The key themes and risks our House View team expect to drive financial markets.
13 minute read
Ongoing impact of COVID-19
The near- and longer-term impact of the COVID-19 crisis, and society’s response to it, is expected to continue to have a major impact on economic outcomes, investor sentiment and financial market reactions. Box A in the executive summary gives our latest thoughts on the possible evolution of the virusitself and how governments may respond from here. Experiences have varied across countries, largely related to the spread of the virus and the timings and extent of policy reactions to it (Figure 1). The broad characterisation for countries other than China (where it all happened earlier) is of a significant hit to GDP in March, a collapse in activity in April and the beginnings of a recovery in May. June and the second half of the year should see further marked rebounds in growth. Figure 2 uses monthly UK GDP data simply as an example of the patterns we are likely to see. Many activity series will look similar to this, but note that in levels terms, we are still well below the pre-COVID-19 starting point at the end of the year.
Figure 1. COVID curves have flattened
Confirmed cases are still rising, but more slowly
In terms of the more conventional quarterly GDP numbers, this sort of pattern implies a fall in GDP of between one per cent and five per cent in Q1 (these data are now known but may yet be revised), before an estimated decline of six per cent and 18 per cent in Q2. These sorts of numbers are simply unprecedented, easily the largest declines since the Great Depression and quite possibly ever. Uniquely, the collapses in output and demand are almost entirely self-inflicted, a direct result of the lockdown measures imposed by Government. As those are now being eased, we will witness a resurgence in GDP on a scale that will also be without precedence. Q3 is likely to witness quarterly increases in GDP of between five per cent and 15 per cent in the major developed nations. While any such rebound is, of course, welcome, it needs to be emphasised that these sorts of numbers will not be sufficient to return GDP to its pre-virus level. In our central case, that is not expected until the second half of 2021 at the earliest.
Figure 2. Moves in monthly activity data are unprecedented
But it will take a longer time for normal service to be resumed
Moreover, the extent of recovery is not assured. It will depend critically on at least three factors. First, the extent to which lockdowns are eased and/or re-imposed going forward. This inturn will depend on the progress of the disease itself, as well as the political backdrop. While it remains under control, it makes good sense to relax restrictions on activity. But there are already warning signs about possible second waves or renewed up-ticks in infections. Second, despite the enormous efforts of monetary and fiscal authorities, it seems likely that there will be some long-term damage from the sudden halt in economic activity through increased longterm unemployment and business closures. Finally, attitudes and behaviours have probably changed because of the virus. In the longer term, this could mean lasting changes in the way firms operate and in the manner in which households work and spend. But in the shorter term, it could well imply greater caution and slower recoveries. With risky asset markets appearing to price in a relatively optimistic scenario, there is potential for some disappointment later in the year.
Substantial policy support
In response to the virus, monetary and fiscal policy have both been loosened substantially.The rationale for this has been two-fold: first, to provide ongoing support for companies and individuals to allow them to survive during lockdown. Secondly, to deliver policy stimulus to help activities recover quickly as restrictions on activity are lifted. Arguably, the first has been of far greater importance during this crisis. Without state support and funding, many businesses would simply have failed, and many jobs would have been lost permanently. Fiscal support, in the form of a host of 'contingent liability' support packages has tried to provide a form of bridging finance to companies and individuals as the public sector absorbs risks that the private sector cannot in current circumstances. Unwinding this support when the time comes will be no easy matter.
In this era of independent central banks, it has been quite normal for monetary and fiscal policies to work to entirely separate agendas. Both should respond to the needs of the economy, but that assessment may well be different for a government and for an inflation-targeting central bank. But in the current episode, it has been vital that the two policy elements at least act in tandem, if not in full coordination. Different countries or regions have approached this issue in different ways. In most cases there is a close correspondence between the additional debt issuance planned by government and the additional purchases planned by the central bank. It may not be monetary financing of deficits per se, but it does not look that different. In the particular case of the euro zone, we have seen a combination of bold initiatives – prompt European Central Bank (ECB) actions and the EU Recovery Fund for example, but also the now familiar complications emanating from divergent views from member states about the appropriate policy actions, leading to deadlock and stasis. In terms of monetary policy, interest rates have been kept at or taken back to the effective lower bound in most countries, or to new lows in some cases (Figure 3). Asset purchase programmes have been restarted and a wide range of measures have been introduced to provide liquidity and ensure that commercial banks are part of the solution to a crisis, rather than being the cause of one as they were in 2008/9.
