The key themes and risks our House View team expect to drive financial markets.
13 minute read
Everything has changed
We should have known better. Just three months ago in our 2020 Outlook, we stated that the world growth outlook was finally improving after two years of gentle, but relentless slowdown. Key risks had receded, and the probability of a global downturn or recession had diminished significantly.
A major global recession is now inevitable
The outbreak of the COVID-19 virus has changed everything. It is now inevitable that 2020 will see a major recession and that all – or very nearly all – nations of the world will participate in the coordinated downswing.
It had initially been hoped that the impact of the virus and associated containment measures might be largely confined to China and some parts of Asia – a significant, but hopefully limited, transient and manageable disruption.
It is now readily apparent that the global pandemic and reactions to it amount to one of, if not the, largest economic shock of modern times. While that may sound overly dramatic, the scale of declines in GDP that we anticipate have not been seen since the Great Depression and dwarf those witnessed during the Global Financial Crisis (GFC) of 2008-9 (Figure 1).
Figure 1. Peak to trough GDP declines
Scale of likely falls in GDP is highly uncertain but will be large
Previously, we have tried to identify the key themes which we believe will frame the investment backdrop over a two-year horizon and also to consider what the key risks to our central view might be – where things could turn out for the worse or, indeed, the better.
This time around, that approach is challenged: there is only one theme and a single risk completely dominates the outlook, albeit one that has several dimensions.
So instead, this section will attempt to characterise the broad macroeconomic parameters of the COVID-19 crisis, assess its likely impact along with those of the many containment measures that have been implemented, and evaluate the multitude of policy responses that have been made.
Winter is coming
Weakness will be concentrated in Q2 for most nations; Q3 should see a rebound
A severe recession is now unavoidable. The hope is that it will be short-lived, and that economic activity will start to make the journey back towards normal levels in the second half of 2020.
But while the downturn is certain, the nature of the recovery path is not, largely because of the form of the disease and resulting doubts about how long restrictions on “normal” activity will have to remain in place. Even more worrying, economic downturns often create their own self-reinforcing downward momentum: businesses fail, people lose their jobs, leading to damaging secondround effects and some permanent loss of productive capacity.
The efforts of central banks and governments aim to alleviate these effects to the extent that they can. But they will not be able to prevent lasting damage, only limit it.
The February and March PMI survey balances in China and the euro zone provide a glimpse of the scale of downturn that we may expect (Figure 2), but also to the possibility of a rebound. The initial declines were not pretty. What is clear is that the falls in GDP will be huge and it will be the domestic-facing service sector which is likely to suffer most. It will be concentrated in Q1 for China and Q2 for the rest of the world.
Figure 2. PMI surveys in China and Europe
Balances have plummeted, especially for services
The rebound in the Chinese balances for March were encouraging, but they need to be interpreted carefully. All they show is that activity in March was better than February. But less bad is a better description – these are “diffusion” indicators, not an indication of the level of activity or what is “normal”.
China is already rebounding, but is not back to normal yet
Hard data will eventually tell us the extent of the downturn and the magnitude of any rebound. But one way of gauging where these comparisons will fall is to look at real-time indicators of activity. And to use China as the example since they experienced the first lockdowns.
Figure 3 shows the pattern of coal consumption among China’s major electricity producers around the time of the lunar New Year. 2020 saw a decline as the holiday period began, as always happens. But the usual pick up did not materialise because of shutdowns related to the reaction to the virus.
Figure 3. China coal consumption of major electricity producers
Activity levels are probably around 10 per cent below “normal”
At times, coal use was 30 per cent or 40 per cent down on comparable periods. It has recovered a bit since then, but still looks below where it might ordinarily have been. Activity levels are "better" in China, but not yet back to “normal”. The same sort of pattern is visible for port activity, pollution levels, congestion aggregates and subway usage.
Financial markets have reacted before the hard facts of downswing become official: composite indices of financial stress have also collapsed (Figure 4). While it is encouraging that these measures have not reached the levels that prevailed in the GFC – partly because of the policy response we assume – they still signify markedly tighter financial conditions than normal.
