Covid-19: Don’t Suffer a Lack of Imagination

20 March 2020

Initial data from China indicate the economic impact of the Coronavirus and efforts to prevent its spread will be significant. I will make some preliminary global economic projections, although they come with a greater degree of uncertainty than normal. Perhaps more importantly, I will set out some guideposts about how to assess the economic impact in the coming months (I will deal with the financial market implications next week). The esteemed Dr. Anthony Fauci, the medical expert advising the White House on the crisis, repeatedly suggests that whenever one thinks enough has been done to confront a pandemic, it’s not enough. The same is true for economic/market analysts, who typically are always playing catch-up in assessing potential economic consequences. Don’t suffer a lack of imagination!

I am often asked how the coming recession compares to previous slumps? And, will the recovery be V- or U-shaped? That is, will the economy snap back sharply once the risk posed by the virus abates? I am not one who tends towards exaggeration. However, the projections in the table above indicate the coming global downturn will be sharper than experienced in the wake of the Global Financial Crisis (GFC). On the other hand, reflecting signs of an acceleration in the global economy prior to the pandemic, as well as the absence of major imbalances/excesses, I anticipate the recovery will be quicker than following the GFC. Nevertheless, my 2021 GDP forecasts appear to be lower than the consensus.

I will be looking for three developments before becoming more certain of the economic climate, and more optimistic about the market outlook. First, a peak in the number of world-wide confirmed cases. Second, confirmation that the virus does not spread further in China once the draconian lockdown ends. Finally, in addition to the supply and demand shocks, confidence needs to be restored before “life gets back to normal”. That will likely require the development of a vaccine, which experts suggest may be 12 months away.

USA: Lack of Testing Clouds the Outlook

No two recessions are the same, but shock contributed importantly to the downturns following 9/11 and the GFC. The same is true now. Despite the devastating initial (and enduring) impact on the nation’s pysche, the economy bounced back quickly following September 11. On the other hand, the US economy contracted more than 4% (from peak to trough) during the GFC slump.

There are a few reasons I am even more uncertain and concerned about the US outlook at present. First of all, the Chart above illustrates that the USA lags far behind other countries in testing for Coronavirus. As a result, it’s impossible to know the true extent of the infection. I suspect the number will rise very, very sharply as widespread testing takes begins in earnest in coming weeks.

Many still seem complacent, as there have been only 217 deaths at this stage. However, 30,000 people die annually during an average flu season. And, we know Coronavirus is twice as infectious and potentially 30 times more lethal. Do the math.

On the other hand, Korea has been testing aggressively, and the number of daily confirmed cases has slowed sharply. Likewise, the fatality rate is only 0.6% compared to 3% world-wide (still far above the 0.1% rate for seasonal influenza). The mortality rate in China outside of Hubei province is similarly low, which shows that testing and containment make a huge difference (thanks Worldometer for the valuable data).

In addition, I expect the shock to consumption will play a larger-than-usual role in this downturn. During the GFC recession, American household spending declined 2.5%, compared to 14% contractions in more cyclical capex and exports. The Chart above illustrates the importance of the US consumer compared to other countries, which adds to risks in the current downturn.

Overall, I expect the US economy may contract over 5% (from peak to trough) in the year ahead (compared to 4% in 2008/09). If viral testing reveals the extent of infecting is less than I fear, I will revise. On the other hand, aggressive monetary and fiscal stimulus makes me optimistic that the recovery may be less muted than following the GFC. Specifically, I expect economic losses will be recover fully within 5 quarters, compared to over two years in the wake of the GFC.

Europe: Now the Epicenter of the Crisis

The Chart above confirms Europe is now the epicenter of the Coronavirus crisis. On February 1, Europe recorded 22 cases cumulatively, but now the number of infected exceeds China. Cases are growing at an alarming rate, having doubled in the past four days (whereas China’s infections may be peaking). The following illustrates that deaths now also exceed the number in China. Indeed, Italy alone has more fatalities than in China.

As the disruption in global supply chains is a key supply-side shock in this recession, Europe’s heavy reliance on exports may leave the region more vulnerable than other less-open economies (next Chart).

Likewise, given the devastation in the hospitality industries, the dependence on tourism of many European nations exposes them to particular risks.

