Will the future for the global economy be V or U-shaped?
The human cost of the coronavirus (COVID-19) has been significant, and the evidence suggests it may worsen over the coming weeks and months. We hope that our stakeholders and their families stay safe through this difficult period. Details of Insight’s current mitigating actions and business continuity plan can be found here.
This note aims to set out a framework for how our active fixed income team is thinking about the impact of COVID-19 on economies and markets, including the impact of policy responses to it.
We believe there are two key questions:
- Whether and how the impact of COVID-19 might be mitigated, and
- Whether its impact will lead to increased unemployment – taking into account the effects of monetary and fiscal policy.
Ultimately, the answers will signal the nature of the future path for the global economy: in simple terms, whether growth will head for a V or U-shaped curve.
The immediate impact of the virus: China as a lead indicator
The outbreak originated in China, escalated first in China, and China was first to take decisive measures to try and contain it. It is therefore worthwhile looking at what is happening in China as a potential lead indicator for how things may progress elsewhere.
Since China enacted serious lockdown measures, the rate of new cases has been significantly reduced, with a lag for incubation time. This has been successful to the extent that in less affected parts of the country they are now beginning to restart normal economic activity. So far, the low point in the equity market (the Shanghai Shenzhen CSI 300 Index) was about a week and a half after the lockdown began (see graphic).
Source: Insight Investment. Data as of March 12, 2020.
Which sectors could be affected the most?
We are conducting analysis on the potential impact on Chinese GDP. We would expect output for some sectors to be permanently lost (e.g. consumer discretionary services such as cinema, restaurants or tourism), and others to take a potentially very large hit, but to ultimately rebound in a recovery (e.g. business investment). Some sectors may offset this to some extent (e.g. government spending, healthcare or IT and communications).
How the virus might spread globally
It appears reasonable to assume that most countries will fail to keep COVID-19 out. Countries are likely to roll out measures similar to those seen in China and elsewhere, such as in South Korea and Italy; or else people are likely to change their behavior of their own accord. We believe countries with governments that have a good track record of following scientific advice are more likely to be successful, whereas others may choose to initially prioritize economic impact.
We are cognizant that potential lockdowns, and hence peak economic impacts, will occur in different places at different times. For example, we expect further lockdowns in Europe in the short term.
The economic impact of the virus: will this lead to a V-shaped or U-shaped recovery?
At this stage, we believe it is reasonable to assume that most countries will experience at least one quarter of negative economic growth. Recessions – marked by two quarters of negative growth – are quite likely in many places.
However, we expect that COVID-19 would then be brought under some sort of control: either due to a substantial proportion of people having already caught it, control measures working and being safely unwound, or a widespread vaccine breakthrough.
Whether there is a longer-term impact on economies, and hence markets, depends in part on what happens to corporates: on whether there are large-scale bankruptcies, or if corporates generally follow through on cutting investment and also cutting their workforce, which would have longer-lasting impacts on consumption.
The outcome is likely to be influenced by economic policy action. Our expectations, based on previous research on different countries' scope for monetary or fiscal easing, are already being realized: for example, the Federal Reserve has cut rates aggressively and implemented other monetary easing measures, including restarting bond purchases. In Europe – although the European Central Bank (ECB) has moved further into extraordinary monetary policy – the focus is more clearly on fiscal policy.
In the short term, the key need is for liquidity to avoid unnecessary bankruptcies, and that is generally being provided.
Over the longer term (the next six to 24 months), as well as the lagged impact of monetary and fiscal policy, there is also likely to be an upwards economic impulse from the fall in oil prices, at least in those economies that are not significant fossil-fuel producers.
Policy actions announced/expected as at April 20, 2020
- Interest rates reduced by 150bp to 0-0.25%
- Quantitative easing (QE) has been restarted, with an initial target of $700bn for 2020, before moving to unlimited, open-ended QE
- The Term Asset-Backed Securities Loan Facility (TALF) has been reintroduced, with the purchase of up to $100bn of consumer, equipment and auto ABS. This program is also able to include new issues from AAA rated CLO and CMBS that have a static asset pool, although this is a small universe.
