Critical economic issues related to COVID-19

Critical economic issues related to COVID-19

I. Global economies in deep contraction

COVID-19 and the efforts to contain it are generating a global recession with steeper declines than in the 2008-2009 recession. The global recession that stemmed from the U.S. financial crisis involved a 2% decline in global output in 2009, with advanced nations declining by an estimated 3.5%; emerging market and developing nations fared much better. Their growth slowed sharply from 8.3% in 2007 and 5.3% in 2008 to 1.5% in 2009, but they never incurred contraction. This pandemic crisis is fundamentally different: it directly affects virtually all households and businesses and is a negative shock to both aggregate demand and supply. Advanced nations’ economies will decline by a similar magnitude or more (as in 2008-2009) but over a shorter period, while emerging market and developing nations’ economies (EM) will contract even more.

*Global output is approximately $100 trillion annually. A 3.5% decline would involve a contraction of $3.5 trillion in economic activity, with large declines in global production and employment, consumption, trade volumes, and business investment.

*Global trade, which had been weak going into the crisis (falling roughly 1% year over year), will likely fall as much as the cumulative peak-to-trough 20% decline in 2008-2009.

*Industrial production, which also had been falling modestly prior to the crisis, is projected to drop more than the 14% decline in 2008-2009. Gross capital formation will fall at least as much as the 8% decline in 2008-2009.

*Employment losses will far surpass those of 2008-2009, reflecting the shutdown of most economic activities. In the U.S., initial unemployment claims of 10 million in the last two weeks of March already exceed the total job decline of 8.8 million in 2008-2009. Employment is falling most in the leisure & hospitality and retail trade industries, the hardest hit sectors. In Europe, job losses are likely to surpass their peak-to-trough decline of 4 million in 2008-2009.

II. China has incurred a sizable economic blow

China’s economic performance, which had slowed far below what its official strong growth data had indicated in 2018-2019, has suffered through the same kind of shutdown and deep recession as other nations, with temporary steep declines in GDP, consumption, production and business investment and exports. However, much of China’s National Bureau of Statics sugarcoats the data: in reality, China’s GDP incurred a significant decline in the first half of 2020.

China was weak going into the crisis. Its domestic demand had slowed sharply, highlighted by a persistent decline in auto sales, despite fiscal and monetary stimulus designed to boost activity. Business fixed investment had decelerated materially, while growth in gross capital formation had been propped up by government infrastructure investment. Consumer and business debt levels were very high, which has reduced the government’s flexibility to stimulate more. Exports had flattened, reflecting in part the U.S.-China trade war and policy uncertainties, slower global trade volumes, and also China’s higher unit labor costs. China’s imports had also flattened, reflecting, to a large extent, reduced imports of commodities, materials, and durable goods used in China’s export-related manufacturing sector. Reflecting all this, China’s employment had declined and wages had been cut.

As the driver of global growth and trade for several decades, and also at the epicenter of the global pandemic and on the leading edge of recovering from the crisis, China plays a critical role. In contrast to 2008-2009, China is now faced with more constrained resources and flexibility. Researchers attached to China’s official State Council now readily acknowledge these challenges, expressing concerns about deteriorated balance sheets across government (different levels), companies, and households. Businesses also face significantly weaker product demand, both domestic and foreign.

Compounding China’s problems, its leaders face a substantial credibility problem domestically and internationally that will affect its economic performance. Domestically, sizable portions of Chinese citizens distrust their government leaders. This will lead consumers to save more and spend less, and private businesses to behave cautiously. This will constrain China’s recovery in domestic demand, undercutting responses to government stimulus.

Internationally, China’s credibility challenge cannot help but tarnish business relations and to some extent ding China’s role as the hub of global manufacturing and global supply chains. The widespread international presumption that China’s data on the incidence and deaths of COVID-19 may have been fabricated – which may have influenced global efforts to address the pandemic – are being taken seriously by some of China’s global partners. Witness frayed China-India relations: it is uncertain how this will affect global supply chains and trade, foreign direct investment and debt arrangements like China’s Belt and Road initiatives, but there are clear downside risks.