Figure 3. Policy rates are back at the effective lower bound
Close to zero in developed market rates, new lows in emerging nations
Fiscal policy has also been loosened substantially, with budget deficits set to soar in 2020 and, perhaps, 2021 as well. The many measures introduced will inevitably lead to significantly higher ratios of public debt to GDP in short order. In some cases, this may lead to justifiable questions about longer-term fiscal sustainability, but for now such actions are critical to avert economic disaster (Figure 4). It is also vital for borrowing costs to be kept as low as possible, given the additional debt that is being taken on by the public sector. The key point is that the next year or two are virtually certain to be characterised by continued policy support. There may be pressure to ease back on fiscal measures before monetary ones (see the Risks section), but it seems highly likely that policy interest rates will remain close to the lower bound for some time yet, while central bank balance sheets will grow rapidly. During the global financial crisis, there was considerable debate about whether such 'unconventional' policies were appropriate or not. This time around, they seem universally acceptable.
Figure 4. Size of fiscal response has been enormous
Much support takes the form of contingent liabilities
Long-term strategic competition
The relentless trend towards closer integration of the global economy, that had dominated much of the post-war period, has changed over the last decade or so. Since the Global Financial Crisis, more questions are being asked about whether all aspects of globalisation are beneficial and whether a more inward-looking, potentially more uncompromising approach might be better. The main focus currently is on relations between the two largest global superpowers – China and the US – but the issue is broader than that, touching on areas such as populism in Europe, Brexit, re-shoring, international institutions and world trade flows. There have always been battles for supremacy between countries in a range of fields, and purportedly healthy competition across international borders. But the status quo is now being questioned more and more, boosted by a determined China, a single-minded US president and changing attitudes to openness in many countries. If anything, the COVID-19 crisis has intensified the 'cold war' between China and the US (and may have hardened attitudes elsewhere too). It has certainly given it another dimension. Prior to it, there had been some significant, if stuttering, progress towards a phase one deal that seemed to have partially defused trade war concerns. But hostilities have resumed, with President Trump making political capital where possible by referring to the 'Chinese virus' and accusing China of not taking adequate steps to control the disease or to be honest about its origins. Although lip service is paid to the building of bridges and the forging of new relations between the two countries, both parties have more self-interested ambitions.
Figure 5. The world is changing
US is shrinking in relative importance, while China is growing
Coming years are likely to be characterised by increasing strategic competition, largely related to Sino-US dealings, but quite possibly including several other nations as well. As we stated at the start of the year, it would be naïve to believe that US and China differences in areas such as trade, technology and international relations can be quickly resolved. But it is not unreasonable to think that some agreements can be reached over time and that pathways towards more harmonious trading arrangements and the greater inclusion of China in free market commerce can be sketched out. However, such a congenial outcome is far from inevitable and many believe instead that a more antagonistic positioning is more likely. How this pans out over the next few years will help frame the boundaries of the new world order and will be a key driver of both economies and financial markets.
Figure 6. Share of USD and other currencies in the International Monetary System
There are many critical aspects to this theme. They include the future treatment of China technology firms (Huawei perhaps the most important), China’s relations and influence in both Taiwan and Hong Kong, any initiatives aimed at addressing China’s human rights violations and any issues relating to the virus itself including the COVID-19 Accountability Act in the US. One key dimension will be how the US election result drives the form of the future relationship between China and the US. More generally, nations other than the US are likely to play a more significant role in determining the free market constraints within which China will be permitted to operate. This is not an attempt to dictate separate rules to control China, but rather to ensure that it is brought into line with internationally accepted rules and practices.
