- What Coronavirus Could Mean for the Global Economy
- What Markets are Telling Us
- What Would a Covid-19-Induced Recession Look ?
- What is the ly Recovery Path?
- Will There be Any Lasting Economic Consequences of Covid-19?
- What Should Leaders Do in Relation to Economic Risks?
- Market Recap
- Historic Interest Rate Moves
- Yield Curve Inversion and Recession Risks
- A Manufacturing Recession
- QE is Again in Vogue
What Coronavirus Could Mean for the Global Economy
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Market volatility has sparked fears of a Covid-19-induced recession. To glean insights into the path aheads, business leaders need to take a careful look at market signals across asset classes, but also look beyond the markets to recession and recovery patterns, as well as the history of epidemics and shocks.
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Having largely ignored Covid-19 as it spread across China, global financial markets reacted strongly last week when the virus spread to Europe and the Middle East, stoking fears of a global pandemic. Since then, Covid-19 risks have been priced so aggressively across various asset classes that some fear a recession in the global economy may be a foregone conclusion.
In our conversations, business leaders are asking whether the market drawdown truly signals a recession, how bad a Covid-19 recession would be, what the scenarios are for growth and recovery, and whether there will be any lasting structural impact from the unfolding crisis.
In truth, projections and indices won’t answer these questions. Hardly reliable in the calmest of times, a GDP forecast is dubious when the virus trajectory is unknowable, as are the effectiveness of containment efforts, and consumers’ and firms’ reactions. There is no single number that credibly captures or foresees Covid-19’s economic impact.
Instead, we must take a careful look at market signals across asset classes, recession and recovery patterns, as well as the history of epidemics and shocks, to glean insights into the path ahead.
What Markets are Telling Us
Last week’s brutal drawdown in global financial markets might seem to indicate that the world economy is on a path to recession. Valuations of safe assets have spiked sharply, with the term premium on long-dated U.S.
government bonds falling to near record lows at negative 116 basis points — that’s how much investors are willing to pay for the safe harbor of U.S. government debt.
As a result, mechanical models of recession risk have ticked higher.
Yet, a closer look reveals that a recession should not be seen as a foregone conclusion.
First, take valuations of risk assets, where the impact of Covid-19 has not been uniform. On the benign end, credit spreads have risen remarkably little, suggesting that credit markets do not yet foresee funding and financing problems.
Equity valuations have conspicuously fallen from recent highs, but it should be noted that they are still elevated relative to their longer-term history.
On the opposite end of the spectrum, volatility has signaled the greatest strain, intermittently putting implied next-month volatility on par with any of the major dislocations of the past 30 years, outside of the global financial crisis.
Second, while financial markets are a relevant recession indicator (not least because they can also cause them), history shows that bear markets and recessions should not be automatically conflated.
In reality, the overlap is only about two every three U.S. bear markets — in other words, one every three bear markets is non-recessionary.
Over the last 100 years, we counted seven such instances where bear markets did not coincide with recessions.
There is no doubt that financial markets now ascribe significant disruptive potential to Covid-19, and those risks are real. But the variations in asset valuations underline the significant uncertainty surrounding this epidemic, and history cautions us against drawing a straight line between financial market sell-offs and the real economy.
What Would a Covid-19-Induced Recession Look ?
Though market sentiment can be misleading, recessionary risk is real. The vulnerability of major economies, including the U.S. economy, has risen as growth has slowed and the expansions of various countries are now less able to absorb shocks. In fact, an exogenous shock hitting the U.S. economy at a time of vulnerability has been the most plausible recessionary scenario for some time.
Recessions typically fall into one of three categories:
- Real recession. Classically, this is a CapEx boom cycle that turns to bust and derails the expansion. But severe exogenous demand and supply shocks — such as wars, disasters, or other disruptions — can also push the real economy into a contraction. It’s here that Covid-19 has the greatest chance to infect its host.
- Policy recession. When central banks leave policy rates too high relative to the economy’s “neutral” rate, they tighten financial conditions and credit intermediation, and, with a lag, choke off the expansion. This risk remains modest — outside of the U.S. rates are already rock bottom or even negative, while the Federal Reserve has delivered a surprise cut of 50 basis points. Outside of the monetary policy response, the G7 finance ministers have also pledged fiscal support.
