Coronavirus: A course through the crisis
13 March 2020 | Markets and Economy
By Peter Westaway, Chief economist and head of investment strategy, Europe
In our 2020 Vanguard economic and market outlook, we wrote that we are entering a new age of uncertainty. Coronavirus (COVID-19) is of course first and foremost a humanitarian tragedy and is where counter-measures are focused. But it has undoubtedly added a further layer to economic and market uncertainty, with equity, fixed income and oil prices all falling sharply to reflect this new pandemic.
Only time will tell whether global containment efforts are successful and the global economy can avoid recession, but it is in the nature of pandemics eventually to recede. According to the World Health Organisation, the number of new incidences of COVID-19 has already peaked in China1. Should the rest of the world experience a similar pattern, we might expect the pandemic as a whole to dwindle significantly following a crest in the coming months.
There is considerable uncertainty around this, not least because government measures to prevent the spread of the virus might be ineffective or not adhered to. As a result, it is possible that the virus could drag on longer, or even turn into a persistent, worldwide threat to health, though we consider this latter outcome less probable.
The economic impact is also very uncertain even if we knew how the virus were to play out. And those impacts come from both the direct impact of the illness and, perhaps more significantly the indirect effects as measures are taken to mitigate its spread.
This shock to the economy is also unusual because it comprises a shock to both demand and supply, as economists refer to it; a demand shock means that people are less willing or able to spend, because they are unwilling to go out in public or travel abroad; a supply shock means that firms are less able to produce, either because cities are put into lockdown, businesses temporarily close down, or schools shut; or because intermediate inputs to production processes, perhaps sourced from China or elsewhere, are unavailable, so causing production to be suspended.
This distinction between demand and supply matters. In a typical slowdown, like the global financial crisis (GFC) of 2008-9, it was possible for policymakers to stimulate the economy to encourage spending. But in current circumstances, it is not easy for policymakers to mitigate the effects of a shock to supply. Moreover, governments and central banks will not necessarily want to encourage more spending while they are still trying to minimise social interaction that spreads the virus.
Instead the need is for measures to be more targeted, to provide a “bridge” for firms and households to help them navigate difficult financial circumstances while the economic effects of the virus rage.
Central banks and governments have begun to act, channelling spending to areas such as healthcare, where it is needed most, and providing liquidity in ways that helps businesses to stay afloat until the crisis recedes.
The Federal Reserve’s emergency, out-of-cycle 0.5% cut to its target rate was taken negatively in the markets, being seen as too blunt an action and evidence of undue nervousness. The Bank of England’s (BoE) response was taken much more positively. It included a 0.5% cut to the base rate, returning to the historic low of 0.25%, but this was accompanied by measures to ease conditions around bank lending, providing a mechanism to provide liquidity to business as and when needed. The BoE’s package was further timed to coincide with the Budget, which announced £30 billion of new government spending, equivalent to 1.3% of GDP, a good proportion targeted to support for the coronavirus.
In the euro area, where the deposit rate is already at -0.5%, the European Central Bank (ECB) announced that it would increase quantitative easing, adding €120bn to the €240bn programme for buying bonds in 2020. This would be combined with measures similar to those in the UK, with added liquidity for bank lending provided through its long-term refinancing operations (LTRO).
What does all this mean for investors? In our 2020 outlook we discussed how elevated uncertainty was leading to greater fragility in financial markets, while there was a higher risk of a large drawdown for equities and other high-beta assets.
The market response to the virus has been especially strong, perhaps exaggerated by the stretched nature of valuations, with huge falls in the price of riskier assets like equities and falls in bond yields to historically low levels. The temptation is to compare current market falls with 2008 but there are significant differences. The GFC had systemic causes. In simplistic terms, a significant expansion of credit over many years which required a restructuring of the economy. By contrast, COVID-19 has a substantial but largely short-run economic and financial impact, but its effects will eventually pass.
At times like these, it is perhaps wise to look up from immediate concerns, and to remember an adage of Jack Bogle, Vanguard’s founder, that an investor’s two worst enemies are expense and emotion. That’s never more true than in times of uncertainty, when investors need to exercise discipline to stay on course.
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