COVID-19: What will unprecedented policy response mean for economies and markets?

While global policymakers around the world have acted with unprecedented speed and force to the COVID-19 pandemic, their actions are unlikely to prevent the world falling into the deepest recession since World War II.

7 minute read

COVID-19: What will unprecedented policy response mean for economies and markets?

With as much as one third of the planet’s population under lockdown as governments frantically attempt to slow the advance of the COVID-19 pandemic, the global economy looks to be heading for the deepest recession since the Second World War, and possibly the Great Depression.

Authorities have reacted with unprecedented speed and aggression in trying to limit the economic fallout from measures taken to fight the pandemic. But the unique nature of the problem means there is a limit to what their actions can achieve.

Major central banks are keen to dispel the belief they are largely powerless to prop up economic activity

Major central banks, which have responded quickly, innovatively, and forcefully, are understandably keen to dispel the belief they are largely powerless to prop up economic activity. US Federal Reserve Chairman Jay Powell on March 26 denied the central bank – which earlier in the month cut rates to near zero, purchased huge quantities of government debt and broke a taboo by lending directly to American businesses – was going to run out of ammunition.1

However, while broad-based lending programmes and asset purchase schemes should alleviate stresses in financial markets and help keep some companies afloat, monetary policy can only do so much to help otherwise sound businesses that have suddenly seen revenues evaporate. Nationalisation, either partial or full, could prove the only way to save some firms in the hardest hit sectors.

There is less scope for monetary policy to boost households’ disposable income via lower mortgage rates

Monetary policy will arguably be even less potent when it comes to addressing cratering consumer demand if, as expected, unemployment soars. After all, interest rates were already skirting the ‘zero lower bound’ in much of the world and not much higher elsewhere, even before the crisis began. Unlike previous recessions, there is less scope for monetary policy to boost households’ disposable income via lower mortgage rates.

Powell expressed concerns in February about the Fed’s ability to support activity, telling lawmakers low interest rates “means that it would be important for fiscal policy to support the economy if it weakens”.2

Can governments ride to the rescue?

Not surprisingly given the unique nature of the crisis, a number of governments have heeded his advice. For instance, Washington recently passed a $2 trillion stimulus bill, the equivalent of ten per cent of GDP and the largest in US history. The package includes more generous help for various industries, such as airlines, that have been particularly hard hit.3

In the space of four weeks, more than 22 million Americans have filed for unemployment benefit, smashing all previous records.4

Figure 1: US weekly jobless claims soar
US weekly jobless claims soar
Source: Macrobond

In response, Washington is doling out $1,200 to every adult American and $500 per child (phased out above $75,000 income for individuals and $150,000 for households). It is also giving money directly to state governments, and extending unemployment benefits to those not normally covered, such as freelancers and workers in the gig economy.

Governments elsewhere are promising similarly vast sums of money as they attempt to play the role of consumer of last resort amid spiralling unemployment and precautionary savings. For example, in an effort to staunch redundancies, the UK is offering to pay 80 per cent of salaries up to £2,500 per month of private sector employees who are unable to work due to the pandemic but are kept on by their employer.5

Even fiscal stimulus on this unprecedented scale will not be enough to stave off a deep recession

In the circumstances, solutions such as these are warranted, and should cushion the blow and help the subsequent recovery. Nevertheless, even fiscal stimulus on this unprecedented scale will not be enough to stave off a deep recession. While the full extent of the economic decline is impossible to predict given uncertainty as to how long countries will be locked down for, it is already clear in most major economies the scale of decline in GDP will dwarf that witnessed during the Global Financial Crisis.

Figure 2: Peak to trough GDP declines

Scale of likely falls in GDP is highly uncertain but will be large

Peak to trough GDP declines
Source: Aviva Investors, Macrobond as at 31 March 2020

Ending lockdowns quickly is key to economic revival

Although economic growth might rebound sharply if governments are able to ease restrictions relatively soon, the longer lockdowns persist the weaker recoveries will be as more and more firms are driven to the wall. And any recovery might prove short lived if the virus were to flare up again, forcing renewed lockdowns.

Looking beyond the immediate future, basic economics suggests there will be a permanent impairment of GDP that no central banking and governmental sleight of hand can disguise. While higher government spending via transfers and tax cuts can lessen the depth of the current downturn, the quid pro quo may well be lower economic growth further ahead as future generations pay that debt off, and a permanent transfer of wealth from some sectors to others.

Paying large numbers of people to do nothing is precisely what many governments are now choosing to do

John Maynard Keynes, the original champion of fiscal activism in times of deep recession, pointed out the wastefulness of having large numbers of economically active people unemployed. He argued even paying people to dig holes in the ground and then fill them up again would be preferable. And yet perversely, paying large numbers of people to do nothing is precisely what many governments are now choosing to do. Unless the lost hours are made up once the crisis is over, wealth will be permanently destroyed regardless of the speed of recovery.