- Financial crisis. Financial imbalances tend to build up slowly and over long periods of time, before rapidly unwinding, disrupting financial intermediation and then the real economy. There are some marked differences globally, yet in the critical U.S. economy, financial crisis risks are difficult to point to. Some commentators point to the bubble in corporate credit, as seen in significant issuance and tight spreads. Yet, we struggle with the subprime analogy of the last recession, as corporate credit neither funds a real economy boom (as subprime did with housing), nor is the debt held on banks’ balance sheets. Both factors limit the systemic risk of a potential shakeout in credit, though this risk can’t be dismissed entirely. It’s difficult to see Covid-19 contributing to financial imbalances, but stress could arise from cash flow strains, particular in small and medium enterprises (SMEs).
Looking at this taxonomy, and again at history, there is some good news in the “real economy” classification.
Though idiosyncratic, real recessions tend to be more benign than either policy recessions or those induced by financial crisis, as they represent potentially severe but essentially transient demand (or supply) shocks. Policy recessions, by contrast, can be, depending on the size of the error, severe.
In fact, the Great Depression was induced by perhaps the largest policy error ever. And financial crises are the most pernicious kind, since they introduce structural problems into the economy that can take a long time to be corrected.
What is the ly Recovery Path?
Whether economies can avoid the recession or not, the path back to growth under Covid-19 will depend on a range of drivers, such as the degree to which demand will be delayed or foregone, whether the shock is truly a spike or lasts, or whether there is structural damage, among other factors. It’s reasonable to sketch three broad scenarios, which we described as V-U-L.
- V-shaped: This scenario describes the “classic” real economy shock, a displacement of output, but growth eventually rebounds. In this scenario, annual growth rates could fully absorb the shock. Though it may seem optimistic amid today’s gloom, we think it is plausible.
- U-shaped: This scenario is the ugly sibling of V — the shock persists, and while the initial growth path is resumed, there is some permanent loss of output. Is this plausible for Covid-19? Absolutely, but we’d want to see more evidence of the virus’ actual damage to make this the base case.
- L-shaped: This scenario is the very ugly and poor relation of V and U. For this to materialize, you’d have to believe in Covid-19’s ability to do significant structural damage, i.e. breaking something on the economy’s supply side — the labor market, capital formation, or the productivity function. This is difficult to imagine even with pessimistic assumptions. At some point we will be on the other side of this epidemic.
Again, it’s worth looking back at history to place the potential impact path of Covid-19 empirically. In fact, V-shapes monopolize the empirical landscape of prior shocks, including epidemics such as SARS, the 1968 H3N2 (“Hong Kong”) flu, 1958 H2N2 (“Asian”) flu, and 1918 Spanish flu.
Will There be Any Lasting Economic Consequences of Covid-19?
To understand this, we need to examine the transmission mechanism through which the health crisis infects the economy.
If the taxonomy of recessions tells us where the virus ly attacks the economy, transmission channels tell us how the virus takes control of its host. This is important since it implies different impacts and remedies. There are three plausible transmission channels:
- Indirect hit to confidence (wealth effect): A classic transmission of exogenous shocks to the real economy is via financial markets (and more broadly financial conditions) — they become part of the problem. As markets fall and household wealth contracts, household savings rates move up and thus consumption must fall. This effect can be powerful, particularly in advanced economies where household exposure to the equity asset class is high, such as the U.S. That said, it would take both a steep (more bear market than correction) and sustained decline.
- Direct hit to consumer confidence: While financial market performance and consumer confidence correlate strongly, long-run data also shows that consumer confidence can drop even when markets are up. Covid-19 appears to be a potentially potent direct hit on confidence, keeping consumers at home, weary of discretionary spending, and perhaps pessimistic about the longer term.
- Supply-side shock: The above two channels are demand shocks, but there is additional transmission risk via supply disruption. As the virus shuts down production and disables critical components of supply chains, gaps turn into problems, production could halt, furloughs and layoffs could occur. There will be huge variability across economies and industries, but taking the U.S. economy as an example, we think it would take quite a prolonged crisis for this to feed through in a significant way. Relative to the demand impact, we see this as secondary.
Recessions are predominantly cyclical, not structural, events. And yet the boundary can be blurred. To illustrate, the global financial crisis was a (very bad) cyclical event in the U.S., but it had a structural overhang.
The economy rebounded, yet household deleveraging is an ongoing secular phenomenon — household willingness (and ability) to borrow is structurally impaired, and the collateral damage, structurally, is that policy makers find it much harder to push the cycle just by managing short-term interest rates today.
Could Covid-19 create its own structural legacy? History suggests that the global economy after a major crisis Covid-19 will ly be different in a number of significant ways.
