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Coronavirus – how could it impact the economy?

We look at the economic impact the virus might have, and what central banks could do.

Important notes

This article isn’t personal advice. If you’re not sure whether an investment is right for you please seek advice. If you choose to invest the value of your investment will rise and fall, so you could get back less than you put in.

Will Ryder, Equity Analyst

Published on 6 March 2020

This article is more than 6 months old

It was correct at the time of publishing. Our views and any references to tax, investment and pension rules may have changed since then.

There’s a lot we still don’t know about COVID-19, the recent strain of coronavirus, including how widespread and disruptive the outbreak will turn out to be. Any predictions we make will be deeply uncertain, so we’ll restrict ourselves to making a very broad sketch of how a pandemic may impact the global economy.

A supply shock

The primary effect of a coronavirus pandemic is likely to be a ‘supply shock’. This is economese for a reduction in the economy’s output as people take time off work, supply chains get disrupted and businesses suspend their operations.

The recent decision by digger manufacturer JCB to temporarily cut its UK employees’ hours in February is a prime example. This was because it was unable to get necessary parts from China due to factory closures. Fewer JCBs were manufactured as a result, and other suppliers sold less to JCB. The knock-on effects of supply disruption can be significant.

What about reduced demand?

During a pandemic people may put off some spending until the outbreak subsides. You might choose to delay your trip to Venice or spend less money going to concerts, for example.

So far the demand disruption has largely been confined to airlines and travel companies, but it could spread to other parts of the economy. Businesses that are already on shaky financial footing may struggle to stay afloat. Flybe has already gone into administration.

Feedback loops

Unfortunately, reductions in supply and demand can lead to more problems.

If people lose their jobs they’ll tend to spend less money, putting strain on businesses. If businesses see cash flow fall significantly, they may be unable to pay their debts. Lenders that are relying on being paid back may then have problems of their own.

At its worst, this feedback loop could lead to a recession.

What can central banks do?

By lowering interest rates central banks can make borrowing cheaper. Sadly, cheaper debt isn’t very effective when dealing with supply shocks.

It can’t prevent the spread of the virus, put sick people back to work, fix broken supply chains or otherwise materially boost the supply of goods and services in the economy.

Lower interest rates can take some of the pressure off borrowers and help boost demand, but this may be less effective during a pandemic than a traditional economic slowdown.

It doesn’t help that interest rates are already very low. We think central banks still struggle to help much using conventional monetary policy. However, targeted liquidity and support for financial institutions may be of use.

What about the rest of government?

Many of the remedies governments can use to control the spread of coronavirus are likely to exacerbate the economic problems. Quarantining cities, shutting public transport or banning large gatherings are all virus fighting measures, but all will reduce economic activity too.

However, there are some levers governments can pull.

For example, they can spend money in the hope of stimulating some economic activity. Italy is launching a €7.5bn stimulus plan aimed at supporting families and businesses during the outbreak. We don’t know the exact details yet, but may involve wage support and financial assistance for those struggling. At the extremes they can even hand money directly to citizens. Hong Kong, for example, is giving all permanent residents the equivalent of about £1,000 to get them spending.

Many of the people and businesses that could get into trouble are fundamentally in sound financial shape. However, they may face short-term cash flow problems. This is where targeted debt relief, or extra liquidity from central banks, could prove effective.

So what’s actually going to happen?

We don’t know, and no-one else does either. If coronavirus turns out to be widespread and very disruptive it could be the trigger to end the record long market rally. On the other hand, if the disruption is relatively minor and temporary, we might simply see slightly lower global growth, and markets could recover.

Ultimately, the end result will depend on two questions:

How far will the virus spread and how disruptive will it be?
How effective will the policy response be?

However, risk is part and parcel of investing. Regardless of what causes disruption we generally think long-term investors should sit tight and resist trying to time the market. Markets have fallen recently because uncertainty has increased. Those who stay invested might be rewarded for staying the course.

On the other hand, if the disruption proves substantial, the market may not recover so quickly. Investors who are approaching retirement, or who might need their money in the next few years, could think about de-risking their portfolio a bit, perhaps by moving some money from stocks to other assets like cash.

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