Figure 4. Bloomberg composite indices of financial conditions
Overall conditions have tightened significantly in the last month
A different world
Hard economic data in coming months will be horrendous
The cold facts are that these are unprecedented times. That word is badly overused, but there is no more apposite description today. The bare truth is that no-one knows how the transmission of this disease will unfold, how many people will be affected, how restrictive and extensive the containment measures will have to be and how damaging and lasting the economic downturn will be.
As many others are doing, we are attempting to model different outcomes, but the disease is new and many aspects of it are, as yet, unknown.
Meanwhile, in the area where we should have greater confidence in our methods – economic modelling – some of the numbers that are implied are “off-the-scale” awful in the context of recent times and so do not lend themselves to routine analysis. The technical explanation might refer to complex non-linearities in what were previously considered to be well-understood relationships; a more prosaic description would be, no-one knows.
With that qualification in mind, below we attempt to distil some strands of analysis that are useful and do at least help us frame the discussion.
Supply and demand shock
This is both a supply and demand shock. Not that long ago, most people – ourselves included – believed that it would primarily be the former. A transient interruption to activity, mainly in parts of China, that would adversely impact global supply chains. That was enough to cause a ripple of anxiety in financial markets, but such worries quickly dissipated.
It is now clear that the demand component of the shock will dominate. One of the key differences between the GFC and today is that the COVID-19 virus is in some ways a known enemy – the cause of the shock is clearly identified (even if some aspects of the disease itself are still mysterious).
In 2007-09, one of the underlying themes of the crisis was that no-one really knew exactly where some of the problems were. This made identification of appropriate policy responses more difficult. Many were delayed, inadequate or poorly directed.
This time around, the negative demand shock is a deliberate intention for medical reasons. Sadly, that does not make it any less painful.
Containment measures are necessary, but will have a huge economic cost
The downturn is, essentially, an act of economic self-harm. But one that is necessary if we wish to limit the spread of the disease to a pace at which health systems can cope. The experiences of Wuhan, Italy, Spain and others have demonstrated how fast treatment capacity can be reached and we are still at a comparatively early stage of the spread of the virus.
The demand shock is likely to be deflationary in the first instance
The demand shock that is coming is deflationary, potentially on a disturbing scale. Central banks around the world had previously been struggling to achieve inflation targets, typically around two per cent.
Moreover, the collapse in the oil price following the spat between Saudi Arabia and Russia (and others) was already pointing to significantly lower inflation in coming months anyway. Steep declines in energy prices were inevitably going to lead to much lower CPI inflation in all economies in any case, just as they did in 2009 and, to a lesser extent, in 2014/15 (Figure 5). Estimates varied but it was likely that headline rates of inflation would have fallen by a full percentage point between February and May and perhaps more.
Figure 5. Oil prices and world inflation
Tumbling oil price already likely to weigh on global inflation
The overlay of the huge demand shock could well push many countries into deflationary territory. The mechanical impact on inflation rates from the collapse in oil prices is one thing. The deflationary impulse from collapsing demand is another and is far more of a concern: as history has shown, once deflation sets in, it can be difficult to shift.
As the extreme policy measures that have been adopted gain traction, it is plausible that inflation will receive an upward jolt. There were siren voices during the GFC that QE and the like would lead inevitably to hyperinflation. Such worries were unfounded and betrayed a woeful misunderstanding of the monetary transmission mechanism.
Nevertheless, higher inflation in the future is possible, but central banks would probably like nothing more than an inflation “challenge” – they have the toolbox for that and know how to use it. Runaway inflation is the least of our problems today.
Desperate times, desperate measures
Many commentators have drawn comparisons with periods of war in the past and, in terms of the size of shock and enforced changes of behaviours, there are parallels. But they can only be taken so far.