- Microeconomic legacy: Crises, including epidemics, can spur the adoption of new technologies and business models. The SARS outbreak of 2003 is often credited with the adoption of online shopping among Chinese consumers, accelerating Alibaba’s rise. As schools have closed in Japan and could plausibly close in the U.S. and other markets, could e-learning and e-delivery of education see a breakthrough? Further, have digital efforts in Wuhan to contain the crisis via smart-phone trackers effectively demonstrated a powerful new public health tool?
- Macroeconomic legacy: Already it looks the virus will hasten the progress to more decentralized global value chains — essentially the virus adds a biological dimension to the political and institutional forces that have pushed the pre-2016 value chain model into a more fragmented direction.
- Political legacy: Political ramifications are not to be ruled out, globally, as the virus puts to the test various political systems’ ability to effectively protect their populations. Brittle institutions could be exposed, and political shifts triggered. Depending on its duration and severity, Covid-19 could even shape the U.S. presidential election. At the multilateral level, the crisis could be read as a call to more cooperation or conversely push the bipolar centers of geopolitical power further apart.
What Should Leaders Do in Relation to Economic Risks?
The insights from financial markets and the history of analogous shocks can be operationalized as follows:
- Don’t become dependent on projections. Financial markets are currently reflecting great uncertainty. A wide range of scenarios remain plausible and should be explored by companies.
- Don’t allow financial markets gyrations to cloud judgement about the business you lead.
- Focus on consumer confidence signals, trust your own instincts, and know how to leverage your company’s data in calibrating such insights. The impact will not be uniform, and the conclusions will be specific to your industry.
- Plan for the best and prepare for the worst trajectories. Keep in mind that a V-shaped recovery is the plausible scenario conceptually and empirically, but don’t let that insight make you complacent.
- Begin to look past the crisis. What micro or macroeconomic or legacy will Covid-19 have? What opportunities or challenges will arise?
- Consider how you will address the post-crisis world. Can you be part of faster adoption of new technologies, new processes, etc? Can you eventually find advantage in adversity for your company, clients and society?
(Editor’s Note, March 6): This piece has been updated to reflect the subtypes of the historic flu outbreaks.)
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It has been a wild couple weeks in the markets as investors have been caught in the crossfire of slowing global growth, flattening yield curves, and trade war uncertainty. The latest b volatility was set off when the Trump Administration announced they would slap tariffs on all of China’s exports.
There was a brief respite then Trump decided to delay the hike on many consumer goods until after Christmas (you mean China doesn’t pay after all?), but the uncertainty persists, especially after the Chinese government said on Thursday it will still go ahead and take ‘necessary countermeasures’ to retaliate.
One way the Chinese are already fighting back is by allowing their currency to depreciate. As you can see below, the Chinese yuan moved through 7 (meaning it takes more yuan to buy a dollar – a falling line means dollar appreciation/yuan depreciation).
This raises the specter of the trade war morphing into a currency war as well.
It isn’t helping matters that countries with large manufacturing bases are struggling. We found out this week that the German economy contracted in the second quarter, as you can see below.
Furthermore, China’s industrial production is growing at its most sluggish pace since 2002.
Finally, a surprise election result in Argentina led to dramatic losses for the Argentinian peso as well as the local stock and bond markets.
Stocks were down -46% in dollar terms (the second largest one-day crash in any stock market in the last 70 years) while the currency lost roughly 30% of its value at one point (falling line in the chart below means peso depreciation/dollar appreciation).
Markets are now pricing in an almost 80% chance of Argentina defaulting on its debt given that 80% of the country’s debt is in foreign currency.
Historic Interest Rate Moves
Equity markets around the world have corrected in August, but in the grand scheme of things the selling has been relatively controlled (with the obvious exception of Argentina). The S&P 500 is down a little over -4% this month while the NASDAQ is off about -5%. The two indexes are still up +15% and +19% respectively this year.
The more dramatic moves have been in the bond markets. The yield on the 10-year Treasury hit a low of 1.485% at one point this week while the yield on the 30-year bond fell below 2% for the first time ever!! Global yields have also plunged to new lows. The German 10-year was at -0.71% at one point while Switzerland’s 10-year hit -1.12%. Really unprecedented moves!!
The global stock of negative yielding debt hit a new record of roughly $16 trillion this week.
Probably more amazing, if you exclude U.S. bonds, 45% of all global bonds (government and corporate) trade at a negative yield.
And what really matters to those of us with a mortgage is when will my mortgage rate go negative?? Well, maybe you can get a loan in Denmark. Jyske Bank, Denmark’s third largest bank, has begun offering borrowers a 10-year deal at -0.5%, while another Danish bank, Nordea, says it will begin offering 20-year fixed-rate deals at 0% and a 30-year mortgage at 0.5%.
