Abstract: The COVID-19 pandemic has triggered concerns over a global economic recession, with multiple hazards emerging including oil market turmoil and collapse of the US high yield bond market bubble. Facing mounting downward pressure, it is possible that central banks of developed countries will maintain zero interest rates over the long run, and try out irregular tools such as quantitative easing. For China, with fast economic growth, expanding financial opening and a high interest rate level, there is the possibility that Renminbi will appreciate again and push up asset prices as the global economy resumes.
I. Assessment and outlook of China's economy
With the earliest outbreak, China has done well in containing the coronavirus, and it is now winding up its fight against the epidemic. Most of the newly-added cases outside Wuhan are imported from other countries, and the number of new cases in Wuhan has dropped quickly to lower than ten. It seems very likely that there will be no more infections in China in about two weeks.
At the start of the outbreak, it was widely believed that the virus had dealt significant blows to both supply and demand. On the supply side, transportation was clogged, the supply chain was disrupted, factories were shut down, and employees could not get back to work; meanwhile, demand slumped, at least in the short run, because of strict isolation measures. It seemed hard to tell which side was hit harder, or how big the impacts were.
But with more data disclosed recently, the picture is clearer.
First, for most sectors, the demand side took the brunt of the shock, while the supply side has borne much less strain only on a limited range of products.
The blows to demand are reflected in the following aspects. To start with, demand for optional and durable consumer goods that can hardly be traded online plummeted because people all stay at home during the epidemic, pushing general demand to the brink of collapse. For example, growth rate of automobile sales in February in China slumped to -80%, and the entire Chinese automobile industry has stagnated. As for the real estate sector, despite a slight pickup after the Spring Festival, the sales still dropped by more than 50% compared with previous years. Investment showed a similar trend.
Such plunges in demand were beyond expectation, and the whole supply chain is encumbered with mounting inventories, driving prices down across the board.
The pressure of draining demand is quite obvious in non-food optional consumables, whose prices have dropped sharply in February. Restaurants, hotels, airlines, and tourism all experienced similar stagnation as the automobile sector.
In contrast, the epidemic has had short-term, accidental impacts on the supply of a very limited range of products, such as vitamins, paperboards and petroleum cokes — their prices surged in early February as a result of sudden demand-supply imbalance.
However, as economic activities and transportation gradually returned to normal in the second half of February, supply difficulties in these sectors showed signs of abating, and prices of these products began to stabilize and even to fall. In summary, although resumption of economic activities is occurring at a slow pace, the supply end, compared to the demand end, has showed signs of quicker recovery.
Back to the discussion about the supply chain. At the beginning of the virus outbreak, there were many concerns about the vulnerability of China's supply chain and the pressure it brought on the global supply chain. However, based on the analysis above, and given that most companies maintain inventories which can sustain for an average of two to three months, and complete production disruption in China is relatively short, the pressure on the supply chain has not built up severely. It has gradually eased as factories come into operation.
Economic slowdown in the first quarter is astonishing, which can be compared to the blow from the financial crisis in 2008.
But to be fair, I think there are two problems with analysis of the data. First, part of these losses, maybe a considerable part, can be compensated when economic activities recover. Second, despite the cost to the economy, China has rapidly and effectively contained the virus and combatted the disease successfully. In the long run, this cost is actually small in comparison. On the contrary, measures taken by Europe and the United States will make the process of containing the virus much longer. In the long run, the economic costs may be greater.
Convincing evidence can be found from global financial markets over a period from the outbreak till now. As the virus has spread globally, stocks around the world have plummeted at different levels.
It is generally believed that the reason behind the severe plunge in global shares is worries over the coronavirus pandemic. But comparatively speaking, among stock markets globally, A-shares have been the most resilient. Some argue that the mainland stock market is relatively isolated, but Hong Kong stock market, which is a completely open market with complex trading tools, also outperforms many international counterparts. Moreover, Asian shares generally suffered less than the European and US stocks. Being the epicenter of the outbreak, European markets staged a worse performance than the United States. In general, regions that have done better in containing the virus see better market performances, while those facing greater risks of further contagion, suffer more devastating market drops.
