A summary of our outlook for economies and markets.
8 minute read
COVID-19: A healthcare and economic crisis
The COVID-19 crisis has led to profound changes to the outlook
This is a House View unlike any that we have written before. In the space of just eight weeks, the global economy has gone from one showing encouraging signs of better growth, to one that is likely to see activity decline at a rate not seen since the Great Depression.
Unlike either the Depression, or the 2007/08 Great Recession, the catalyst for this crisis has not been a financial implosion. Instead, it is a sudden healthcare crisis that threatens people’s livelihoods, the global economy and financial markets. The pace at which this pandemic has spread around the world, the tragic deaths that have followed, and measures that governments have taken to protect people have been truly extraordinary.
With much of the global economy in some form of lockdown, people have been forced to stay at home, unable to work (apart from those in essential services) or socialise. Schools have also been closed. As we write this, those lockdowns have begun to slow the spread of the virus.
In China, where the crisis began, restrictions have been significantly eased, although it remains far from normal. Elsewhere around the world, particularly in Europe and the United States, extremely restrictive conditions remain in place. How much longer those conditions will remain in place is unclear. In Box A below, we describe in more detail three scenarios for how the virus might evolve. These scenarios help us frame the potential economic and markets outlook.
The measures have been put in place to prevent healthcare systems becoming overwhelmed and to save people’s lives. But there is a severe economic cost that comes with such measures.
Given how recently this crisis began, we have only limited insight into how severe the economic impact has been so far. Indeed, the depth of the economic decline and the time it might take before a recovery begins are both highly uncertain.
We expect activity to be substantially weaker in the first half of 2020. Recovery thereafter will depend on the success in limiting the spread of the virus and easing social distancing measures
Nevertheless, based on the limited information we do have, alongside the assumptions we have made for the degree to which large parts of the economy will be in hibernation, we expect global activity to fall somewhere between 8-14 per cent over the first half of 2020, compared to where it otherwise would have been (Figure 1). That would be a similar decline to that seen in the United States in 1930, the first year of the Great Depression. For a period, the unemployment rate could rise to over 20 per cent in major economies.
Figure 1. Impact of COVID-19 crisis on level of global activity
Deepest decline in activity in post-war period expected
While we judge our downside scenario to be severe, such is the uncertainty about the impact on activity of this crisis, and the offset that fiscal and monetary policy may provide, that it could plausibly be worse. Based on an analysis of the impact on both industrial output and final demand, the OECD recently estimated that the impact on GDP could be as much as 20-25 per cent for major economies.
While the impact of lockdowns on activity is expected to be severe, unlike in the 1930s, we expect that it will begin to recover as better viral treatments are found, improved data on immunity is utilised and ultimately when a vaccine is available.
Indeed, many sectors should recover quickly, as most of the contraction comes from workers staying home rather than declines in capital or productivity. But we do not know how well small and medium-sized businesses can survive a prolonged shutdown.
Given the uncertainty around the timing of these factors, we consider three scenarios:
- Scenario A: The recovery begins in 2020H2
- Scenario B: The depth of the downturn is greater, but again recovery begins in 2020H2
- Scenario C: The depth is greater still and the recovery begins later
These scenarios broadly map to those laid out in Box A. These scenarios do not see the level of activity back to the previous trend until between late 2021 and late 2022. The paths for activity produce rather dramatic year-on-year growth rates for 2020 and 2021 (Figure 2).
Figure 2. Global growth scenarios
Severe downswing should be followed by a rebound
Crucial to a successful and speedy recovery from this crisis is the policy support from both governments and central banks. Those policies are designed to prevent businesses from becoming impaired or going bankrupt due to a lack of revenue, and to prevent households from suffering hardship from being unable to work.
Governments around the world have announced a range of support measures for both businesses and households. In many countries those measures have focused on a range of loans or loan guarantees for business – particularly small and medium-sized – to assist them with bridging the financial impact of dramatically lower revenues.
