FINANCE | 04.23.2020
Two possible scenarios for the world economy – and another alternative, more gloomy scenario
Typically, the economic analysis centers’ predictions include a central scenario, which experts believe to be more likely and another “stressed” scenario, in which the potential risks materialize, and in which the forecasted parameters are therefore worse.
But the crisis brought about by COVID-19 is causing such a radical break away from the economic circumstances economists are used to analyzing, that right now, it is almost impossible to speculate on the likelihood that these risks will materialize. This is why many of the forecasts from the economic analysis centers, who are becoming a familiar presence these days, such as the Central Bank of Spain, are not giving a concrete estimate, but including a wide range of projections.
The MAPFRE Economics Panorama Report, which we’ve become familiar with this week, has gone one step further and included a “baseline scenario” and another “stressed baseline scenario”. However, it also includes another scenario, which it has called the alternative scenario, which we hope will not materialize under any circumstances as the analysis of this scenario is bleak.
The experts at MAPFRE Economic Research have already ruled out, in any case, that the economic crisis generated by COVID-19 will result in a short recession or that the recovery will be rapid and pronounced, as was expected at the beginning of the pandemic.
The baseline scenario of their study is a U-shaped recession, in which the coordinated response from governments prevents the recession from causing permanent damage. In this case, the recession will last between two to four quarters with a variable depth, which is basically modulated by the biological severity of the virus and the speed and intensity of the measures taken. In short, the damage is severe, but limited in time, thanks to the relative success in flattening the curve. Sooner or later, we will return to pre-crisis levels.
Below are its main features:
• China would recover its activity in the second quarter, and Asian economies would benefit from this. Its role as lender of last resort in the emerging world would not be impaired.
• In the West, automatic stabilizers would work and the curve would flatten, allowing the mitigation strategy to begin at the end of the year, which would eliminate the obstacles to the expected upturn in activity in 2021.
• There would be no feedback between the commercial and finance sectors. The crisis would not create a solvency problem in the developed world, nor would it lead to the emergence of any sort of unexpected risk. A systemic problem would not emerge.
• Oil would return to around $40/b by the end of 2021. The VIX index would remain high but not at levels comparable to Lehman or the Chinese crisis in 2015. The value of the USD would remain below USD 1.1/EUR.
In this scenario, the world economy would fall by 3%, but would recover in 2021. In the same vein, Spanish GDP would fall by 5.6 percent and grow 4.4 percent next year.
Stressed baseline scenario
In this scenario, the decline in economies this year would be twice as pronounced, and worse still, would last for a longer period of time. The fundamentals of this adjustment would occur between Q4 2020 and Q1 2021 and its effects would be felt well into next year.
In this scenario, the world economy would fall by 8,2%, and recover much less in 2021. On the same line, GDP in Spain would fall by 10.7 percent and shrink another 1 percent next year. These would be the main features:
• More countries become more severely infected for a longer period of time, with effects on the relevant finance sectors, especially in emerging countries.
• Global trade would contract by 15 percent over the year.
• The price of oil would remain very low, below $15/b.
• There would be a collapse in corporate profits, leading to sudden changes in the valuation of many assets on companies’ balance sheets, resulting in a significant decrease in the size of the financial market and the potential for global financing. The role of safe-haven assets would increase, hoarding liquidity and pushing down interest rates, which would cause even greater damage to the financial system.
According to experts from MAPFRE Economics, this scenario would lead to “permanent structural changes, triggered by a systemic crisis caused by known risks and vulnerabilities or by the emergence of other unknown risks or vulnerabilities, which lead to permanent economic dysfunctions related to both supply and demand and a finance sector unable to perform basic functions”.
In this scenario, the baseline scenario’s assumptions regarding contagion, seasonality or fatality of the virus are not met, national interests prevail and there is a complete lack of international coordination to tackle the problem.
All of this would trigger a potentially systemic financial crisis, which unties the finance sector from the commercial sector. The financial crisis is triggered by the materialization of some kind of risk relating to liquidity, debt financing, the solvency of the system, a lack of revenue, or counterparties.
These triggers would lead to unsustainable outflows, the depreciation of most currencies, depreciations of all asset types, and consequent adjustments in the size of the commercial and finance sectors’ balance sheets.
This scenario is not quantified in the report because the magnitude of such a correction is not quantifiable with the information available at the present time. We are confident, for the good of everyone, that this scenario will not materialize in any way.