If we assume that the decline in stock prices is a reflection of long-term economic losses, it will be fair to speculate that European and US markets may not have bottomed out yet. But China has passed the inflection point. From this perspective, market investors seem to believe that China's approach is most effective and least costly in the long run.
Next I would like to discuss economic recovery. The recovery of the supply chain will be faster than that of demand though both will take a relatively long time to return to normal. For the demand side, the recovery processes of different fields vary. Business that can be done online, either very easily or somewhat demanding, will recover quickly. Other fields, such as movie theaters, tourism, hotels, will have to recover at a slow pace. Overall, economic activity is still below normal to a large extent.
From the recovery of demand to the resumption of economic activities, the economy needs to go through a destocking process. Until now, most economic areas are burdened with accumulated inventories. Only after the current stock is cleared, can demand recover, and the economic activities return to normal. Inventory and price data indicate that the destocking process is quite far from completion. Economic activities may not be able to return to normal until late April or May in China.
Judging from China's data, Europe and the US are likely to encounter serious negative growth in the second quarter, which may approach or even exceed the level seen during the last financial crisis.
II. Global financial markets
Now I will discuss the markets globally.
First, in the past two or three weeks, 10-year US Treasury bond yields suffered a historic drop, even worse than the situation in 2008. It shows that the market has a severe long-term concern, and we want to know that it is.
Second, for most of the past three weeks, the performance of various markets has been generally normal. Facing the coronavirus pandemic, markets have panicked. Safe-haven assets have risen, and risk assets fallen. But in the week of March 9th, the market fluctuated abnormally, seeing a very rare situation in which the prices of safe-haven assets and risk assets fell together. Along with the decline in stock prices, prices of gold and US bonds also fell sharply, while US dollar rose greatly. This reflected a severe liquidity shortage at the transaction level.
Third, collapse of the oil price. There is plenty of discussion on it, but it deserves more in-depth analysis.
For the first observation, why have the yields on US Treasury bonds suffered such a drastic drop? My guess is that the market believes the US economy will get into a severe recession in the short term, and then there will be a long period of economic stagnation, which will force the Fed to maintain zero interest rate. In short, the US economy and monetary policy are becoming more like those of Japan and Europe.
Second, the oil market. An extremely important event in the oil market over the past decade was the emergence and subsequent development of the US shale oil industry, making the United States the world's largest oil producer, which means that the traditional landscape of global oil market has been fundamentally changed.
The production of shale oil is dispersed across the United States, while the production cost of each oil well differs. Manufacturers could enter and exit the market without delay, while making significant progress in technology.
During the global economic downturn in 2014, Saudi Arabia became aware of the dangers brought by the rise of shale oil, and decided to elbow out the US shale oil through keeping the oil price low. From the Saudi perspective, this strategy was undoubtedly correct, however, it hasn't been carried out resolutely. The US shale oil further expanded and Russia also gained more market share.
One problem was that both Saudi Arabia and Russia were unprepared for such low oil prices at the time, hence they were overwhelmed by the enormous financial stress, and forced to give up eventually. Another problem was that the United States made great technological progress in the shale oil sector and regained competitiveness after brief periods of adjustment.
There is no doubt that we are in the same situation again. The difference between this time and last time is that the shale oil industry in the US is of remarkably larger scale now, with more mature technology. Meanwhile, Russia and Saudi Arabia are better prepared for low oil price.
For Saudi Arabia, its production cost per barrel may be less than $10, Russia's production cost is believed to be below $30, while the cost of US shale oil is probably higher than Russia.
This means that despite of the possibility of a short truce, the oil price war is more likely to evolve into a protracted war. Although it is an unexpected surprise for China and other oil importing countries, it will definitely hit the economic prosperity of the United States and its financial market.