With five months to go until election day (3 November), polling data in the US has shifted significantly in favour of the Democratic candidate Joe Biden. Just four months ago, Trump’s chances of a second term looked better than ever. His impeachment trial ended in an easy acquittal, his approval rating was as high as those that saw both Obama and the younger Bush re-elected, the economy was doing well and the divisive Bernie Sanders was riding high in the democratic primaries. The plunge in Trump’s fortunes has been attributed to a combination of the remarkable resurgence of the generally well-regarded Biden, the inept handling of the COVID-19 crisis, the immense damage to the economy resulting from lockdown measures (rising unemployment, collapsing GDP) and a liberal surge in the wake of the George Floyd killing and rise of the Black Lives Matter movement (Figure 7). Despite this, there is still a battle to be fought and much can change between now and November. Arguably, one of the more important developments will be the impact of any recovery of American GDP in Q3 and beyond. Bill Clinton’s chief strategist famously quipped in the 1992 election campaign (when Bush senior was unseated), “it’s the economy, stupid”, judging that economic weakness would persuade voters to shift their loyalties. But if the economy does revive, will voters respond to that positive momentum or to the disasters of recession, lower stock prices and the highest unemployment rate since the Great Depression? It is hardly surprising that the single-minded Donald Trump is keen to get the US economy re-started as soon as possible.
Figure 7. Big change in Trump's polling since February
Biden is now convincingly in front
As we pointed out at the end of 2019, the Republican party is generally believed to be the more market-friendly choice, but the selection of the 'moderate' Biden over the 'progressive' Sanders or Elizabeth Warren has removed a substantial part of the tail risk from a more radical, reformist agenda after a Democrat victory. There had previously been understandable fears over higher wealth and income taxes, greater regulation of business and even the break-up of some corporate empires. If the Democrats were to win, there may be some smaller biases in those directions, but perhaps not enough to roil financial markets unduly. Nevertheless, there is still a battle to be fought and Trump is unlikely to go quietly. If he continues to trail in the polls, he may take extreme steps himself. Whatever happens, the US election is likely to become an increasingly important driver of markets in the run-up to the event itself and in its immediate aftermath: will we be looking at how Trump will try and fashion his legacy, or at the post-Trump era? Could the Democrats take control of both the House and the Senate (Figure 8)? There aremany, many aspects to this issue, but one of the more interesting (linking back to another of our themes) would be the US-China geopolitical relationship. China might be happy with the way that Trump has disrupted internationally coordinated diplomatic efforts to tame them, but less keen on the collapse of the global trading order that has materialised. On the other hand, a Democratic administration might be even tougher on China, and include their questionable human rights record. Moreover, Biden’s team might be more effective. It is not clear who China might prefer.
Figure 8. Democrats could make a clean sweep
They expected to control the House; the Senate now looks possible, too
The “golden era” of globalisation may be behind us (Figure 9), but the world economy is still expected to engage in mutually beneficial trade and to practice international specialisation. However, a downside risk is that a drive towards de-globalisation, that began for many nations in the wake of the GFC, intensifies after the COVID-19 crisis. The Trump tariffs represented a key step in this direction, but there were already rumblings of heightened nationalism and protectionism in other countries too. Compounding these trends, the virus has exposed some of the vulnerabilities from global supply chains and encouraged some nations to reconsider their international strategies. A return to the damaging “beggar-thy-neighbour” policies of the 1930s is unlikely, but a wave of more inward-looking policies seems quite plausible. A hard Brexit is just one possible example of this type of development.
Figure 9. World trade has been growing more slowly than world GDP…
…a sharp contrast to much of the post-war period
Huge packages have been put in place around the world to support companies and individuals during the lockdown periods so that they can return to normal activity as and when restrictions are lifted. The scale of this fiscal largesse is unprecedented and is already leading to soaring budget deficits. To give just one example, public sector net borrowing in the UK totalled £48bn in the financial year ending in March this year. It then amounted to an additional £48bn in April alone and a further £54bn in May. The OECD estimates that the budget deficits will soar (Figure 10) and the average increase in public debt because of the crisis will be 18 per cent of GDP (more if there is a second wave). As lockdowns are eased, political pressure is already growing in some quarters to start to address this through the removal of fiscal support (e.g. in the UK the planned reduction of the employee furlough support scheme, and in the US the planned reduction or elimination of the boost to unemployment benefits enacted in late March). While the drive towards austerity that came in the post-GFC period seems unlikely this time around, too rapid removal of support measures could result in a nasty negative demand shock.