III. Emerging market nations will suffer far more than developed nations

Whereas most EM nations were in fairly strong positions prior to the 2008-2009 financial crisis, their economic and financial fundamentals entering this pandemic shock were relatively weak. During 2002-2007, the China super-cycle drove up global trade volumes and prices of commodities and materials, boosting the value of exports and economies of many EM nations. This lifted their finances and kept their debt levels manageable. India’s growth averaged over 8% in the years leading up to the financial crisis. Asian nations were particularly strong, feeding off China’s strength. High oil prices had boosted the performance and finances of OPEC nations and Russia, as well as Brazil. Latin American nations were atypically calm and their economies were expanding. China garnered its resources from its booming economy and responded to the financial crisis with massive infrastructure projects at home and around the world. The decade-long weakness in global trade volumes will be punctuated by a dramatic decline in 2020, with further softness in coming years.

The current situation is far different and decidedly more negative for many EM nations. Poor economic performances have harmed finances. In some nations in Latin America and elsewhere, misguided policies and poor leadership have created turmoil that has contributed to capital flight. Debt levels are relatively high, and Turkey and many other EM nations are burdened by large amounts of U.S. dollar-denominated debt that are costly to service.

The biggest immediate challenge is that many EM nations are poorly equipped to deal with the pandemic in terms of technology, medicine, and health providers. Support from the IMF, World Bank, WHO, and other international organizations will help, but local resources are grossly insufficient. At this writing, India stands out as particularly vulnerable.

Many EM nations that rely very heavily on exports of commodities and materials have felt the brunt of plummeting prices. Besides the collapse in oil prices (which has dramatically reduced revenues in OPEC nations, Russia, Nigeria, Brazil, Mexico, and other nations), industrial commodity prices have fallen 21% from their recent peaks, while prices of agricultural commodities like corn, used heavily in ethanol production, have also fallen materially. For some of these nations, export revenues are falling dramatically relative to hard currency reserves. Growth in India, the fifth biggest economy in the world, slowed dramatically in 2018-2019, with falling gross capital formation. Some large EM nations rely heavily on tourism: China, Turkey, Mexico, and Thailand rank in the top 10 of the world’s tourist revenues, and for others like Malaysia, tourist revenues are a material portion of economic activity. International tourism will recover, but perhaps more slowly than other industries.

Despite the lack of fiscal room, to date, the fiscal and monetary policies of many EM nations have been very aggressive. This will partially mitigate the economic hit, but outcomes depend critically on factors that are beyond the immediate control of many nations, including commodity prices, changing trends in global trade, and international consumer spending habits.

IV. The shape of the recovery depends on several factors

The sharp contraction in economic activity stemming from COVID-19 and related shutdowns is temporary, and uncertainty dominates, but the baseline assessment is that the acute stage of the health crisis has largely ended in China and will begin to ease in advanced nations by the end of April and somewhat later in EM nations. This will be followed by recovery. Measures of economic activity will register percentage gains, but they will not match the current dramatic percentage declines now unfolding, and it will likely take several years to lift economic output back up to pre-crisis levels.

Recoveries in different nations will depend a lot on their performance prior to the pandemic and whether factors that supported or detracted from economic performance will change. China’s recovery will be constrained, which will limit recoveries throughout Asia and many EM nations. The U.S. recovery will be moderately better. However, a true V-shaped recovery is not in the cards.

Presently, there are early indicators that China is emerging from the acute stage of the COVID-19 outbreak. China’s latest manufacturing PMI survey jumped above 50 following its collapse to 35.7 in February, which suggests that manufacturing is stabilizing at a significantly lower level (China’s PMI increases, global trade and production to fall sharply , March 31, 2020). Other evidence shows that people are going back to work. Significant obstacles remain, however, including a collapse in product demand and bottlenecks in supply and distribution chains.