- The Secondary Market Corporate Credit Facility (SMCCF) will purchase up to $200bn of investment grade bonds, stipulating that issues must have at least one investment grade credit rating and a maturity of less than five years. The SMCCF will also be able to purchase ETFs, predominantly targeting funds invested in investment grade corporate bonds but also extending to funds invested in high yield bonds
- The Primary Market Corporate Credit Facility (PMCFF) will directly lend up to $500bn to investment grade corporates for up to 4-years
- Both the SMCCF and PMCFF are able to maintain exposure to bonds where the issuer was rated investment grade prior to 22 March, but has since been downgraded, as long as the issuers credit rating remains BB- or above
- The Fed has established a $600bn lending facility to provide term financing backed by loans made to SMEs, including those made under the Federal Governments Paycheck Protection Program (part of the fiscal package)
- The Municipal Liquidity Facility (MLF) will offer up to $500bn to buy municipal debt, issued by state and local governments
- Commercial Paper Funding Facility (CPFF) and Money Market Mutual Fund Liquidity facility (MMLF), allowing funding to banks against bank MMF CP and CDs
- $1.5trn repo program (split between $500bn in 1-month and $1 trillion in 3-month repos)
- The Foreign and International Monetary Authorities (FIMA) repurchase facility allows foreign central banks and other international monetary authorities to enter into repurchase agreements directly with the Federal Reserve Bank of New York to exchange Treasuries for cash. This comes as a complement to USD liquidity swap lines extended to the FED’s usual counterparties
- New fiscal package of $2 trillion includes $1,200 tax rebate for all citizens with an annual income of less than $75,000, or $150,000 for households
- Additional $600 per week unemployment insurance for 16 weeks. Support for states and $340bn of direct funding for federal agencies
- $500bn in loans or loan guarantees will be offered to affected industries, including special allocations for airlines and the defence industry. $350bn in loans for small businesses
- Employer payroll tax payments deferred through year end
- Trade off of economic fallout versus public health, US likely to prioritise economic strength
- No large-scale quarantine, rolling local shutdowns; likely higher infection rates than elsewhere
- 25bp cut to TLTRO rate, increased size to 50% of eligible loan book
- New LTRO to bridge gap until TLTRO III June operation
- €120bn increase in QE into year-end, targeted primarily at the private sector
- €750bn Pandemic Emergency Purchase program into the end of 2020. This includes a waiver of eligibility requirements for Greek government bonds and expands corporate sector purchase eligibility to include non-financial commercial paper. The ECB made it clear they could increase size as required and that they would use full flexibility which we interpret as a likely temporary divergence from capital keys
- The Economic and Financial Affairs Council (Eurofin) meet on 16 March, but a coordinated fiscal response may be difficult to achieve
- Local measures taken, in Italy (various measures including loan guarantees and increased healthcare funding), Germany (€600bn Economic stabilization Fund to provide support to corporates) and to a much lesser degree in France (State guarantees for €300bn of new bank loans)
- Various local quarantine measures with countries such as Italy in full lockdown, but no fully coordinated response as yet.
- Open market operations to keep liquidity high
- Seven-day reverse repo rate cut to 2.2% and $7bn injected into banking system
- 1yr Medium term lending facility rate cut to 2.95%
- Lending facilities to extend credit to SMEs (RMB800bn special purpose vehicle, or SPV) – enacted
- Interest rate on excess reserves cut from 0.72% to 0.35%
- Targeted RRR cuts 50-100bps. Larger cut for smaller banks
- Target tax cuts – enacted
- Rebates for SMEs with limit on layoff rate – enacted
- Local government financing vehicles' quotas increased and brought forward – enacted
- Direct financial support for most affected regions – enacted
- Expect more fiscal stimulus to come in the next 2-3 weeks in the order of 4-6% GDP, mostly targeting infrastructure spending
- Special treasury bonds to return
- Likely to abandon doubling of GDP target for 2020 with focus on protecting jobs
- Large scale quarantine enacted - Mostly over with the exception of Hubei, where the government plans to end restrictions on Wuhan on 8 April
- Resumption of business activity currently at c. 85-90% country-wide
- Strengthened forward guidance with pledge to guide long term rates around 0%
- Target for annual corporate bond purchases has been increased by ¥2trn
- Target for annual exchange-traded fund purchases doubled to ¥12trn per annum. Target not technically changed, left at ¥6trn but actively purchasing with upper limit of 12trn
- Target for annual real-estate trust fund purchases doubled to ¥180bn per annum
- Rates held at -0.1% and future cuts likely contingent on currency strength
- ¥10-20trn fiscal package announced (2.5%-3.5% GDP). This looks like it will be upsized to ¥60trn (c.10% GDP) next week
- 65bp rate cut, taking target rate to 0.1%
- SPV put in place to provide credit facilities
- £200bn QE program started, buying both government and corporate bonds
- Budget confirms large fiscal giveaway with total measures worth up to 1.3% of GDP for 2020
- Statutory sick pay for "all those who are advised to self-isolate" even if they have not displayed symptoms
- Business rates for shops, cinemas, restaurants and music venues in England with a rateable value below £51,000 suspended for a year
- A £500m ‘hardship fund’ set up the protect those worst affected by the epidemic
- Government to pay 80% of wages up to £2,500 per month for employees unable to work with comparable measures for the self employed
- Government has introduced population distancing strategies: closing schools, greater home working, reducing large scale gatherings
How quickly does recovery occur?
Scale of policy response: monetised fiscal expansion
Source: Insight Investment. 26th March 2020. US QE is “unlimited”. QE also includes non-government bond purchases.
There is obviously severe dislocation in markets at the moment, and this could potentially last for an extended period of time depending on how quickly authorities move to mitigate the spread of COVID-19.
Many markets are already pricing in a significant recession. This may be correct, but there may be material opportunities available for those who can keep calm and wait for the right timing.
Whether that timing is near term in the event of a V-shaped recovery, or further out in the event of a U-shaped recovery, remains to be seen. We will continue work in aiming to establish which is correct.