COVID-19 PANDEMIC

Market volatility due to Covid-19 has been at the top of the financial news for the last two to three weeks. Generally speaking, when a sudden crisis like Covid-19 hits, we need to be concerned with two types of impacts to financial markets. The first is a short-term, direct impact, and the second is a longer-term, latent impact. Usually, the direct impact leads to the latent impact, but eventually the two will become at odds with each other, and the reconciliation of the two by investors is what leads to equity market volatility.

The easiest way to understand the direct impact is through a simple example of its effect on a company’s equity valuation. Suppose a company is producing earnings of $100M per quarter, growing at 2% per quarter sequentially, and the firm has a cost of capital of 16% per annum (or 4% per quarter). Using a simple, but widely used model for stock valuation, the firm’s value would be:

Value = $100/(1+4%) + $100*(1+2%)/(1+4%)^2 + $100*(1+2%)^2/(1+4%)^3 + ...

The sum goes on as long as the company is around and producing earnings. For our example, let’s assume the firm exists forever. In this case, the equity value of the firm would be:

Value = $100/(4%-2%) = $5 Billion

Now, let’s consider the same firm’s valuation with just the direct impact of Covid-19. Suppose that the firm is expected to produce zero earnings for a quarter due to the reduction in demand for the firm’s products by consumers. After a quarter, the coronavirus is expected to recede and then things are expected to return to normal. The only exception is that due to the mortality rate resulting from the coronavirus (which has been measured to be about 3%), the world’s population is 3% lower. Let’s assume for simplicity that the impact on earnings due to the lower world population is that earnings are 3% lower permanently relative to where earnings would have been without the coronavirus. Let’s now look at the new valuation of the firm using the same equity valuation model:

Value = $97/(1+4%) + $97*(1+2%)/(1+4%)^2 + $97*(1+2%)^2/(1+4%)^3 + ...

This results in a new value of:

Value = $97/(1%+4%)(4%-2%) = $4.76 Billion

So, we see that the combination of the short-term reduction in demand for the firm’s products and the reduction in the world’s population results in a drop of 5% for the company’s stock price today.

Now, let’s consider the same firm but with an extended version of the coronavirus scenario that we just played out. Suppose that the firm has debt outstanding in the form of bank loans, and some of these bank loans are coming due in the next quarter. As the short-term reduction in demand hits the firm, its revenue dries up. It is left with raw materials, work-in-process, and finished products in inventory which it cannot sell. However much of the expenses of the firm cannot be deferred — items like salaries to employees, interest payments, rent on its facilities, etc. need to be paid. With very little revenue, the firm would dip into its cash to pay these expenses as well as cut whatever costs it can, such as by laying off some of its workers. But the cash account would soon become depleted.

The critical issue is the debt that is coming due. With a lack of cash, the firm would have no choice but to approach the bank to which it owes debt payments to discuss restructuring the debt repayments (including interest payments). Essentially, the firm would be in default. However, once the firm’s debt is in default, the bank would have to hold more capital against it (or one can think about the bank as having lost some of the capital it had been holding). The bank now needs to raise more capital. It can borrow from another bank to accomplish this.

The thing to understand is that all banks are facing this problem. That is because virtually all firms have debt outstanding and many are running into the problem that our example company has run into (the airlines, hospitality, and tourism industries are all facing serious cashflow problems as are most small- and mid-size businesses). The longer the economy is at a standstill, more and more firms will run into the same cashflow problems and be forced into cutting expenses and renegotiating its debt repayments. So, lots of banks would be dealing with more and more of their business (and some consumer) loans needing restructuring.

The last thing a bank wants to do is lend currently to a bank that is facing lots of bad business loans. However, banks can’t tell which ones are facing more problem loans than others, so banks would start tightening up on their lending. So, right when some banks would really need to raise capital, all banks would start tightening their lending, making the situation even worse. And the economic situation would keep getting worse because firms would be laying off people, who in turn would cut back on their spending, which in turn would lead to even less revenues for firms, which would reduce their cashflows, and the cycle would go and keep getting worse. As the economic situation worsens, the banks would restrict lending even more, which through the cycle just described would create even more need for capital by banks. We are in a classic death spiral...or more formally known as a “liquidity crisis”. This is a scenario that would result in enormous stock market losses, similar to the Great Recession of 2008.

As long as the Covid-19 crisis is short, the liquidity crisis would never get a chance to start, and the stock market would drop a small amount today (approximately the 5% calculated above). However, the longer the Covid-19 crisis lasts, the greater the chance a liquidity spiral can start, resulting in huge stock market drops. The reason the equity markets have been fluctuating wildly between huge daily gains and huge daily losses is that the markets are daily (probably hourly) revising the chance of each scenario occurring, based on new news about Covid-19 as well as governments’, people’s, and companies’ reactions to the progressing coronavirus crisis.

A short Covid-19 crisis will be nothing to worry about. The market will drop a small amount, but then the financial markets will return to normal.

The endgame of an extended Covid-19 crisis will be very different. The only way to stop a liquidity crisis is for the central bank to step in as a lender of last resort to all of the banks, insurance companies, and other lending institutions. We saw precisely this occur during the Great Recession. The government would work in concert with the central bank by doing things such as guaranteeing the loans of the companies, like the largest airlines. We saw this occur during the Great Recession as well. Finally, the government would need to spur spending again by utilizing fiscal stimulus programs.

It is difficult to say which scenario we will end up in because it is difficult to say whether the current Covid-19 crisis will be short- or long-lived. That is what the market is keeps reassessing, and it is this continual reassessment that is causing all of the market volatility we have witnessed over the last two weeks.

Footnotes

[1] The cost of capital can be thought of as the time value of money for investors that invest in the stock of the firm. This is relatively unimportant for our example. For simplicity, one could also treat the cost of capital as 0%; then, a company’s stock valuation would simply be the sum of the company’s lifetime earnings.

[2] This is called the discounted cashflow valuation model, and it is one of the simplest valuation models we have. How or why this model works to deliver a stock valuation is unimportant for our examples. We use it just make the main point of this note. Virtually any equity valuation model would deliver the same results. 

[3] The last time we experienced a liquidity crisis was the Great Recession which began in 2008. You should recall that the problem there stemmed from bad mortgages. The problem in this situation would be identical but instead stem from bad business loans due to an extended coronavirus crisis. We refer the reader to “The Global Economic System: How Liquidity Shocks Affect Financial Institutions and Lead to Economic Crises,” which offers much greater detail on liquidity crises.