Amongst the arguments about a lack of protective clothing for health workers and whether governments were too slow to react to the spread of Covid-19, the latest figures show that the pandemic is gradually coming under control. The rate of growth in new infections and fatalities around the world is slowing and the curves are flattening. Real progress is being made as the lockdowns take effect.
However, as the pandemic ebbs, concerns are now turning to the health of the economy where the severe damage from the restrictions is becoming apparent.
Getting an accurate and timely picture of the economy is always a challenge given the lags on data releases. We know that March was weak with industrial activity, auto and retail sales falling in the US, EU and much of the emerging markets. China was an exception as production and retail sales bounced; however, this followed significant falls in January and February and was not enough to prevent a 6.8% contraction in GDP in Q1, the first decline on record.
The picture for April is incomplete, but the latest flash purchasing managers’ indices (PMIs) confirmed that activity went into free fall with significant drops in both the manufacturing and services indices. The US, eurozone, Japan and UK all saw their composite PMIs hit new lows as their economies felt the full force of the shutdown (see chart below).
On this basis the current slowdown is unique in both its depth and speed: the fall has been hard and fast, surpassing the Global Financial Crisis (GFC) at the same stage in 2008.
Chart 1: Flash PMIs signal deeper downturn than in the Global Financial Crisis
Source: Schroders Economics Group, Markit, 23 March 2020
Where does this leave our forecasts?
We have always argued that the current quarter would see the worst economic news on activity. Our forecasts already feature a significant decline in activity in Q2 with US GDP contracting by 22% quarter-on-quarter (q/q, not annualised) for example, so the latest PMIs should not prompt major revisions.
For us, two factors are key for the path of activity going forward: firstly, the response of governments and the banking system; and secondly, the speed with which lockdowns can be lifted.
Key test for policy and the banking system
First, as the economic storm intensifies it is vital that policy support comes on stream where it is needed. The fall in activity will put severe strain on corporate finances and will result in a significant wave of bankruptcies and layoffs. This is where government support packages will be vital in cushioning the blow and preventing the economy from tipping into a much deeper recession. The danger is particularly acute for smaller companies which do not have the same access to credit as their larger counterparts.
Both the US and UK have recently moved to increase the scope of their support packages in this area with Congress agreeing measures this week, but there are still doubts as to whether the action will be sufficient everywhere.
This period will also be a key test for the banking system which will be expected to continue to extend liquidity. It was notable that in reporting JP Morgan’s results last week CEO Jamie Dimon said that companies were drawing on their credit lines at twice the pace seen in the financial crisis of 2008.
Elsewhere, banks have followed government instructions to cancel dividends and build up capital to meet losses and the European banking sector has lost half its value year-to-date.
With shareholders on the hook there will be no direct bail outs of banks this time. Nonetheless, in extending quantitative easing (QE) to commercial paper and corporate credit, central banks such as the US Federal Reserve, European Central Bank and Bank of England are bearing much of the risk. As, of course, are governments through loan guarantee schemes.
Fading hopes for a V-shape recovery
While the first factor concerns the present, the second looks ahead to how quickly credible exit strategies can be developed for the lifting of the lockdown. This is critical to the shape of the recovery as to whether we get a V or something closer to a U, or even an L. In this respect the sharp bounce back, or V-shape recovery, is in doubt.
Those nations which have been ahead in the process of returning to work have seen the emergence of secondary infections and are having to pursue a gradual lifting of restrictions. Singapore, for example, has seen a sharp jump in secondary infections.
There have also been signs that consumers are reluctant to return to shopping malls and restaurants on fears for their physical and economic health. In China, companies are offering credit and discount vouchers to lure consumers back, whilst communist party officials have been told to be seen out shopping.
It would not be surprising if consumer caution were a feature of the global recovery given the shock to the economy and employment, thus tempering the upswing. Alongside a more cautious consumer we are likely to see slower business spending as ongoing uncertainty will inhibit the willingness to make major investment commitments. Higher savings and lower investment would reinforce slower growth and lower interest rates.