In wars, countries typically attempt to maximise output, calling on all resources to contribute to such efforts. Today, the authorities are trying deliberately to restrain demand and output.
In the most simplistic terms, there will be two stages to these actions. In the first, there is a policy-led retrenchment in demand because of disease containment measures. The OECD recently estimated that the negative impact of shutdowns could easily amount to a fifth or a quarter of GDP (Figure 6). In the second, as such measures are relaxed, there will be a rebound in activity and demand.
Figure 6. Potential impact of lockdowns on economic activity
OECD estimates that effects could be enormous
Stimulus measures clearly make little sense in the first stage – they would go directly against the basic principle of containment. Rather, they should be directed in two ways: to keep the period of demand decline as short as possible (subject to the medical constraint) and to try and provide an offset to those (individuals and households) who are hurt by the enforced hits to activity. In the second stage, policies should help restore demand as quickly as possible, supporting it where it has been weakened and replacing it where it has been lost.
This is an immense task, in terms of both scale and complexity. It is highly unlikely that policy makers will get it completely right and it is inevitable that there will be longer-term consequences. Neither of these should prevent them from trying.
Policy response has been massive, but cannot prevent significant damage
Despite best intentions – attempts to keep firms in business and people in employment – there will be widespread damage. Revenues and incomes may be put on hold, but it is generally not as easy for costs. Often it is just not possible.
This is where government and central bank help comes in. The general principle is to nurture and protect both so that they can recover when conditions change or are changed in that second stage and return to normal economic activity.
Nevertheless, casualties are inevitable: cash-flow crises will drive some businesses to the wall and unemployment will rise. This has already begun, as illustrated by the shocking initial jobless claims data in the US recently. The total rose more than ten-fold to over three million and then doubled again.
Taken at face value, this suggests that ten million people have been added to the ranks of the unemployed in the US in just two weeks. If that is right, it means losing all of the job gains of the last five years in an instant. The March US payrolls numbers were poor, back to GFC-style declines (Figure 7). But April’s data will be horrendous, running well into the millions.
Figure 7. US monthly change in non-farm payrolls
Decline in March was bad, but will be swamped in April
Of course, it should be the case that the vast majority of people affected will simply get their jobs back when containment measures are relaxed. But in the meantime, they will lose wage income and have to rely on (lower, sometimes much lower) unemployment benefits. And the entirely justified worry is that while economic activity is deliberately squeezed, not all companies will survive, so not all of the old jobs will be there to return to.
There will be many more economic data release horrors in the coming weeks, but the form of the shock will vary around the world. It was noteworthy in the GFC, for example, that regulated Europe hoarded labour, while free-market USA let the jobs market bear the brunt of the downswing (Figure 8).
Figure 8. GDP and jobs declines in 2008/9
Job losses were far greater in the US in the GFC
Big increases in contingent liabilities for the public sector
It is heavy-handed to characterise so bluntly, but broadly speaking the US seems to have adopted a similar approach to the COVID-19 crisis – allowing unemployment to take the strain – while others, such as Europe, the UK and parts of Asia have instead tried to protect employment by providing wage subsidies.
The UK scheme is just one example, but it is a good illustration of the principle. The British government has effectively underwritten 80 per cent of workers’ incomes (employed and self-employed) for those affected by the lockdowns. Sadly, even with this support buffer, there are still going to be significant and permanent job losses across all nations.
The policy initiatives that have been put in place are wide-ranging. There has been a combination of monetary and fiscal measures. While there is no single panacea, it is very likely that fiscal measures – both direct and indirect – will have to do much of the heavy lifting.
Access to cheap lending will help some, but not all. Others will need grants, handouts or other forms of direct transfer. The basic principle will see a massive run down in public saving to finance an increase in funding for the private sector.
Here again there are some parallels with war financing. Cash handouts to households or grants to companies will help both groups in the first and the second stage as referred to above. But they will certainly not be enough to prevent some pain – and quite possibly lasting damage – during the harrowing first stage.
