Europe: Will Second Wave Derail Recovery?

12 October 2020
After Europe’s devastasting Coronavirus outbreak in early 2020, painful measures succeeded in suppressing the spread of Covid-19 during the summer. As health experts warned, however, social lockdown is only akin to hitting the pause button; buying time to allow more sustainable mitigation to be put in place. Unfortunately, as lockdown measures were eased during the summer, certain European countries are now experiencing an alarming new spike in Covid cases (Chart below).

Following the dramatic 15% decline in GDP (not annualised) during the first half of 2020, the European economy has begun to rebound in recent months. However, will the second Covid wave derail the economic recuperation? I remain hopeful that Europe’s recovery will be quicker than following the Global Financial Crisis (followed by the Euro Crisis). However, even under the optimistic so-called “V-shaped” recovery, Europe will not recoup the output lost in H1 2020 until the middle of 2022! To be sure, that’s better than the seven years it took after the GFC. But, the pathway to recovery will remain long, and more uncertain than in previous cycles. Also, additional fiscal support will almost certainly be required. Hopefully, policymakers will not repeat the mistakes following the GFC. The performance of individual countries may vary widely, largely reflecting their ability to suppress the second wave of Covid this winter.

Diagnosing Symptoms Helps Find a Cure

Identifying the forces driving Europe’s recent economic performance helps evaluate what lies ahead. The Chart above illustrates the countries with the most serious virus outbeaks have experienced the most dramatic economic contractions, e.g. the Spain, UK, France, Italy, and Portugal. The USA is an exception; despite its mishandling of the pandemic, the recession has not been as deep as in Europe so far. While Scandinavia and Germany (along with the Netherlands, Switzerland, and Austria) have suffered painful recessions, the slump has been less severe than elsewhere.

Many suggest that Sweden’s decision to introduce less stringent lockdown measures is responsible for its relatively less severe economic downturn. However, Sweden’s recession has been deeper than in neighbouring Scandinavian nations; suggesting its performance may have more to do with cultural issues (household size, less reliance on hospitality) than its handling of the pandemic (as we will see).

Unlike past downturns, the Chart highlights consumer spending has been the weakest segment of both the European and US economies during the first half of 2020 (with only minor exceptions). Not surprisingly, lockdowns in hospitality, concerns about job and income loses, and curtailment of tourism took a toll on household spending.

To be sure, business sentiment has also suffered significantly. However, the contraction in capital spending in many European countries (and the USA) has been somewhat less than in the consumer sector (Chart above). However, business investment did decline sharply where the health emergency was most severe — Spain, Italy, France, and UK.

Likewise, European exports collapsed in March and April, but have begun to recover in recent months (Chart above). Overall, therefore, as devastating as the contraction has been in the general business sector, the consumer-related area have suffered even more. PMI surveys undescore this distinction. The service sector index (left-hand scale) has declined more severely than the manufacturing reading. Moreover, the recent service sector recovery has been comparatively modest, and the index remains below the key 50 level (sub-50 readings suggest recessionary conditions).

Is the Recovery Losing Momentum?

After rising sharply in May and June, the recently decelerating pace of retail sales and industrial production gains has raised concerns that Europe’s recovery is already losing momentum (next Chart).

Without seeming overly optimistic (I am not), there are reason to hope the second wave will not lead to a double dip recession. First of all, the earlier PMI Chart illustrated that sentiment in the manufacturing sector continues to improve. To be sure, while the outsized May/June gains were not sustainable, the Chart above indicates industrial production continues to expand, which is supported by the recovery in export performance (earlier Chart).

As the consumer has been at the heart of the recession, household spending will be decisive in sustaining the nascent upturn. In this regard, July’s outright decline in European retail sales was worrisome. However, the fiscal support provided has been massive — well in excess of the the post-GFC stimulus, and larger than the huge boost provided in the USA (Chart above). More support may well be required; European governments are already extending expensive labour market furlough schemes until well into next year.

In addition, the Chart above illustrates households have been saving much of the money provided; suggesting considerable ammunition exists to maintain spending. To be sure, household sentiment will not fully recover until the pandemic is under control or a vaccine emerges. However, while still depressed, consumer confidence is still ticking upward (Chart below). The 4% rebound in August’s retail sales may indicate the consumer will play its vital role in sustaining the upswing.

