Deflation due to swine flu?

The UK Telegraph ran a story on Monday Swine flue threatens deflation slump, Ernst & Yound ITEM Club report warns. To quote: "The group said a pandemic reaching 100,00 cases a day by August, and lasting six months, would lead to a 7.5pc fall in GDP this year. The lingering damage would cause a further fall of 1.2pc next year. 'With the western world still teetering on the brink of deflation it is not an exaggeration to say that a pandemic on this scale could tip it over the edge,'it said. The figures are based on projections made by Sir Liam Donaldson, the Government's chief medical officer. The report assumes that infections will ultimately reach 50pc, with a mortality rate of 0.4pc. Most of spread will occur before a vaccine is ready. 'Sir Liam is an expert on pandemics. We think his advice should be taken very seriously,' said the report. 'The main effect on the supply side will be that sick employees cannot go to work. On the demand side, spending on discretionary goods and services such as restaurants or tourism is likely to fall as people stay away from public places to avoid infection. Uncertainty about these developments is likely to make businesses further postpone investment projects,' it said."

It has been relatively calm in the Northern Hemisphere regarding the Swine Flu over the past months. However, in the Southern Hemisphere where it is currently winter, the virus has spread further. For the Northern Hemisphere, the situation will get worse when the usual flu season starts, i.e. around autumn.
As this article suggests (written in German by the Swiss daily NZZ), the swine flu might start to hit especially hard in September when most of the tourists are back from vacation and kids are back to school (as schools are a good reservoire for a virus). The expert quoted expects a vaccine to be ready during October. Effectively a vaccine will be produced by mid August but needs to be tested for effectiveness and security which will last into September. Thereafter national authorities will be informed and have to decide how to proceed. For Switzerland it is expected that between 1 and 2mln people will catch the swine flu (out of approx. 7.7mln).
So far the mortatility rate has been low. Nevertheless, if indeed infections reach such a high percentage of the population, it will have a significant impact on the economy. Both demand and supply will be negatively affected and therefore the impact on GDP growth is clearly negative. However, I have my doubts whether this will prove deflationary. First, it affects both supply and demand and it is not clear how the balance between the two will shift. Will we end up having more goods relative to demand than would otherwise be the case or is supply falling more than demand? Furthermore, at least part of the drop in demand will likely be temporary only and be reversed once the pandemic subsides (i.e. if I do not buy a car this week because I am sick, I am most likely still going to buy it once I recover).

Overall, there is a substantial risk that economic growth will be hit seriously during autumn and winter in the Northern Hemisphere amid a swine flu pandemic. The impact on inflation is less clear cut though. Moreover, following the Swine Flu scare earlier this year which did not leave an impact on the major economies, markets do not seem to price this risk adequately. It would clearly be a negative for risky assets as well as a positive for government bonds (due to lower growth and rising risk aversion). Within the government bonds universe, however, it is not clear whether inflation linkers or nominals will be the winner. The likely effect of a Swine Flue pandemic as well as its timing lend further support to my base case that the current recovery in risky assets will prove temporary.