The year started with a real sense of optimism that last year’s global growth slowdown ended in the fourth quarter. The slowdown was concentrated in semiconductors and automobiles, together with US housing.
The optimism was justified as we saw a decisive upturn in US housing activity, the rate of change for semiconductor sales troughed last summer and the auto sector also showed signs of stabilisation. Meanwhile global labour markets remained resilient throughout. Then economic time stopped.
The market reaction to the coronavirus (COVID-19) was initially muted on the expectation that the virus would be a temporary supply shock and contained within China. The expectation was that China could then pull sufficient policy levers to revitalise the economy. As it became increasingly apparent that the virus was spreading globally, with severe consequences for economic activity, the equity market adjusted sharply lower, credit spreads widened markedly and sovereign bond yields plunged.
Economists have described the level of uncertainty as “Knightian”, that is, an unknown for which we cannot even quantify the odds of various outcomes. The sudden stop was caused by draconian shutdown measures imposed across an increasing number of countries in an effort to control the spread of the virus and “flatten the curve”. This includes many of the most important economic regions in the world and forecasts suggest that second quarter growth in the US will be the weakest since 1947. Labour markets and credit markets are two of the most important factors which will determine the depth of the slowdown and how quickly activity can bounce back.
The dizzying pace of recent policy developments suggests that we are suddenly seeing a bold new economic policy consensus emerging. Following the slow recovery since 2009, economists have debated how much fiscal capacity countries have, with concepts such as helicopter money or Modern Monetary Theory becoming popular topics.
Given that discretionary spending accounts for around one-third of GDP in developed markets, it is clear that policy support is required with utmost urgency; economic definitions can wait. Robert Chote, head of the Office for Budget Responsibility in the UK, has said that Britain faces a “wartime situation” and must support households and businesses, with now not being the time to be “squeamish about debt”.
Certain sectors of the economy are more directly exposed to the economic shutdown, but the breadth of this shutdown will impact every sector. Airline, discretionary retail, restaurant, and hospitality employees make up more than 10% of the US workforce, but small- and medium-sized businesses are also particularly exposed. JP Morgan estimates suggest that half of small businesses hold a cash buffer of less than one month.
US businesses with fewer than 100 employees account for around 33% of employment and pay 27% of household income, so it is imperative that support arrives quickly to avoid a vicious cycle of layoffs. The UK announcement that the government would commit to providing grants covering 80% (up to £2,500 per employee per month) of the wages of workers at risk of losing their jobs is a very bold step and is likely to be followed by further action to help the self-employed. The US has been working on plans to quickly get cash-payments to American households (possibly $1,000 per person) which will be a very positive step, but needs to be accompanied by support for viable businesses and measures to support continued employment.
In recent years, central banks have successfully responded to growth slowdowns with various rounds of quantitative easing, backstopped the Eurozone bond market and responded to stress in funding markets. Financial markets have operated in an environment of low but stable growth and inflation, and largely benign credit conditions. However, the current crisis exposes some market vulnerabilities, particularly corporate debt.
We have seen significant stress in credit markets recently and this has been accentuated by fund outflows and Exchange Traded Funds trading at record discounts to NAV. Some have suggested that financial markets should be closed temporarily, but this would suppress an important feedback mechanism without solving underlying issues.
Financial commitments will continue as companies still need to pay payroll, expenses and service/roll over debt. The post-2008 experience provides central banks with a playbook for easing financial conditions and we are now seeing this extended aggressively. Ben Bernanke and Janet Yellen advocated the Federal Reserve buy corporate bonds and this is now happening, along with additional large-scale asset purchases “in the amounts needed”.
As Larry Summers eloquently described, economic time has stopped but financial time continues to tick. Central banks can help pause financial time to a degree, mostly for large companies, but pausing financial time for small businesses and households requires creative and bold fiscal action.
Containing the virus and stabilising credit markets are necessary, but not sufficient, conditions for a financial market rebound. There are optimistic signs that activity in China is starting to recover, but the depth of the recession in the West and subsequent recovery are dependent on effective policy now. It is imperative that policymakers do all they can to support the economy; we can worry about the deficit later.
Sources: TS Lombard, BCA Research, Bloomberg, JP Morgan, The Carlyle Group
Disclaimer: The views expressed are the opinions of the writer and whilst believed reliable may differ from the views of Butterfield Bank (Cayman) Limited. The Bank accepts no liability for errors or actions taken on the basis of this information.