It Will Get Better, But After We Feel Even More Unsettled
We are living through a highly unusual period as efforts to combat the coronavirus shut down an increasing number of businesses and personal activities that we take for granted. While reversible over time, we are likely to feel a lot more unsettled first due to the five main drivers of this unprecedented situation. The faster we internalize this and respond accordingly, the greater the scope for minimizing the immediate damage and also accelerating our way back.
1.The unusual nature of the economic shock
Driven by “social distancing,” “separation” and “isolation,” concepts that are increasingly featured in public and private sector responses to the coronavirus threat as efforts to enhance containment, the global economy will experience deeper and wider sudden stops. By choice or through employer/government direction, this will fuel a growing number of simultaneous supply and demand disruptions (mostly destructions, such as we are seeing in the airline industry where demand has collapsed and airlines are reducing capacity). In the next few days and weeks, country after country will see schools and companies close and, as many other aspects of normal life also come to a standstill. The global is heading into recession.
2.The economics of uncertainty and fear
Behavioral scientists warn that we will feel even more unsettled as we are forced further out of our comfort zones. Heightened uncertainty and risk aversion are almost guaranteed, as is an important element of fear. Our personal adaptability and agility will determine how quickly we bounce but only if we first overcome a natural inclination to deny inconvenient realities or reframe them into something more familiar and comforting, as unrealistic as this is.
Some of us will accelerate our economic and social disengagement, tempted first to run to the store and empty the shelves for what we regard as staples. The worst of us will fall victim to prejudice and bias, both conscious and unconscious, thereby contaminating our behavior towards others and undermining social integrity.
Unless interrupted by medical advances that increase our confidence in virus containment and immunity (a vaccine would do both), these dynamics will run a while before they eventually exhaust themselves. Fearing all sorts of overshoots, more pressure will be placed on governments to come up with circuit breakers that interrupt and reverse the worsening dynamics, and to flood the system with monetary and fiscal stimulus in a “whatever it takes” policy mode.
Policy willingness is not the issue. Immediate effectiveness is, as is the need to prioritize the most vulnerable segments of the population and crucial sectors (starting with medical). Moreover, unlike financial sudden stops where central bank intervention can by itself restore confidence to the system, there is no simple way to overcome economic sudden stops and instantaneously restart an inter-connected market economy.
4.Financial market over-reaction
Unusual financial volatility is unavoidable as markets scramble to price the new reality of a looming global recession, higher risk aversion and limited policy effectiveness. Asset prices fall, bid-offer spreads widen and there isn’t enough liquidity to accommodate all those suddenly wishing to get out. Two pro-cyclical market reactions are likely: Fund managers selling what they can sell rather than what they first wished to sell, thereby spreading financial pressures from one asset class to another; and such selling accelerating as money is pulled out of funds by worried investors.
Resulting market malfunctions risk a reverse-contamination from finance back to the economy in an increasingly damaging self-feeding cycle. Already this week the Federal Reserve was forced to increase its liquidity injection in markets by over $5 trillion after seeing signs of stress in Treasuries, the mother of all financial markets.
5.Over-extended initial conditions
Finally, there is the starting point (“initial conditions) that influences both the journey and the destination.
Over the last few years, a deeply unhealthy co-dependency relationship has developed between the major central banks and markets. In the process, they also became each other’s de facto hostage.
Thrown by politics into the role of “the only game in town” policy-wise, central banks used massive and predictable injections of liquidity to heavily repress financial volatility, encourage excessive risk taking and artificially boost asset prices – all in an attempt to improve economic conditions. Conditioned by repeatedly observing this behavior, markets treated the banks as their BFFs (the “central bank put”), buying every market dip quickly and paying little regards to the corporate/economic fundamentals that ultimately validate asset prices.
Like a beach ball repressed deep under water and suddenly released, all five of these factors will overshoot before we settle into a new equilibrium. The journey will include experiences, like empty store shelves and travel restrictions that are more common in fragile/failed states and in communities hit by a devastating natural disaster, than in advanced countries.
Fortunately, each of the drivers is reversible, and quickly if medical science is able to contain and counter the virus. Our collective responsibility is to manage the journey in a responsible manner while also seeking to shorten it.
Dr. Mohamed A. El-Erian is the Chief Economic Advisor of Allianz and President-Elect of Queens’ College Cambridge. The author of two New York Times bestsellers, he is a senior advisor to Gramercy, professor of practice at the Wharton School (University of Pennsylvania) and senior global fellow of the Lauder Institute.