The downside risk scenario is that the pandemic extends longer and/or that an extended period of getting back to normal activities lengthens the period of lower level of economic activity. If this were to occur, GDP would drift sideways or modestly lower from its depressed Q2 level, rather than falling sharply further. Economic activities that have already ground to a halt will not fall further but will have negative spillover financial and economic effects onto other activities – but to a far lesser degree than the collapse in Q2.

Would this downside risk scenario be followed by a stronger recovery than the baseline case? Not necessarily. The shape of the recovery from whatever base depends on critical factors: What will happen to prices of oil and commodity prices? Will China’s stimulus initiatives boost domestic demand or will consumers balk? Will global trade continue its recent years’ weakness or bounce back? Will business investment continue to languish, or stage a typical cyclical rebound? What will happen to rates of personal saving?

V. Confidence, consumption, and business investment

The critical element that will influence the character of the economic recovery will be confidence that the acute stage of the pandemic has passed (and will not reoccur) and that normal activities are safe – which hinges critically on confidence in medical and health delivery systems, readily available testing for COVID-19, and other such supports. Confidence among businesses as well as households is critically important.

Even after conditions are deemed safe – through effective tests of COVID-19 and the presence of antibodies confirming immunity – the return to normal consumer spending will be constrained by higher unemployment and the hit to disposable incomes and household wealth. In addition, consumers may remain cautious, and the return to normal spending patterns may take a while. This would be reflected as an increase in saving. Prior to the 2008-2009 financial crisis, the U.S. rate of personal saving was 3%; during the first several years of the recovery, the rate increased to 6%, and in the last several years the savings rate averaged nearly 8%. Will consumer caution lift it higher? A quick bounce-back in big spending sectors like leisure and hospitality (bars and restaurants, hotels, and international tourism) and discretionary and luxury goods is not expected. Younger generations may bounce back quicker than older age cohorts.

Historically, capital spending and fixed investment fall hard during recession and bounce back sharply during recovery, but that is not expected this time. Capital spending was notably soft in most advanced nations prior to the crisis. During the recovery, businesses are likely to be cautious, taking a wait-and-see-attitude on investment expansion plans until they gain confidence about the future, while placing a high priority on efficient operations and restoring damage to their cash flows and balance sheets. Businesses will invest to replace depreciated equipment and software, but in addition to general caution, sharp declines in investment in the oil and drilling sector in the U.S. and other oil producing countries will weigh heavily on overall capital spending.

While business fixed investment is a relatively small share of GDP (in the U.S. it is 13%), its swings are a major source of cyclical fluctuations. Moreover, history shows that whereas wars destroy capital that require rebuilding in post-war periods, pandemics (and there have been many through history) do not destroy capital, and recovery periods are not boosted by capital investments.

The pace of normalization of economic activity will be determined by the easing of government shutdown rules, which will vary by country. In the U.S., these decisions will be made on a state-by-state basis. Almost all state governors who issued executive orders on who can work (“essential workers”) and who must stay home likely will begin to ease restrictions beginning in May, but they will do so very cautiously and subject to any new evidence. Most likely, that will not mean “back to normal” but rather ongoing modified restrictions that affect labor markets, social gatherings, and various industries including leisure & hospitality and retail trade.

Production processes will be hampered in some industries by supply chain bottlenecks and different speeds of normalization internationally, particularly in EM nations. For example, India, one of the last countries to enter lockdown mode, controls over 50% of global IT sourcing, and services 75% of U.S. Fortune 500 companies.

