Diagnosing the world economy

Fear about the spread of COVID-19 has infected the world’s financial markets, causing drops in stock prices as alarming as spikes in a patient’s temperature. As investors struggle to predict the impact the virus will have on the global economy, The Well asked neuroeconomics expert Camelia M. Kuhnen, finance professor at Kenan-Flagler Business School, for her insight. Kuhnen’s interdisciplinary research in neuroeconomics, behavioral finance and corporate finance focuses on trying to understand how people make financial and economic choices that concern them as individuals or as decision makers in firms.

Q. How is the coronavirus affecting financial markets?

A. Financial markets have been volatile due to the news about the spread of COVID-19. Aside from large swings in stock prices, we also have seen the value ofstocks drop by more than 18% since the peak in February. Clearly, investors are pessimistic about the global economy and unsure about what will happen to firm values down the road. The expectation is that the virus — including the economic impact of quarantines, disruption to supply chains, lack of consumer confidence — will significantly and negatively impact firms’ cash flows. Also, investors’ appetite to take on risk may be lower now than before. As a result, stock prices are lower than they were just a few weeks ago.  

Q. Why is the news about the coronavirus making the stock market so volatile? 

A. Two things are driving the volatility in stock prices. First, there is continuous news coming about the spread of the virus and about mortality rates. Prices move with news, and that’s one reason for volatility. Second, prices move because people disagree about how to interpret the same information. In an uncertain environment, with insufficient information, there will be lots of disagreement and thus, price volatility. That being said, volatility in financial markets is not by itself a big problem. The problem is the uncertainty that leads to these price fluctuations. If consumers are uncertain about whether they can go to work and earn a paycheck, given all the news about the virus, they won’t spend money as they used to. They will act in a precautionary manner. Similarly, when firms are uncertain about the demand they will face, they won’t start new projects or invest in new activities. Uncertainty tends to freeze investment and spending.

Q. The Fed lowered interest rates last week in an attempt to calm the market, but Monday saw another steep decline. What’s going on?

A. Lowering interest rates in theory makes the cost of getting funds lower for both consumers and firms. But if there is sufficient panic among consumers about getting the virus, these people won’t really care that mortgage rates fell by a few tenths of a percent and won’t jump into buying a house now. When everybody is sufficiently scared of a doomsday scenario caused by this virus, firms won’t spur investment all of a sudden just because they can borrow money at an annual interest rate slightly lower than before. So, while the Fed attempted to encourage economic growth by lowering interest rates this past week, it is unlikely that their action will have a meaningful effect on spending by consumers and firms, given the current level of uncertainty.

Q.Monday also saw a sudden drop in oil prices, 10% by Saudi Arabia. Will this compound the economic impact of coronavirus? Will we have a recession? 

A. There are some positives to having low crude prices, but negatives also. The large (7%) drop in the stock market value in the United States and globally Monday indicates that the negatives outweigh the positives. What are the positives? Cheap crude means low gas prices, which is good for American consumers, since they’ll pay less to fuel their vehicles. This should leave more money to be spent on other things by these consumers. But will they spend it in this highly uncertain environment? Perhaps not.

What are the negatives? Many energy firms, in the United States and elsewhere, have profits tightly linked to oil prices. If crude is trading at really low prices, many of these energy firms (including those dealing with shale oil production, which is costly to do) will not generate a profit, and some of them may not be able to pay their debt. There could be defaults among these firms, which mean losses for the banks that extended credit to these failing companies. If banks face these losses, they may be protective of cash and diminish lending to other firms.

In other words, it is possible that default in the energy sector could lead to less financing to be available to firms in other sectors, which in turn can curtail those firms’ investment or expansion plans, or their ability to hire more people or pay higher wages. Hence, this would slow down economic activity. Is this scenario very likely? Probably not, but you couldn’t tell this from the remarkable drop in the value of the U.S. stock market that we witnessed Monday. Let’s hope this 7% drop was an over-reaction.