularly among fragile and failed states, but not in large, interconnected economies such as China.
With fear amplifying things, the result is what I have called a series of cascading economic sudden stops that virtually paralyze impacted activities. Unlike financial sudden stops, where the spike in counter-party risk and resulting disengagement of banks can be overcome by strong central banks activating their balance sheets, there is no quick way of ensuring that the damage is transitory (i.e., contained, temporary and reversible). The risk of limited policy effectiveness is not just a central bank issue. It also applies to fiscal stimulus, albeit to a lesser extent.
The outlook for the global economy, with considerable likelihood not just of a significant slowdown but also several countries in recession, worsens at a time that already included fragile growth dynamics. With one exception, every component — consumption, investment and trade — of the gross domestic product growth equation is coming under pressure in a multiplicative fashion. The one that doesn’t is net government spending, due to likely fiscal policy responses and automatic stabilizers. Yet it risks adding to funding (and, in some cases, exchange rate) pressures in the most financially stressed countries.
For their part, most companies face challenges due to lower revenues, higher costs, complicated inventory management, staffing shortages, pricing power erosion and, therefore, profit margins and balance sheet positioning. These pressures are particularly acute for those operating in the affected areas, followed by multinationals with global supply chains and markets.
Phase 2: Financial contagion and feedback loops
The market reaction at the outset is to frame the dynamics of such an initial exogenous shock as constituting a sharp V that can be “looked through.” In the case of the coronavirus, it encouraged “buy-the-dip” investment behavior, anchored by recent experiences such as the September attack on Saudi oil fields and the U.S. missile strike in January that killed a senior Iranian general. But the ability to brush off mounting inconvenient truths is subject to a tipping point. In this case, that occurred last weekend with the spread of the coronavirus to Iran and Italy and its growing presence in Japan and South Korea.
Once reached, the tipping point launches technical market dislocations that have their own dynamics. This includes sharp downward price moves, forced deleveraging, and panic selling. The market for new funding starts to freeze and pockets of illiquidity become more pronounced. Pressures build on central banks from many sides to cut rates and find other ways of injecting liquidity, even though this does not address underlying causes but instead targets the financial symptoms.
The longer these financial dislocations persist, the higher the risk of contaminating economic and corporate fundamentals. The resulting pressure is particularly acute for companies, households and governments that need short-term access to funding due to low cash balances and maturing debt obligations.
Phase 3: Bottom formation
Markets will typically overshoot on the way down, providing the basis for a technical bottom. For it to prove a steppingstone to a large and sustainable recovery, rather than just what the marketplace terms a “dead cat bounce,” the dislocation’s initial cause needs to be addressed. In this case, that means successfully containing the spread of the disease and significantly increasing the patient recovery rate (best done via a vaccine). Economic expectations would pivot from an L to the brighter side of a U, resulting in significant comeback in growth and buoyant financial markets.
Phase 4: Longer-term effects
This type of exogenous shock is likely to leave scars. These could well include a further push toward de-globalization, due to a less-open approach to travel and migration. More companies will assess the disruption risks of global supply chains, and not just their benefits of lower cost, just-in-time inventory management and greater efficiency. Financial regulators may more seriously evaluate the extent to which liquidity risk has migrated from banks to non-banks.
The initial romance with a quick “V” by markets and corporate/economic analysts has finally given way to a more realistic assessment of the seriousness and severity of the sudden stops unleashed by the coronavirus. Still to come is the required, more holistic understanding of the different stages of this consequential shock. The sooner this materializes, the better equipped we will be to handle the damage to economic prosperity and financial stability.
This column does not necessarily reflect the opinion of Bloomberg LP and its owners.
Mohamed A. El-Erian is a Bloomberg Opinion columnist. He is the chief economic adviser at Allianz SE, the parent company of Pimco, where he served as CEO and co-CIO. He is president-elect of Queens' College, Cambridge, senior adviser at Gramercy and professor of practice at Wharton. His books include "The Only Game in Town" and "When Markets Collide."
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