VI. Monetary and fiscal policies and the recovery

Macroeconomic policies will also influence recoveries, but for many nations monetary and fiscal policies will play different roles than in prior cycles. Central banks – the U.S. Fed, ECB, BoE and BoJ – are already very easy, having lowered interest rates to historic levels and infused tremendous amounts of money and liquidity into financial markets to help stem a financial crisis. Further massive QE – large-scale purchases of sovereign debt and other financial instruments like corporate bonds – that successfully boosts asset prices eventually will lift economic activity. However, in the near term, it is very unlikely to offset health-related uncertainties as long as the acute stage of the pandemic lasts. Moreover, a sustained recovery requires that the monetary easing stimulate bank lending and put the high-powered money to work in the real economy. Impairment of bank credit channels stemming from damaged balance sheets and capital losses may require further unconventional central bank policies, including temporary regulatory forbearance on bank capital adequacy and leverage ratios.

The U.S.’s sizable fiscal packages provide much needed income support for sidelined workers and financial support for businesses that are facing interrupted product demand and cash flows, but they are not fiscal stimulus that will generate stronger growth. This is true of many nations. In the current situation, applying some made-up “fiscal multipliers” to the size of the deficit spending and spreading the estimate over a handful of future quarters is a highly unreliable exercise.

Most likely another U.S. fiscal policy initiative will take the form of Federal disbursements to states to fill budget deficit gaps and finance infrastructure spending. This would stimulate jobs and output similar to traditional countercyclical fiscal stimulus. President Trump has indicated that the Administration may favor such a plan, as do state governments that have incurred large declines in tax revenues.

Germany’s fiscal policy, with its uncharacteristically large fiscal package in addition to its many automatic fiscal stabilizers and permanent income support programs, more closely resembles fiscal stimulus that will lift will domestic demand. In contrast, Italy’s increase in government deficit spending is primarily income support that partially offsets the temporary collapse in aggregate demand, but will not stimulate growth in the absence of a viable growth strategy.

VII. The tilt away from globalization

The tilt away from globalization that has been underway for about half a decade is likely to be reinforced. In an earlier report, we showed that, since the financial crisis of 2008-2009, global trade volumes had flattened relative to global output (GDP), and the key factors that have historically driven trade relative to GDP had turned negative(The decade-long deceleration of global trade: sources and implications, January 13, 2020). Those key factors include China’s material slowdown; declining business investment and rising services as a share of GDP; the tilt away from complex international supply chains; and higher tariffs and barriers to immigration. New factors stemming from COVID-19 will fuel the move further away from globalization in select economic activities.

The jarring psychological aspects of the pandemic will lead policymakers and people to look inward, tilting toward nationalism in some respects. Many businesses will assess their global supply chains with the aim of streamlining, simplifying, and reducing risks. One likely outcome will be a concerted effort by some businesses to reduce reliance on production of select products in China. This will involve several years of relocating production to facilities domestically or to other countries. Government mandates will initiate some changes. For example, in health care, the U.S. government may require that the production of select pharmaceuticals and medical supplies be produced domestically or diversified among designated nations with strict FDA and CDC oversight. For products relating to defense and national security, already close scrutiny will intensify.

The tilt away from globalization and dampened trade volumes, combined with China’s continued decelerating potential growth, will weigh significantly on nations that rely heavily on trade. This includes nations with substantial reliance on manufactured industrial products as well as those with heavy reliance on commodities. Some structural reforms of their economies will be necessary.

VIII. “Semi-Game Changer?”

Historical studies show that pandemics and wars were game-changers – inflection points that generated marked shifts in economic and social activities. Many things will get back to normal after the COVID-19 pandemic, but the horror of watching its global spread on social media and its devastating economic costs and social disruptions will leave some lasting impacts on consumers and businesses. Moreover, some government functions and goals will change.

Consumers will obviously get back to spending but will be more cautious, at least early on. In the U.S., consumption is 70% of GDP and it is a large portion in other advanced nations. Global tourism will be slow to recover, affecting the wide array of hospitality and leisure activities. Consumption of various discretionary items, including luxury goods, may also lag. The shift to online buying will continue to drive retail sales. Businesses will take a large hit to profits and retained earnings. Private capital spending will fall well into the early stages of recovery, as businesses focus primarily on improving their finances and improving the efficiency of their operations and streamlining their supply and distribution chains. Commercial banks, hit once again, will be forced to tighten credit standards and rebuild capital.

