We think that comparisons of the potential impacts of COVID-19 with those of the GFC are premature. Below we draw on the views of leading economists to explain the most likely scenarios for the global economy from here.
Uncertainties remain, but calm logic suggests the sky isn't about to fall, and that major economies are in far better shape now than they were in 2008 to combat coronavirus impacts.
The wave of global fiscal stimulus is now ramping up which should help to absorb market volatility.
COVID-19: Similarities and differences versus the GFC
The GFC was essentially a "balance sheet" recession. The bursting of an earlier housing bubble punched a hole in household balance sheets, forcing a collective shift towards saving/de-gearing rather than spending.
This exposed vulnerabilities in a highly-leverage banking system and as counter-party confidence collapsed, the financial system froze up. This all manifested itself in a collapse in demand.
COVID-19 affects both supply and demand within the economy. Restrictions on people movements (factories, travel etc) reduces the productive capacity of the economy.
Less patronage also represents a demand shock as consumer spending falls, not helped by a falling stock market. These effects can also be self-reinforcing as lower incomes can affect spending.
The GFC was a financial shock affecting the demand side of the economy while COVID-19 is an economic shock affecting both the demand and supply. The two situations are fundamentally different which has implications for what is likely to follow.
What's next from here
The GFC led to a deep recession followed by a slow recovery as households and financial institutions repaired their balance sheets. The coronavirus is likely to trigger material falls in output in affected economies over the next quarter but, provided that the virus fades, activity should rebound as supply constraints are lifted.
The outlook is unusually uncertain but a sensible base case scenario at this stage is most likely to be a short, sharp shock. Policymakers will play a critical role in cushioning the downturn and stimulating a recovery.
Both fiscal and monetary actions stimulate demand and had a clear role to play in 2008 but its role today is less obvious.
Targeted, temporary and large fiscal support (e.g. loans, subsidies) can help to mitigate the shock form the virus, and monetary support can help to counter financial effects.
Cheap finance to banks lending to the most affected sectors and regulatory forbearance may also help to mitigate any strains in the banking sector. However the speed of recovery will depend on how the virus spreads, when containment measures are lifted and life returns to normal.
The financial system is in better shape to cope with this shock
The worst-case scenario today looks different versus 2008. History shows the most severe depressions tend to be caused by asset price collapses. In 2008, these effects were magnified by high leverage in the banking system and vulnerabilities in the global financial system (dependence on wholesale finance, short-term credit).
Debt levels remain high today but are concentrated in less risky areas (government vs households). Meanwhile, banks are far better capitalised. Pockets of risk exist – particularly in the corporate sector – and some of these vulnerabilities in the energy sector may be exposed by the sharp drop in oil prices.
Logic suggests these aren’t large enough (yet) to trigger a global crisis. Overall the most likely worst-case scenario today is a sharp but probably short downturn, rather than an outright depression.
As the virus spreads, there’s a chance that this scenario becomes the most likely scenario, but the prognosis for the virus beyond the next 6-12 months remains uncertain.
The sky isn’t falling : Michael Knox’s view
Chief Economist Michael Knox acknowledges the unique healthcare challenges posed by COVID-19 and the unknowns in how the pandemic will be resolved.
In The China Panic, March 3, he explains how the US economy is far more important for financial markets than the Chinese, and that it's strong outlook offers support to world capital markets and investors.
Ultimately Michael thinks that fiscal responses by both the US and Australian governments – ramping up now and over the course of 2020 – will act in time to buffer the Australian economy from recession.
Globally, he thinks there is ample liquidity in the financial system to absorb financial market volatility.
Facts will help suppress speculation: What you should do now
This story is a rapidly evolving one and unfortunately we've seen financial markets yet again move quickly to discount (and potentially oversell) uncertainty. Markets hate uncertainty, which can see equities re-price at abnormal discounts just as readily as complacency can (and was) pricing them at abnormal premiums.
We think market’s will calm as more information on the humanitarian and fiscal responses from key policymakers ramps up, which is happening now.
We advocate investors keep abreast of the calm facts through volatility and keep an open mind to deploying spare capital to capitalise on equity opportunities priced at far more realistic levels then they were heading into this.
More to follow.
Acknowledgements: Neil Shearing, Capital Economics, Michael Knox, Morgans
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