In the meantime, fiscal deficits are set to balloon in many countries as a result of government intervention. In the UK, the Institute for Fiscal Studies estimates government borrowing will be as much as eight per cent of GDP this fiscal year, and potentially substantially more. It says even once the COVID-19 outbreak is over, “the tax and spend trade-offs facing policy makers will be made starker for years, and more likely for decades, as they strive to bring debt back down”.6

Money doesn’t grow on trees

With deficits already elevated across the developed world, central banks are having to step in to purchase huge quantities of government debt to prevent borrowing costs from rising. That begs the question: where will the money will come from?

For now, central banks are keen to dispel suggestions they are engaging in direct monetary financing – effectively printing money – due to concerns financial markets may see this as inflationary. Andrew Bailey, governor of the Bank of England, has signalled he would oppose any calls to print money to allow the government to run up a bigger deficit.

Using monetary financing would damage credibility on controlling inflation

“Using monetary financing would damage credibility on controlling inflation . . . It would also ultimately result in an unsustainable central bank balance sheet and is incompatible with the pursuit of an inflation target by an independent central bank,” he wrote in the Financial Times.7

While Bailey says the purchase of £200 billion of government bonds does not represent a “permanent” expansion of the bank’s balance sheet, others are less sure. However, most would agree that regardless of the way in which soaring deficits are financed, a significant spike in inflation is unlikely to follow, at least in the near term. The scale of the expected drop in consumption and collapsing oil prices should see to that.

After all, when central banks first deployed unconventional monetary policy in the wake of the financial crisis there were widespread fears it would lead to much higher inflation. These proved unwarranted. Indeed, the Bank of Japan has been monetising the country’s deficit for a number of years without generating inflation.

Market implications

According to Peter Fitzgerald, multi-asset and macro chief investment officer at Aviva Investors, while higher inflation in the future is possible, deflation seems a far bigger threat. Despite recent turmoil in government bond markets, he sees little prospect of a major rise in yields.

“Faced with such substantial government debt issuance, we think central banks are going to have to pin yields to the floor for a very long time across the maturity spectrum,” he says.

As for riskier asset classes, David Cumming, Aviva Investors’ chief investment officer for equities, says while policymakers in developed countries have by and large taken the right steps to try to mitigate the economic impact of the pandemic, there is only so much those measures can achieve.

Central banks and governments can only protect the economy for so long

“Central banks and governments have between them provided liquidity and a level of support to companies and households, but they can only protect the economy for so long. The key uncertainty now is the pandemic itself and the success of the global lockdown exit strategies. In that sense, the faster the pathway to normality the better.”

Colin Purdie, chief investment officer for credit at Aviva Investors, says the crisis is already posing an existential threat to companies in multiple sectors exposed to discretionary consumer spending, such as travel and tourism, leisure and non-food retail. He says the longer the crisis persists, the bigger the wave of bankruptcies will be.

Cumming agrees the long-term survival of some companies in struggling sectors is at risk, especially those that had weak balance sheets before the crisis. However, many others still have options available to see them through the short-term economic shock.

“Companies are slashing costs wherever possible, halting dividends and looking to raise capital either in debt or equity markets as they try to repair their balance sheets. If necessary, we expect governments would pressure banks to continue funding better run companies,” he says.

Purdie, like Cumming, believes banks are in a far stronger position than they were during the crisis in 2008, and believes bank debt looks comparatively attractive.

Politicians desperately need banks to be stable, well-capitalised institutions

“Right now, politicians desperately need banks to be stable, well-capitalised institutions. They have a quasi-policy role to play in ensuring the flow of capital and funding into the real economy, so it is in governments’ interests that the banks are on a sound footing” he says.

He also sees attractive opportunities in US investment grade debt with shorter maturities. “The Fed came in and bought the front end of the US credit curve; both in the primary and secondary markets. That’s been really positive and although some of the widening we saw has reversed, there’s room for spreads to tighten further,” he says.

As for Cumming, he says it is especially important to try to “stay as close as we can” to companies. “We’re looking at stock specifics, trying to understand their dynamics, the financial risks, and try and take advantage of opportunities that are still being thrown up in a volatile market gripped with fear.”

Fitzgerald adds caution. He argues that although riskier asset classes may draw some support as a consequence of policy initiatives to suppress government bond yields, provide companies with cheap financing and prop-up economic activity, it would be premature to call a decisive turnaround in these markets’ fortunes.

There is still an awful lot of uncertainty over the spread of the virus

Risk assets have recovered sharply in the past few weeks as investors try to call the bottom. But Fitzgerald says there is still an awful lot of uncertainty over the spread of the virus, the economic impact of the measures governments are taking to contain it, and the effectiveness of support being given to companies and households.

“It’s safe to say there has never been so much riding on the development of a safe and effective vaccine. Unfortunately, that still looks to be some way off. The exit from the extraordinary measures that finance ministers and central bankers have taken looks to be at least as distant,” he says.

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