Government policymaking has been fundamentally changed. Central banks have played an expanded role around the world, with dramatic increases in their balance sheets and heightened involvement in financial markets. Fiscal policy responses have greatly increased the size of government spending. Government debt is rising dramatically. The lines between monetary and fiscal policies have been blurred. Whether these changes are temporary or more permanent is yet to be seen.

Moreover, the COVID-19 pandemic has elevated health care to a national security issue. This will result in ramped-up health care and medical emergency preparedness and heighten the government’s role in the private sector’s provision of health care and pharmaceuticals. On a positive note, there will be more global coordination on health care policies.

IX. Temporary, moderate deflation, despite aggressive monetary expansion

Despite the massive amounts of liquidity the Fed and other central banks are pouring into financial markets, and unprecedented fiscal spending initiatives, a temporary bout of modest deflation is expected. In the U.S., the general price level of all goods and services in the CPI and the personal consumption expenditures (PCE) price index will fall modestly in the near term, reflecting insufficient aggregate demand relative to constrained supply that will put downward pressure on prices.

Nominal GDP – current dollar spending in the economy – is falling by double digits in the U.S., and the pattern is similar in other advanced nations. While product capacity is declining due to shutdowns and bottlenecks in supply chains and production processes, overall the situation of insufficient demand predominates. This will persist into the recovery.

Prices of select goods in scarce supply, such as some basic personal necessities, have risen rapidly. They are receiving significant popular attention. But these large increases on select goods and services are more than offset by declines in prices of energy, owner equivalent rental values of property, consumer discretionary goods, personal and business services, and other large components of the inflation indexes.

Even when households and businesses begin to resume normal activities, price-setting behavior will put downward pressures on prices. Businesses will seek to jump start their revenues and cash flows through price discounts, and consumers will seek bargains on the goods and services they buy.

The massive increases in so-called high-powered money generated by the Fed and other central banks through large-scale asset purchases (QE) and other liquidity infusions are a necessary but not a sufficient condition for rising inflation. As long as the increases in the monetary base (reserves plus currency) remain in the financial system and are not put to work in the economy, increasing credit and generating an acceleration of aggregate demand, inflation will not accelerate. That is currently the case, as increases in base money are more than fully offset by a decline in money multipliers (M2/MB) while money velocity (GDP/M2) is also falling, reflecting the increased demand for money.

In the short run, the bigger risk is a contraction of credit as banks deal with balance sheet stresses and capital impairments. Inflation will emerge when aggregate demand accelerates above productive capacity, putting upward pressure on prices of all goods and services. In the U.S., historically changes in inflation and deflation have lagged changes in nominal spending activity.

Certainly, there are large costs and risks involved in central banks’ very aggressive monetary easing, but in the near term, inflation is not a risk. The central bank’s biggest concerns are addressing the sharp economic contraction and to maintain smooth functioning in financial markets. If and when nominal GDP begins to accelerate sharply, the Fed and others will have to respond, perhaps aggressively. The Fed is aware of these risks.

X. Financial market observations

The Fed and other central banks moved much more quickly and aggressively than in 2008-2009 with large-scale asset purchases and quantitative easing. The Fed’s provisions of liquidity into short-term funding markets limited spikes in LIBOR-OIS and commercial paper yields. The ECB’s decisive actions and forward guidance constrained a potentially very damaging spike in yields of the sovereign debt of some weaker EMU nations, while its stepped-up purchases of corporate bonds lowered yields.

Central banks have indicated that they will respond as needed to maintain operations and avoid dysfunction financial markets during this crisis, and it is clear they will keep policy rates ultra-low as economies recover. Combined with their purchases of select corporate bonds and financial support of small businesses, along with expectations of very low inflation or even mild deflation, bond yields will remain very low. Interestingly, historical studies of pandemics have found that real interest rates fall during pandemics and remain low for decades.

