This article was first published on: https://www.linkedin.com/pulse/how-covid-19-may-affect-world-economy-financial-markets-weber/
The world economy is characterized by low inflation, low interest rates and high debt. Despite money-printing central banks and low unemployment, inflation stays stubbornly low. Low interest rates lead to high asset valuations and increase the carrying capacity for debt – which is why we don’t yet observe classic imbalances (i.e. asset bubbles). There is always the risk of an impending recession; and once we find ourselves in one, the way out will be difficult, as central banks have mostly used up their ammunition. Also, the political will for fiscal responses and their effectiveness remain highly uncertain. There are structural reasons for this situation, the most important of which are high global savings rates (forgone consumption) that for a variety of reasons (i.e. demographics, globalization and technological change) aren‘t used for investments. Low global demand has led to underutilized production capacities.
How does COVID-19 affect this situation? I see two main scenarios. In the first one, the above described dynamics don‘t change and may even accelerate. The pandemic further decreases global demand from already low levels, increasing the risk of recessions. Central banks react by further lowering interest rates (where possible), stimulating demand for debt and giving a boost to stock markets - until the next recession hits.
In the second scenario, world politicians react with overwhelming force against the pandemic, shutting down production lines and isolating citizens – not unlike what we currently see happening in China. Global production decreases faster than demand, resulting in both a recession and inflation (stagflation). If the inflationary shock is big enough, central banks will react by increasing interest rates, prioritizing the fight against inflation over stimulating the economy. This will lead to a severe economic downturn with high human and economic costs.
Personally, I consider scenario 1 to be much more likely than scenario 2. A severe economic downturn, induced by draconian countermeasures against the pandemic, would cause real human suffering on a massive scale. In and outside of China, the focus will lie on managing the pandemic while at the same time having a healthy economic development, ensuring that the cure isn‘t worse than the disease. I therefore don‘t expect this pandemic to significantly change the current economic paradigm. Maybe some other supply shock (i.e. trade or real war, or a more severe pandemic) will manage to do that. COVID-19 may also transform into something more lethal, in which case draconian interventions would be the only means available to fight the deadly pandemic. Let's hope that won't happen.
Samuel S. Weber, M.A. HSG SIM
SW Kapitalpartner GmbH - Strategisch, Wertorientiert