By William Watts, MarketWatch
This is an updated version of an article originally published on Feb. 25.
The potential for what’s known as a supply shock helps explain why investors are so worried about the threat that the COVID-19 outbreak poses to the global economy.
“Because of its genesis in China, coronavirus is both a demand and a supply shock to the global economy,” said Brian Nick, chief investment strategist at Nuveen, in a Tuesday note. “Outside of China, however, evidence based on February’s survey data suggests that demand remains solid, and supply issues are the key risk.”
A supply shock — an unexpected change in the supply of a product or commodity — is unnerving to investors who are more used to dealing with the occasional threat of negative demand shocks — an unexpected hit to demand for goods and services.
As Erik Nielsen, group chief economist at UniCredit Bank, explained in a Feb. 23 note, investors know that efforts by policy makers to stimulate the economy can partly address demand shocks.
But it is “much more complicated, if at all possible” to offset supply shocks, he wrote, offering the following example:
|Think of it this way: China has closed a reported 70,000 movie theatres because of the virus. That’s a supply shock, and no amount of income (demand) stimulus will boost ticket sales. Of course, people may increase the number of downloads of films and games to play at home, as we have seen, but this is nothing more than drops in the ocean in terms of the overall economy|
Big, negative supply shocks are rare, Nielsen noted, with the oil shocks of the early and late 1970s offering perhaps the most well-known examples. Other examples of supply shocks include storms, tsunamis, earthquakes, wars, and strikes. The problem is that there’s little that looser monetary policy or additional fiscal stimulus can do to offset the impact because those stimulus measures work by boosting demand.
Federal Reserve officials over the past week had pushed back against calls for rate cuts. That changed on Friday afternoon when Chairman Jerome Powell released a statement warning that while the fundamentals of the U.S. economy “remain strong,” the outbreak “poses evolving risks to economic activity” and that the Fed would “act as appropriate” to support the economy.
Stocks weathered temporary pullbacks earlier this year, with bulls shrugging off warnings about the potential impact of quarantine efforts and shutdowns on Chinese consumer demand and global supply chains.
But the spread of COVID-19 outside of China and the potential for broader disruptions to both activity and demand was blamed in large part for a sharp, sustained selloff that pushed the Dow Jones Industrial Average /zigman2/quotes/210598065/realtime DJIA -0.30% , S&P 500 /zigman2/quotes/210599714/realtime SPX -0.22% and Nasdaq Composite /zigman2/quotes/210598365/realtime COMP -0.54% into correction territory — defined as a drop of 10% or more from a recent peak. The speed of the slump was extraordinary, with the S&P 500 falling from a record close and into correction in just six trading days.
Stock-market bears have argued that the nature of the potential economic shocks from the viral outbreak, coming at a time when central bank stimulus efforts were seen as already stretched, could threaten the long-running bull market.
While demand has so far held up outside of China, the disruption to global supply chains running through China, Korea and, potentially, Japan is likely to take a toll on production, wrote Nuveen’s Nick.
If Asian production stoppages worsen or continue well into the second quarter, a global supply crunch could hit the already weakening manufacturing sector, he said, with implications for jobs and the wider global economy.
Moreover, it comes in an environment where valuations for U.S. stocks and credit markets were “’priced to perfection’ or something close to it following the three Fed interest rate cuts last year and the resolution of various trade deals,” he said.
Indeed, coming into this week, markets had largely reacted in “a rather casual, and inconsistent, way,” said UniCredit’s Nielsen.
That was due largely to central bank asset purchases and ample liquidity, as well as the unsubstantiated belief the outbreak would be a brief passing issue on the order of the SARS outbreak in the 2000s, he said, along with “apparent confusion about the nature of demand versus supply shocks and the (limited) effectiveness of policy stimulus in these circumstances.”
Nick said that even after Monday’s drop, U.S. stocks still reflect a very positive outlook for earnings growth and the U.S. economy, along with the potential for the November presidential elections to result in “market-friendly status quo”.
“All of that can be thrown into doubt should the global impact of the virus continue to spread,” he said. “In the near term, look for stocks and other risk assets to respond negatively to signs of deterioration in economic data.”