The disadvantage of the suppression strategy is that it does not build up the widespread “herd immunity” which would enable a wholesale return to normal working without the risk of further significant infection. Analysis from the World Health Organisation (WHO) suggests that only 2% to 3% of the population have antibodies which show they have had Covid-19. Studies are ongoing, but a figure closer to 60% would be needed for herd immunity.
Sweden has taken a different approach with fewer restrictions so as to build immunity and Stockholm is expected to achieve this within weeks. Nonetheless, unless their trading partners also recover, Sweden (like China, Korea and Singapore who are also emerging from the crisis), faces the same problem of a lack of global demand.
The pressure to lift the lockdowns more rapidly will now intensify as the economic damage becomes more apparent. However, our current thinking is that the V shape recovery is too optimistic and we are likely to be revising down our forecasts for global growth in 2020 in our next forecast round. The recovery will be weaker and delayed, closer to a U-shape.
The hope would be that with a more gradual lifting of restrictions the world economy should be able to avoid a significant second wave of infection and the double dip recession, or W scenario.
The return of inflation… or deflation?
How will inflation play out? As anyone who has tried to obtain a tin of paint during the lockdown can testify, there are bottlenecks in the system as a result of disruption to supply chains. Moreover, there are fears that the scale of the fiscal and monetary stimulus will result in a significant rise in prices in 2021 as the world economy finally recovers. There are also serious concerns over the supply of food, where labour shortages may slow the harvest due to restrictions on mobility.
At this stage though we see little prospect of inflation. Commodity prices are in retreat and will keep inflation low in coming months. Driven by the collapse in oil prices, the S&P GSCI commodity index is down nearly 50% year-on-year (y/y), close to the decline seen during the GFC when US CPI (consumer price index) inflation turned negative at -2% (see chart 2).
Chart 2: Commodity prices and US inflation
Source: Schroders Economics Group, Refinitiv, 23 March 2020
Looking further ahead, the recession is likely to keep inflation under control well into next year given the long lags between growth and prices. During this period the risks may run the other way such that we see a spell of deflation as the output gap opens up and puts downward pressure on inflation, which is already below 2% in many economies. Clearly, the reduced likelihood of the V forecast increases the time taken to return to trend and the risk of deflation.
Permanent effects from the crisis: scarring
Although the policy aim is to prevent the pandemic from having a lasting effect, the economy which emerges from the crisis will be different. Travel and tourism, for example, is likely to be considerably weaker, whilst the trend toward greater home shopping and working from home will accelerate at the expense of High Street retailers and offices.
Business is likely to rethink supply chains and its dependence on distant travel links. There may well be a preference to move more production closer to home, although this may mean more automation rather than a big rise in demand for local labour.
Eventually, trend growth may be restored, but more immediately the dislocation will lead to a period of weaker activity as the world economy adjusts to a new equilibrium. Just as we saw after the GFC, significant recessions can have lasting effects on productivity and growth with adverse effects on living standards. In this environment, government debt levels may be permanently higher.
We plan to explore the post-Covid-19 economy further in coming weeks. In the meantime we would emphasise that there is more bad news to come on the economy and confidence in policy support will be tested, thereby intensifying pressure to lift the lockdown. However, whilst we believe policy can help business bridge the financing gap, it will be the difficulties in devising a successful exit strategy which will delay the upswing and turn the V into a U.
Issued in the Channel Islands by Cazenove Capital which is part of the Schroders Group and is a trading name of Schroders (C.I.) Limited, licensed and regulated by the Guernsey Financial Services Commission for banking and investment business; and regulated by the Jersey Financial Services Commission. Nothing in this document should be deemed to constitute the provision of financial, investment or other professional advice in any way. Past performance is not a guide to future performance. The value of an investment and the income from it may go down as well as up and investors may not get back the amount originally invested. This document may include forward-looking statements that are based upon our current opinions, expectations and projections. We undertake no obligation to update or revise any forward-looking statements. Actual results could differ materially from those anticipated in the forward-looking statements. All data contained within this document is sourced from Cazenove Capital unless otherwise stated.