The policy measures themselves
There is no merit in listing the details of the various policy assistance measures that have been put in place around the world. There is a vast range of such schemes and they are changing daily. Rather, we can group them into the following broad categories:
- Monetary – conventional
- Monetary – unconventional
- Fiscal – direct
- Fiscal – indirect
(Note: these are separate from specific medical and health policies being put in place.)
The categorisation is neither perfect nor all-encompassing and there are some blurred edges between some of them. But it allows us to provide a summary.
Monetary – conventional
Policy interest rates have been reduced in most countries and to new lows in many. Several have jumped instantly to where the effective lower bound is perceived to be (Figure 9).
Figure 9. GDP-weighted policy interest rate around the world
Rates have been cut quickly in response to the crisis
Partly as a result of the GFC, central banks better understand the dangers of delaying or not acting boldly enough and have reacted swiftly to the current crisis. Policy rates are likely to remain low – they could even move lower – until an economic rebound is assured and underway. The most basic cost of credit will be kept as low as possible for an extended period.
A critical part of the monetary policy response and central bank signalling is the implicit commitment to own the debt and to keep debt servicing costs as low as possible now and in the future.
There is, rightly, a recognition that significantly more public debt is going to be required. Issuance will rise enormously and the additional debt must be willingly held if markets are to remain orderly. It must also be serviced of course, and to ensure that will happen without stress, rates will need to be kept low not just at the policy end of the maturity spectrum, but all along the curve.
Monetary – unconventional
Unconventional is fast becoming an outmoded description as extraordinary global central bank action has become widely 'normalised'. Old rule books have been ripped up.
Details vary, but most have restarted asset purchases (QE), some on an unlimited basis, and introduced new such facilities. Central bank balance sheets are going to expand rapidly once more, just as they did in the wake of the GFC (Figure 10).
Figure 10. Size of major central banks’ balance sheet (USD)
CB balance sheets are about to balloon again
In addition, a wide range of schemes have been put in place to ensure that the banking system has access to unlimited liquidity. In the 2008/9 crisis, banks were perceived to be a major part of the problem; today they have to be a key part of any solution, becoming in part a vehicle for public policy. In return, the state must indemnify them in the form of state guarantees on loans. A range of resources have been put in place in attempts to ensure smooth functioning of corporate finance markets, a key requirement for larger enterprises.
Together, these schemes should help prevent funding crises – for both private firms and the government. But while necessary, such schemes are not sufficient to achieve these aims. More will be needed, much of it in the fiscal arena, but also in the grey area between monetary and fiscal policy.
It can be argued today that purchases of government bonds – conventional QE if you like – even mortgage-backed securities too, are not that contentious any more. But extending the range of asset purchases to private sector risks assets is a bigger step. It is already the case that central banks have bought and are buying corporate bonds and equity ETFs, but it may become necessary for them to go further if this crisis deepens.
Fiscal – direct
Significant direct fiscal assistance is expected everywhere
Traditional discretionary spending initiatives and tax reductions will help provide some offset to impacted parties – mainly small and medium enterprises and households, but also several larger companies too. Arguably far more important are the range of measures that have been introduced to directly address the cash-flow problems that are already hitting many companies and individuals and will undoubtedly do so much more in the near future.
Again it is difficult to characterise in general, but most estimates suggest that the remainder of 2020 and 2021 (recall that governments don’t want to stimulate activity during lockdowns) could see fiscal stimulus amounting to around two per cent of GDP. In several countries, that number is likely to be much bigger: Germany and the UK, for example, could soon see budget deficits balloon higher by four or five per cent of GDP. Others may well follow (Figure 11).
Figure 11. Public sector budget deficits as a % of GDP
The recently agreed $2 trillion package in the US as well as ongoing negotiations in Congress over additional stimulus provision, if taken at face value, indicate that the US budget deficit could very swiftly double as a proportion of GDP and move above ten per cent. Public debt everywhere will rise sharply, exposing existing vulnerabilities (Figure 12).