Overall, I am projecting the European economy to contract 5% from peak to trough, roughly the same as during the GFC. The outlook will remain particularly uncertain until the number of confirmed cases peaks in the weeks/months ahead (as I do expect will be the case). Do not be surprised to observe a quarterly contraction of more 15% (annual rate), as lockdowns bite.

Both the United Kingdom and France have announced assertive fiscal stimulus. The Chart above illustrates the improvement in Europe’s budgetary situation since the GFC. Germany, the Netherlands, Switzerland, Scandinavia, and central Europe have considerable scope to provide a significant fiscal boost. It is urgent they do so — now!! If delivered, I am projecting Europe’s economic losses may be couped by early 2021. Europe did not fully recover from the impact of the GFC and Euro crisis for 7 years.

China: No Engine of Growth this Time

The early signals from China concerning the economic impact of the draconian containment efforts make grim reading (Chart above on industrial production). Even prior to the viral outbreak, I was pessimistic about China’s prospects. I now expect GDP growth below 4% in 2020 (indeed, less than 3% in the first half of the year), as output surely will contract in the first quarter at least.

Observing China will be especially important in the period ahead. First of all, the Chart above indicates that confirmed cases in China may be stabilising. Will cases pick up again once the stringent containment is eased? How will the economy respond in the wake of the shock?

In addition, unlike following the GFC, obviously China is not in a position be the driver of global growth. During that crisis, fueled by massive fiscal expansion, China’s GDP continued to grow more than 6% annually — helping the global economy avert outright depression. In contrast, China’s current economic difficulties will weigh heavily on world-wide activity, especially as China’s role on the global stage has expanded dramatically in recent decades (Chart provided by OECD). This will have particularly important consequences for Australia and the open-Asian economies, which are deeply integrated in global supply chains (Chart below).

Early Recovery Requires Monetary and Fiscal Action

There are many legacies of the GFC. First of all, massive monetary and fiscal stimulus were required to limt the economic fallout, and to pave the way for recovery. However, as a result of those earlier policy efforts, we enter the current downturn with already ultra-relaxed monetary conditions, and government debt well above 2007 levels in most countries (see next Chart).

Even though central banks have less room to maneuver than in 2008, monetary authourities are committed to acting aggressively to migitate the economic damage. However, fiscal policy will need to play the major role. In some nation, e.g. the USA and Japan, government debt has continued to rise since the GFC. Even in these cases, however, low interest rates provide leeway to increase borrowing in this emergency. The scale of the proposed US budget stimulus is impressive. It needs immediate implementation.

Europe has the scope and need for considerable fiscal action, especially in Germany, Scandinavia, central Europe, and other core countries. Even France’s fragile public sector finances have not dissuaded President Macron from announcing a large boost. Likewise, the United Kingdom’s recent budget announcement was an important contribution. JP Morgan’s analysis indicates some nations are acting quickly; others less so (Chart above). A replay of the EU dithering during the Euro-crisis must not be repeated.

The emerging Asian nations have ample scope to boost government spending, as the Chart above illustrates that deficits (and debt levels) are low in many countries. Despite its already large government deficit, China has already implemented additional stimulus, as has Korea, Russia, Singapore, Poland, amongst others. India and Turkey have less scope to act, and Brazil’s financial position remains highly precarious.

Implications

  • While there would seem to be little reason for optimism at present, I do believe the spread of the virus can be contained within 3-6 months. The SARS experience illustrates this is possible if aggressive testing, contact identification, and delay tactics are successfully implemented (Chart above).
  • I project the contraction in global GDP is likely to exceed that of the Global Financial Crisis. Perhaps most importantly, China will be a drag on growth, not an engine.
  • Aggressive monetary and fiscal stimulus will assist the global economy recoup the losses more quickly than following the GFC. Constructive fiscal programs are emerging in the USA, UK, France, China, and elsewhere. The Eurozone has ample room to act, and must not delay.
  • Before getting more optimistic about the economic and financial market outlook, I will observe what happens as China eases its strict lockdown: both to the economy and a possible renewed spread of the virus. Chinese authourities may be reluctant to post GDP numbers near 2% (YOY), but that’s where we are heading. EM Asia will feel the pain. It’s easy to forget GDP contracted 5-8% in several Asian nations during the GFC.
  • I am concerned by the slow pace of testing in the USA. This clouds assessment of the spread of Coronavirus, and creates additional economic risks. Consequently, I project the US recession could extend into Q3 2020.
  • Development of a vaccine would pave the way for a V-shaped recovery.