This is really unprecedented stuff.
Yield Curve Inversion and Recession Risks
Falling long-term rates has triggered a closely watched recession alarm bell. For the first time since December 2005 the difference between the yield on the 10-year Treasury and the 2-year Treasury has fallen into negative territory. You need to squint at the chart below, but briefly this week the line fell below zero.
By Friday’s close the yield curve was once again positively slopped, but the press was all over this story with headlines heralding the coming recession. Of course, there are some caveats.
First off, this is a terrible timing tool.
If you look back at the last five yield curve inversions, the lag between inversion and the start of the recession can be long and varied (average is roughly 17 months).
Furthermore, the market has a history of doing ok after inversions. As you can see below, the average return between inversion and the start of recession is almost 16%.
And this ignores the false signals. For example, the curve inverted in 1998 but we avoided recession.
But things yield curve inversions can become self-fulfilling if it causes businesses and consumers to pull in their horns. Also, if banks slow lending activity this could easily trigger a contraction. Clearly recession risks are higher than they were at the end of June, but it is by no means a sure bet.
A Manufacturing Recession
To have greater confidence calling a recession you’ll need to see some of the hard data start to roll over. At least so far, we are not seeing this type of activity. Job growth persists and consumers are still spending. Thursday’s retails sales number was solid, as you can see below.
Both the Philly and New York Fed manufacturing surveys actually surprised on the upside. Growth estimates for the third quarter are running around +2%. Of course, all of this could be lagging data, but we wouldn’t peg the recession odds at greater than 1 in 3 currently.
Even in Germany the news isn’t all bad. Yes, growth contracted in the second quarter, but this was largely due to a slump in manufacturing. The services sector is still doing well, as you can see below. A distinction clearly needs to be made between the recession in manufacturing and on-going growth in the consumer sector.
As The Economist notes:
“Yet a recession is so far a fear, not a reality. The world economy is still growing, albeit at a less healthy pace than in 2018. Its resilience rests on consumers, not least in America. Jobs are plentiful; wages are picking up; credit is still easy; and cheaper oil means there is more money to spend.
What is more, there has been little sign of the heady exuberance that normally precedes a slump. The boards of public companies and the shareholders they ostensibly serve have played it safe. Businesses in aggregate are net savers.
Investors have favoured firms that generate cash without needing to splurge on fixed assets.”
QE is Again in Vogue
There is one other factor that cannot be ignored and could very well be distorting yield curves around the world. Ultra-dovish central banks.
Just in the last week central bankers in Brazil, India, New Zealand, Peru, the Philippines and Thailand have all reduced their benchmark interest rates.
Then on Thursday we found out the European Central Bank wants to move in a big way. From the Wall Street Journal report:
The European Central Bank will announce a package of stimulus measures at its next policy meeting in September that should exceed investors’ expectations, a top official at the central bank said.
Speaking in his offices in Finland’s capital on Thursday, Olli Rehn said the slowing global economy would see the ECB rolling out fresh stimulus measures that should include ‘substantial and sufficient’ bond purchases as well as cuts to the bank’s key interest rate.
‘It’s important that we come up with a significant and impactful policy package in September,’ said Rehn, who sits on the ECB’s rate-setting committee as governor of Finland’s central bank.
‘When you’re working with financial markets, it’s often better to overshoot than undershoot, and better to have a very strong package of policy measures than to tinker,’ Rehn said.
It is looking more and more ly that the ECB will hoover up as many government bonds as they can in the coming months, and when they are done with that, will start snapping up corporate bonds. This naturally leads to lower bond yields and a flatter curve in Europe. Falling bond yields in Europe and around the world have, in turn, led to lower yields and a flatter curve in the U.S.
Without question liquidity conditions are going to become materially easier in the months to come. A half-point cut at the upcoming Fed meeting in September isn’t the question.
The Fed still has time to get ahead of the inversion through rate cuts in the months to come. But political risks will persist.
How much will Trump risk a recession and a loss in 2020 to make a point about trade? We think he cares more about getting re-elected, but??
I think Tim Duy summarized the outlook as well as anyone:
“In my opinion we should be reasonably concerned about the outlook as recession risks have risen but recognize that a.) the time between yield curve inversion and recession could be long and b.
) the Fed has been and will continue to be more dovish in the wake of the inversion than they have been in the past.
On the other hand, the risk of continued chaotic policy the White House is high and could foster the type of coordinated pessimism that overwhelms the Fed.”
Have a good weekend.
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