Figure 12. Public debt as a per cent of GDP
Of the major nations, Italy is the most vulnerable (excluding Japan)
Fiscal – indirect
Numerous schemes introduced to ensure financial markets function as smoothly as possible
A vital part of the collective “whatever it takes” policy approach that has been adopted by many countries is the wide range of loan guarantee and de facto underwriting schemes that have been announced. The headline numbers that define these arrangements are truly mind-boggling in scale.
It is important to understand that the figures involved do not represent the actual cost to government. Rather, they represent a contingent liability that will be incurred if and when such facilities are accessed by companies and people. It is inevitable that they will do so in coming months, but the scale is inherently unpredictable.
There is also the not insignificant issue of ensuring that such funding gets to the appropriate recipients – the potential for deceit and fraud is enormous.
It is impossible to generalise, but the financial resource that effectively underpins these sorts of facilities can easily amount to ten or even 20 per cent of GDP. The eventual fiscal cost to governments should be a fraction of that, depending on the amount that is drawn down and not repaid – in other words, the size of the effective transfer from public to private.
“Whatever it takes” policies being adopted everywhere
In such a fast-changing environment it is almost impossible to quantify the size of the stimulus that will be provided. But is very clear that all of the policy authorities are trying to reassure with the sort of “whatever it takes” message that Mario Draghi famously provided in 2012 during the euro zone sovereign debt crisis. On that occasion, merely the threat of extreme actions was enough – in the end the ECB did not have to deliver.
This time around, that will not be enough – real assistance will be required on a massive scale and in short order. During the GFC, budget deficits around the world rose sharply. Something of at least a similar magnitude is likely to be required in 2020 – but it could be larger than that and may be needed for a long time.
It is little more than speculation really, but given the scale of measures already announced around the world, it seems inevitable that the size of deficits seen in the GFC will be matched again very soon and could very easily be quickly exceeded.
Currently, the US is running a deficit of a little over four per cent of GDP, while those for the euro zone (overall) and the UK are both less than two per cent. Again, it is little more than guesswork at this stage, but a rise in public debt of the order of 20, 30 or more percentage points of GDP may well be required.
Will the policy response be enough?
Enough for what? It will not be sufficient to prevent a nasty recession. But it might be enough to avert a depression. Although there are still many worries about assistance reaching the right people in time (this applies to financial help rather than medical), most policy makers are to be applauded for the size and speed of their reactions.
The magnitude of the crisis has meant that, in most quarters, there has been an almost instantaneous acceptance that there will have to be a substantial increase in public debt. There may also need to be private debt cancellation.
Loans and direct transfers will be required
Loans, even cheap loans, are not enough. Some companies will be able to survive by borrowing until the good times return. Others will not, but if they are not helped, the longer-term consequences of business failure, idle resources and permanent loss of productive capacity will be far more costly.
The appropriate length of lockdown period is not known but will depend fundamentally on the extent and form of the disease’s spread. This will vary from country to country, but some common patterns are becoming apparent (Figures 13 and 14) and, thankfully, containment measures do appear to be working, albeit at huge economic cost. It is entirely appropriate for the public sector to deploy its balance sheet to absorb those risks that the private sector cannot. That has always been the purpose of the state.
Figure 13. Pattern of confirmed COVID-19 cases
Figure 14. Pattern of COVID-19 deaths
While “joined up” policy thinking between governments and central banks is welcome, it is not always perfectly harmonious and, in any case, does not guarantee perfect results. Some problems will prove insurmountable and mistakes will be made.
One area of concern is the euro zone where, not for the first time, differences of view about fiscal union and debt mutualisation have hampered attempts to provide the necessary backstop in these unprecedentedly difficult times.
Moreover, while the immediate global crisis is a health one, in the very near future it will also become an economic one. The toxic combination of collapsing GDP, a deflationary down-draught and huge increases in public sector deficits will push some countries onto unsustainable fiscal paths. Those with already high public debts, such as Italy, look most vulnerable.