Fiscal policy response has been swift and sizeable and should help to prevent longer-term economic effects
In addition, there has been focus on keeping people in their jobs, even if unable to work, through various forms of wage subsidy. Many countries have also enhanced unemployment benefits, most notably the United States, to provide a stronger safety net for those who cannot be retained and therefore become unemployed. Other measures, such as deferral of tax payments, encouraging forbearance from lenders (e.g. through mortgage payment holidays) and direct cash handouts all serve to provide support.
Monetary policy has been eased dramatically, with a range of liquidity measures and asset purchases
The magnitude of these fiscal measures is vast. Figure 3 attempts to quantify both the direct measures and the contingent liabilities (in the form of loan guarantees and similar) as a percentage of annual output. Perhaps just as striking as the magnitude for the developed market economies is the, so far, limited fiscal response from emerging market economies, where institutional and market constraints may have limited the response.
Figure 3. Unprecedented peace-time fiscal support for major economies
Estimates of fiscal response to COVID-19 crisis, % of GDP
In addition to the fiscal response, there has also been a vast monetary policy response. Policy rates have been cut to the effective lower bound in the major developed economies. More importantly, a host of balance sheet measures have also been put in place to improve market liquidity and functioning.
The Federal Reserve (Figure 4) has been most active in this area, launching a range of facilities to support international dollar funding markets and short-term money markets, while a host of central banks have begun large-scale asset purchases of government bonds, and in some cases corporate debt.
Figure 4. Central bank support
Federal Reserve balance sheet (% of GDP) expands rapidly again
The pace and scale of purchases of government debt by the Federal Reserve and the Bank of England has been vastly greater than in 2009. This has been important in returning functioning to government bond markets, and in creating fiscal space for increased government issuance.
While the fiscal and monetary support will undoubtedly cushion the global economy from the worst outcome, it is not likely to provide an offset to the near-term decline in activity. With such uncertainty around the outlook, both in terms of risks to personal health and financial situation, it may be that much of the support to households is saved, rather than spent. And the cost to business profitability will be significant. Perhaps the best that can be hoped for is that policy support measures help to ensure a quick recovery once the uncertainty has passed.
The COVID-19 pandemic has resulted in a sharp sell-off in risky assets and a flight to quality in the form of government bonds (Figure 5). It has also led us to materially change our outlook and asset allocation views (Figure 6).
Figure 5. Risk assets materially lower already on COVID-19 crisis
Figure 6. Asset allocation summary
Underweight equities, overweight government bonds
Those changes reflect both the immediate impact and further disruption over 2020. We have increased preference to be overweight government bonds, expressed primarily through US Treasuries. That reflects our view that central banks will continue to act to maintain easy monetary conditions, and at the same time allow for fiscal space to be created without higher yields.
We have reduced our equity allocation to be moderately underweight overall. The equity allocation view reflects our concern about severe economic weakness translating into historically weak corporate earnings in 2020.
Further, we have moved to a more cautious stance in our currency allocation, with a preference to be long Japanese yen and short Asian currencies.
Our view across credit is neutral, where corporate bond spreads have widened sharply, but where there is now significant support from central bank asset purchase programmes.
Opportunities to invest in companies, sectors or countries with strong balance sheets is even more attractive
We acknowledge that there is enormous uncertainty regarding the outlook. That uncertainty pertains to the likely further spread of the virus, the measures governments might take to contain the spread, the economic impact of the both of those factors, and finally the monetary and fiscal policy support for households, businesses and asset prices.
With so much uncertainty, our confidence in market developments from here is even less than usual. As such, at this time we regard it as imperative to act in favour of capital preservation.
But there will also be an opportunity to look beyond the current crisis and invest in those companies, sectors and countries which will be more likely to recover rapidly. For now, that likely means avoiding those carrying excessive debt, where the current crisis will be more likely to expose those vulnerabilities, and instead seeking out strong balance sheets.
Box A: Scenarios for the spread and containment of COVID-19
One of the challenges of trying to make market assessments at the present is the uncertainty around how the COVID-19 pandemic will progress.