The Fed’s announcement that it would begin purchasing investment grade corporate bonds has narrowed the bond yield spreads of those highly rated companies, but many businesses are suffering. Prior to the crisis, U.S. total business debt had risen to 74% of GDP, an all-time high. Under conditions of sustained economic expansions and even modestly rising corporate cash flows, debt service costs were manageable.

The unanticipated interruption of businesses’ revenues and cash flows is reflected in sky-high yields on sub-investment grade bonds, accentuated by risk-adverse trading. These will add significant burdens on some companies, especially those with maturing bonds, potentially imperiling their futures. Many U.S. smaller businesses will receive financial support provided by the CARES Act through the Small Business Administration or directly from the Fed; however, without a timely recovery in product demand and cash flows, many will shut.

Stock markets are responding to the shock of the sharp contraction in economic activity and horrible news on the devastating impacts of the pandemic. This once-in-a-lifetime crisis will prove temporary, although in real time, temporary seems endless, and markets are not focusing on the eventual economic recovery. That’s typical. Research in empirical psychology shows that bad news is weighted by multiples more than good news, in virtually every issue. Once the light at the end of the tunnel comes into focus, stock valuations will rise to reflect sustainable intermediate-term economic and profit conditions, even if the new normal differs somewhat from pre-crisis.

XI. For the U.S., what are the costs of the policy responses and who will pay?

Besides the decline in output and massive job losses and reductions in wealth stemming from the pandemic and shutdowns, the aggressive monetary and fiscal policies are costly. Unlike most wars, which have been paid for through higher taxes and deficit spending that spread the cost burdens across current and future generations, virtually all of the immediate costs of this pandemic will be debt-financed. Massive increases in government deficits are adding significantly to already high government debt. Some portion of the increase in government bonds has been purchased by the Fed, which ultimately is capitalized by the U.S. Treasury.

Despite the sizable increase in government debt, the government is fully capable of financing it: U.S. potential economic growth remains healthy; the government can exercise its power to tax and lower spending; and the U.S. dollar is the world’s reserve currency and U.S. dollar-denominated assets are favored internationally. But the increases in debt are certainly not costless.

Even at low interest rates, the deficits add to government debt service costs, which will impinge on the Federal budget and burden future generations. As long as interest rates remain below future nominal GDP growth, the debt-to-GDP ratio will recede gradually. That decline in debt-to-GDP would be faster if inflation reduced the government’s real debt burden. That’s what happened post-World War II when government debt receded from a peak of 109% of GDP to 23.2% in 1974. Thus, the burdens will be paid for through some combination of higher taxes and a cutback in services and inflation. State governments in the U.S., which must balance their operating budgets and now face a shortfall, will respond with higher taxes, a reduction in services, and postponing infrastructure projects.

The bottom line is that, even if inflation or interest rates do not go up, the costs of responding to this pandemic will reduce standards of living of citizens currently and in coming years, one way or another.

XII. How will COVID-19 affect sustainable potential growth in the U.S.?

The economic impact of the pandemic is severe but temporary, and whether it affects intermediate- and longer-term potential growth depends crucially on how government policies affect labor supply and productivity. If the emergency monetary and fiscal policies in response to the crisis are unwound on a timely basis, economic activity will get back to normal, and the earlier pace of growth will be sustained. Capital has not been destroyed and labor has been temporarily sidelined. The pandemic and temporary shutdowns will largely be a one-time loss. In some sectors like health care, innovations in technology and improvements in the provision of goods and services stemming from responses to COVID-19 may raise productivity and lead to a more flexible labor supply. However, if some of the emergency initiatives are not unwound and the scope of government – in terms of higher spending and taxes and broader regulations –become permanent, larger government absorption of national resources and impingements on labor supply and productivity would lower sustainable potential.

Mickey Levy, mickey.levy@berenberg-us.com

Member FINRA & SIPC
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