LONDON: This was the week that COVID-19 caught up with markets. There were big falls in the major stock market indices this week.
European and US stocks had lost 7 to 10 per cent of their value over the past week, wiping out all the gains since the new year and then some.
This is hardly surprising; indeed there have been warnings that such a reaction was just a matter of time because of how the epidemic is disrupting supply chains. But while the market moves are big, they are not disorderly, and can be interpreted as “aiming to correct economic expectations in the light of news”.
That news is getting more dramatic: the closure of an Italian car part plant means auto manufacturing supply chains are now being disrupted in Europe as well as Asia. And there could be worse to come – and hence worse market reactions too.
But all this has left me scratching my head because the economic impact of COVID-19 would have to be a lot bigger than anyone seems to be envisaging to make arithmetic sense of sustained stock price falls this big, let alone bigger.
Ultimately what is valuable about stocks is the right to the underlying companies’ “residual” profits, that is to say what is left over after paying interest to debt investors (and taxes). No matter how bad the immediate supply disruption gets, what matters is the value of economic activity over the long run, since that is what produces the future profit stream.
Even if there is a global recession this year, it should be possible to re-establish the status quo ante once the epidemic has played itself out.
Remember that the Great Recession was an exception in that output is still well below the pre-crisis trend; after most downturns the economy returns to the previous trajectory.
It stands to reason that if global economic output returns to the pre-outbreak trend, then so will company profits.
A steep fall in equity prices must, in other words, be justified by sufficiently large temporary falls in corporate earnings. Of course, stock prices should be more volatile than earnings, since shareholders come behind bondholders in the pecking order for whatever income companies generate.
But despite worries about corporate debt, on the whole the rich world’s corporate sectors are not terribly leveraged. The “interest coverage ratio” – roughly gross profits as a multiple of gross interest costs – is about five for US non-financial corporations, according to Federal Reserve researchers, and close to 10 for eurozone ones, according to the European Central Bank.
That implies a permanent10 per cent drop in earnings across the board would reduce the residual profits for shareholders by 12 to 22 per cent, which would justify a similar fall in share prices.
But permanently lower economic activity, and hence corporate earnings, is very unlikely.
What should matter, then, is the depth and duration of a temporary dip. We don’t know what these will be.
But we do know that at the current ultra-low interest rates, the long-term trajectory should weigh heavily in the calculation. Even a complete wipe-out of corporate profits this year need not justify more than a few per cent off share prices.
WHY STOCK PRICES MIGHT TAKE A BIGGER HAMMERING
This argument does not, of course, constitute investment advice – rather a criticism of markets’ functioning. There are plenty of reasons why stock prices might take a bigger hammering, at least in the short run.
First, if the stock market behaves like Keynes’s famous “beauty contest”, then the way to make money is to second-guess other market participants rather than calculating fair values.
The sensational nature of the epidemic encourages traders to expect – and therefore to generate – large price moves.
Second, policy matters. Macroeconomic policy does need to react forcefully even if this shock originates in a supply disruption. Fiscal and monetary stimulus should sustain weakening demand, and monetary and financial policy should be used to prevent liquidity problems caused by the supply shock.
If policymakers do not act appropriately, the economic impact will be both more severe and more protracted than it needs to be.
Third, one cannot rule out the “tail risk” of permanent damage to the world’s economic capacity. The less likely way this could happen is if the new virus becomes endemic and constitutes a lasting addition to the world’s disease burden and drag on its economic activity.
The more likely way is again though policy: The temporary disruption of global value chains and the increased awareness of international interdependence could lead to efforts to restructure global production within narrower national or regional boundaries.
COVID-19 could cause more economic damage by tilting the balance in favour of deglobalisation than by making people sick.