Figure 10. Public sector deficits will widen sharply
Debt sustainability in some countries will come into question
Balance sheet vulnerabilities
Generally speaking, financial crises and recessions – both in their origination and consequence – can be linked to balance sheet weaknesses in some part or parts of the economy. There are a number of candidates in the present episode, but as Warren Buffet famously said, it is only when the tide goes out that you discover who’s been swimming naked. Even with the support of public funds, corporate balance sheets around the world are bound to be more stretched after enforced shutdowns and there will be a delicate balancing act as funding schemes are withdrawn, which could expose the vulnerabilities of some. The fundamental health of public finances has taken a severe hit from the measures taken and those countries where there were already fiscal vulnerabilities, may be pushed over the edge. Finally, several EM nations are seeing worrying virus trends, but do not have the resource or the resolve to take steps that other, wealthier nations have been able to take. There is a risk that the COVID-19 experience reveals balance sheet weaknesses in specific countries. In its June Economic Outlook, the OECD runs some stress tests on corporations in a number of geographies (Figure 11).
Figure 11. Corporate balance sheets to come under severe strain
Some EM countries may be especially vulnerable
The end of US exceptionalism
The US has long prided itself as the wealthiest, strongest and most scientifically advanced nation in the world. Yet it leads the world in terms of both confirmed cases of the COVID-19 virus and of related deaths. They are widely believed to have mis-handled the virus badly. It is rather fanciful to leap from these facts to a more general conclusion that the US position in the global hierarchy is evolving. But when considered in parallel with the many Trump policy whirlwinds over the last four years, entrenched inequality and the emergence of more radical political factions on both the left and the right, it is a question that is now being asked more often. In terms of the attack of the Covid virus, the US has been shown to have much in common with all other nations. Attitudes are changing: fewer and fewer Americans agree with the idea that they stand above other countries. And the image of the US has fallen in the eyes of several other nations. The hegemony of the US may be dwindling and that would create a very different geopolitical backdrop for economies and markets.
COVID-19 uncertainty clears
Amid all the many and entirely justified concerns about the virus and the damage created by lockdowns, it should not be forgotten that there are upside possibilities to the resolution of this episode. The transmission of the disease has been successfully reduced by the measures put in place (Figure 12) and we are already starting to see the clear beginnings of strong activity upswings in many countries. If the measures put in place to protect and nurture firms and workers during the pause have been successful, then perhaps lasting damage can be avoided. Conviction can then grow that the virus has been defeated and that things can go back to normal. If a vaccine can be discovered and distributed – a latently unpredictable development, but one that should not be ignored – then the swift removal of COVID-19 uncertainty could become self-reinforcing and lead to a post -virus boom. Far-fetched as this might seem at times, it could lead to a pressing re-assessment of policy settings.
Figure 12. The spread of the virus has slowed dramatically
Significant country variations, but peak has passed
The euro zone has had a turbulent 20-year history, with episodes characterised by serious policy errors and major differences of doctrinal opinion and basic values mixed up with periods of great advancement. The ECB has been a key component and, ultimately, backstop to the slow grind towards closer fiscal and political integration that is the eventual goal. If unity is, as some suggest, borne out of crisis and difficulty, then the single currency project must stand a good chance of success. After some significant wobbles at the beginning of the COVID crisis, when it briefly looked as if some old fracture-lines would re-open, member states have stood firm and together in facing down the disease and presenting a reasonably coherent and coordinated approach to dealing with it. There will still be some difficult times ahead, but It is possible that euro zone countries will come out of this crisis more closely aligned and with renewed dynamism to achieve their ambitious goal of creating an entity that looks more like a united state of Europe.
Figure 13. Euro zone has seen many swings in growth since its formation
COVID-19 experience may bring member states closer together
Emergence of inflation
During the GFC, many voiced concerns that the extreme policy stimulus being provided would result inevitably in runaway inflation. That view was wrong then, largely because of a fundamental misunderstanding of the monetary transmission mechanism. On that occasion, a hobbled banking system meant that money was not being “created” in the usual (credit creation) manner. QE programmes replaced such activities and underlying monetary growth did not change much. This time around, there are more legitimate concerns regarding possible inflationary consequences of “de facto” monetary financing of (much larger) budget deficits. Added to this, possible disruptions to global supply chains could compound any supply-demand imbalances and push inflation higher. Core inflation has generally been below target since the GFC (Figure 14). By and large, central banks know how to deal with rising inflation, but they may face the dilemma of choking off demand before recovery has become assured.