Part of the difficulty lies in the fact that there is a lack of consistent and reliable data available for medical researchers and others. The data is being collected in a crisis event and is subject to many constraints (e.g. testing regimes).
As a result, many assumptions need to be made when modelling the potential spread of the virus. Given the exponential nature of the spread, small changes to those assumptions can result in vastly different conclusions. This is part of the reason why there is much debate within the research community regarding the path forward.
While we can't claim to be any better at assessing this research than the experts, we can try to use a scenario-based approach to think about possible outcomes and their implications. We can then use expert opinion, as it is released, to think about whether one or another path is becoming more likely.
Scenario A: After the first lockdown the virus can be contained whilst economy is restarted.
China has been successful in reducing the numbers of new infections across the whole nation, including in Hubei where the spread had been most rapid. They are in the process of restarting their economy and have so far only identified small and seemingly containable outbreaks.
First, this suggests that the measures being employed in China can be effective in limiting the size of outbreaks, if done early and comprehensively. Second, it suggests that enforced lockdown can be successful in reducing the spread of the virus.
These measures included phone apps to track contacts between people, to warn those who may have been in contact with an infected person, and temperature checks at entrances to many public buildings to identify those who should be tested. Those who are identified as higher risk are asked to self-isolate or are tested to check whether they are clear. Face masks were compulsory in the early stages for anyone venturing out in public.
Clearly, we are in the early stages of their economic reopening and it is important to watch to see if there is a limitation to the degree of restarting that will be possible.
There are also those who are sceptical on the validity of the China numbers. However, at present what we hear from non-governmental organisations (NGOs) on the ground and from most researchers is that their achievements are real. Using Hubei as an initial indication suggests this scenario might require a lockdown of two months to reduce the number of cases to one in which the second stage of containment can be achieved.
Scenario B: After the first lockdown, restarting economic activity results in new infections rising again. However, more targeted social distancing for at-risk groups, alongside improved testing, contact-tracing and health system capacity means that social distancing can keep the numbers to a level at which treatment can be provided to those in need.
Across the world there is a monumental effort to increase the capacity of health systems to manage the impact of the virus. We see industrial manufacturers utilising their expertise to begin production of ventilators, cosmetics firms switching production to sanitisers and research engineers everywhere looking for ways to provide additional equipment specific to the needs of those with severe symptoms.
While we may not be able to contain the virus, as economic activity increases it is entirely conceivable that the achievements in increasing treatment capacity mean that social distancing, rather than social isolation, could be sufficient to keep the level of infections at a level at which health systems can provide treatment to those who require it.
This may involve the most vulnerable being asked to follow a more stringent protocol than the rest of the population to reduce the number of people requiring hospitalisation. It may also result from the discovery of new treatment options which reduce the severity of symptoms. An unprecedented global effort to find such options is already underway.
Another indication of this would be strong evidence that a high proportion of infections are asymptomatic. Many experts currently estimate this to be around 50 per cent. However, without testing along statistical sampling methodologies it is hard to establish the true number.
With the greater testing capacity being introduced across the world, there will also increasingly be the ability to extend testing from being purely driven by symptoms or the effort to track outbreaks, to studies to find the extent of infection and produce better measures of the severity of the virus.
Scenario C: After the first lockdown, restarting economic activity results in a resurgence of new infections. Further rolling lockdowns occur periodically across much of the globe.
Prior to this pandemic, much of the academic research was very sceptical on the ability of even extreme social distancing measures to contain a virus with these characteristics.
This can be seen in the UK government’s influenza pandemic preparedness document, where the impact of such measures was downplayed. It’s possible that this was because the extent of the current lockdowns was not considered as a viable option.
It is also possible, however, that containment strategies will ultimately be unsuccessful alongside increased economic activity.
One scenario could be that this results in further periods of rolling lockdowns as the virus spread declines and then subsequently re-accelerates. This would continue until the development of a vaccine that protects populations from the virus and allows a sufficient population immunity to develop that makes further outbreaks much slower to spread and easier to stop in their tracks.