What to Watch: Avoiding Past Mistakes

Continued recovery, however, is not inevitable. Policymakers must avoid repeating the mistakes of the past. To be sure, governments will face pressure to address soaring public sector debt. During the GFC, following intial budgetary stimulus, European authourities imposed austerity measures which contributed to the long, painful road to recovery (next Chart). This must be avoided. Additional stimulus should be targeted to support workers and hard-hit sectors, and to boost public investment in priorities of the future (climate change, infrastructure, broadband, etc).

Likewise, the following Chart illustrates that deflation is a more serious risk than inflation. In 2011, the ECB began to tighten monetary conditions prematurely; a mistake that was quickly reversed. Interest rates should remain at emergency low levels into 2022, at least.

Individual country performance may continue to differ widely. Given the importance of the consumer/service spending, countries reliant on these sectors may be more vulnerable: UK and the USA stand out especially.

As hospitality will remain a vulnerable sector, countries reliant on tourism will face additional challenges.

Finally, labour market support differs across countries. In particular, Europe’s furlough schemes have led to far fewer job loses than in the USA (which have relied on generous, direct income support). If Europe’s approach proves too costly eventually, the US experience provides clues as to the possible scale of job loses (and the impact on consumer sentiment).


Covid’s Second Wave: Is this Time Different?

Nevertheless, the recovery’s durability will hinge largely on the progression of the pandemic, and the impact of the additional measures required to control the spread of Covid-19. The situation will remain fluid, and the upcoming winter will be challenging.

Investors hate the suggestion that “this time may be different”. But, is it possible that the economic (and health) consequences of second wave may be less damaging? Before addressing that question, the legacy of the first wave may well continue to depress setiment in the hardest-hit countries. The Chart above illustrates that the cumulative death toll (as a share of the population) has been especially high in Brazil, USA, UK, Spain, Italy, and France. Also noteworthy, Sweden’s approach has led to much higher mortality levels compared to its Scandinavian neighbours. Korea and New Zealand illustrate it did not have to be so bad.

The Chart at the beginning of this blog illustrated the worrisome second spike in new cases in Europe. New infections (as a share of the population) already exceed the first wave’s peak in Spain (especially) and France, and the UK is now rising quickly. German and Scandinavian infections are lower, and Italy’s performance is far better this time (thank goodness!).

To be sure, part of the explanation for the rising number of cases lies in a desirable surge in testing throughout Europe. Therefore, the positivity rate — the proportion of tests that reveal Covid infection — is now a key metric. All countries have seen a meaningful rise since the summer. Countries with a positivity rate above 5% are viewed at great risk: Spain, France, Netherlands, Austria, and USA. Again, Italy’s improvement, at least so far, is a noteable achievement.

Fortunately, despite the spike in new cases, the Chart above illustrates that the death rate is is sharply lower than during the initial outbreak in all countries. Brazil, USA, and Spain appear most vulnerable on this metric. There are numerous reasons why deaths are lower, depite the huge surge in cases. The following Chart reveals that in the UK the sharpest rise in cases has been in the 10-29 year-old age group, who are least vulnerable to serious health consequences. Older people appear to have remained cautious, despite the easing of lockdown restrictions this summer. However, this can change quickly. In recent weeks, for instance, UK cases in all age groups are rising sharply, with the 30-50 year-old cohort accelerating noticeably (presumably as they returned to work).

Strategic Considerations

  • While things can change quickly, I am hopeful that Europe’s second Covid wave will be less lethal than the first.
  • Consequently, I anticipate the economic recovery will continue, but lost output will not be recouped until mid-2022. This is a far better outcome than following the GFC.
  • Germany and Scandinavia, along with Netherlands and Austria, should fare best. Spain, UK, France and Belgium appear most at risk. Italy’s performance has improved dramatically (at least so far).
  • ECB policy will remain on hold, perhaps through the end of 2022. Yield curves will steepen. Deflation is unlikely; inflation is implausible.
  • The United States’ struggle to control Covid’s spread will be an additional headwind for the US dollar. While the US economy has fared better than Europe so far (as expected), America’s rebound could lag unless mitigation efforts are more successful than to date.