Previously, it was widely believed that there were bubbles in the US high-yield bond market, whereas the shale oil companies were major bond issuers. Under the influence of the oil price war and the epidemic, the bubbles may be bursting, the bond issuance even froze for a time. Its impact on the economy will gradually appear, too.
In addition, facing the risk of economic recession, will the US listed companies stop buy-back of shares with heavy borrowing? Have the passive index investing and algorithmic trading hit the ceiling for the moment?
We have to consider the possibility: is the bull market over? Is the appreciation of the U.S. dollar coming to an end?
Let's turn to the global market.
Judging from the historical data of infectious diseases in the past 100 years including Spanish influenza, epidemics will eventually disappear, probably in a few quarters, with economic activities returning to normal. None of the infectious diseases in history has had a sustained impact on the long-term economic growth.
Take Europe as an example. So far, European stocks have fallen by more than 30%. If the stock price before the outbreak was reasonable, in a few quarters, the market should return to its previous level as the epidemic disappears, which means that European stocks will go up by 50% from their current level. Even if there is a lot of uncertainty, considering that the risk-free interest rate is close to zero, we believe that a 50% increase in stock price should be enough to compensate for these opportunity costs and uncertainties. If the epidemic will only hit us once, why is there such a sharp plunge in the market? Is it an unexpected opportunity or a beautiful trap?
One possible explanation is that although the impact of the epidemic is one-time and short-term, the economic recession thereafter will affect the confidence and expectations of enterprises and prompt companies to reduce investment, causing secondary damage to the economy.
More importantly, in such a situation, central banks in developed countries have little policy space. Europe and Japan have had negative interest rates for a long time, while for the US, interest rates have little room to fall further.
In this context, after the end of epidemic, the economy may gradually shift from a severe recession to a long-term stagnation, accompanied by a vicious cycle of debt-deflation. This may be the focus of long-term concerns of market players.
III. Policy Analysis
What is the focus of policy intervention is the next question. Undoubtedly, policies should focus on two levels.
At the first level, in the face of stalled economic activities, it is necessary to maintain the healthy cash flows of enterprises and residents. Healthy cash flows are extremely important for two groups: highly leveraged enterprises and individuals; and low-income groups and small businesses.
The second level is the aforementioned secondary damage, such as the adjustment of the US crude oil industry, the bursting of bubbles in the US high-yield bond market, and the widespread blow to corporate investment.
To avoid the debt-deflation cycle, loose monetary policy and fiscal expansion seem inevitable. But many central banks have already been pursuing a zero interest rate policy, meanwhile the fiscal leverage is not low. In this case, the market seems to be confused about what the policy response would be, and begins to pay attention to the discussion of Modern Monetary Theory (MMT).
The logic behind these analysis is generally applicable to China, but for China, the epidemic has been brought under control so fast that the economic activities have begun to recover. In addition, there's still much room for adjustment in China's monetary and fiscal policies, at least bigger than Europe, the United States and Japan. This puts China in a relatively advantageous position.
The challenge facing China now is that the rapid spread of epidemic overseas plus the decline in global consumption of durable goods and investment. This will put great pressure on China's export sector, which will extend to the entire economy through various transmission channels. With the slow recovery of domestic economy, we might be seeing weaker external demand in the short term, and uncertain external demand in the long term. The complexity of and challenges to policymaking cannot be underestimated.
Finally, considering that the Europe, the United States, and Japan are racing to loosen their monetary policies, when the economy gradually returns to normal, where will all that liquidity go?
Looking around the world, as a major power, China is still able to maintain economic growth, while the nominal interest rate on ten-year treasury bonds remains above 2.5%, much higher than in other countries. Under such circumstances, with further opening of the financial sector, will we see continuous inflow of foreign capital, RMB appreciation and rise in stock market valuations? Will they contribute to the adjustment of the real economy? How should policies leverage the opportunities presented and avoid mistakes? We need to watch the development closely and carry out in-depth analysis.
