Avoiding the crash of a second wave?
27 Jul 2020
We are beginning to see signs of a recovery from the coronavirus pandemic given the lifting of containment measures in many countries. However, some nations have yet to bring the virus under control, while others face the risk of renewed outbreaks and the possibility of lockdowns being reinstated. Our latest Global Economic Overview sees some mild forecast revisions, with the pace of global contraction in 2020 being moderated thanks to a stronger performance in China.
Countries such as Brazil and India have yet to bring the virus under control, whereas others who had initially been successful have had to tighten restrictions again amid a spike in cases. Although the latest lockdowns will hinder the pace of recovery, they have been imposed to avert a severe second wave. We have not had to alter our forecasts much, having already assumed a degree of lockdown reversal. However, we have brought forward China’s recovery owing to the robust rebound in the second quarter. Our forecast now envisages a more moderate fall of 3.8% in global gross domestic product (GDP) for 2020 (previously -4.1%), followed by a firmer expansion of 5.5% in 2021 (previously +5.3%). Beyond Covid-19, risks to the outlook include rising trade tensions and the potential for a so-called taper tantrum as central banks rein in the pace of quantitative easing (QE) purchases.
The US has continued to struggle to control coronavirus case numbers, leading to a tightening in restrictions. Worryingly, California, the country’s largest state with 14.6% of national GDP, has the most punitive restrictions. The increase in restrictions has led to a levelling off in economic activity data and forced us to re-appraise our third-quarter recovery expectations. However, we have also reduced our expected second-quarter decline, with the net effect resulting in us upgrading our 2020 GDP forecast to -5.6% (previously -5.9%). We’ve also raised our GDP growth forecast for next year to +4.4% (previously +4.2%). We expect that further fiscal support will be agreed, with an eye on the impending presidential election. Soon investors will more closely appraise the likely consequences of the election result and how any fiscal repair work will be tackled from 2021. Here Joe Biden is calling for a 28% corporate tax rate, but he is also likely to be less hawkish in international trade disputes.
Official euro-area statistics have so far pointed to a rebound in activity as lockdown measures have been eased. Still, the path of recovery to regain pre-crisis levels will likely be drawn out. The EU’s agreement on a €750-billion Recovery Fund represents a significant positive milestone and should begin to provide additional stimulus in the medium-term, just as some government support measures lapse. Our Eurozone GDP forecasts envisage a 7.5% contraction in 2020, an upgrade from our previous estimate of a 7.9% decline. Next year is expected to see growth of 5.3%. European Central Bank (ECB) policy is set to remain exceptionally accommodative, with the full utilisation of the €1.35 trillion Pandemic Emergency Purchase Programme (PEPP). One feature to be adjusted is the ECB’s tiered deposit rate threshold, given rising excess liquidity and the resulting de facto penalisation of banks.
A huge improvement has been made in the rate of coronavirus infections and fatalities since the spring. Still, the number of daily cases seems to have begun to rise again recently, albeit modestly. That may well be due to clustering in specific areas rather than a generalised outbreak and as such does not threaten national relaxation of restrictions or related economic activity. Also, while May’s rebound in GDP was relatively subdued, both June and July should see a more robust rise in activity on the back of a more significant lifting of restrictions. Further ahead, the key will be the extent of second-round effects, but the chancellor’s latest measures should help prevent a double-dip recession. Our broad view of GDP is essentially unchanged, and our forecasts have only been tweaked. These are now -8.3% this year and +6.4% next (previously -7.9% and +6.0%).
That will put the brakes on the green shoots of recovery that have recently emerged. In June, the global composite Purchasing Managers Index (PMI) climbed from 36.3 to a five-month high of 47.7. Of the 14 component nation PMIs, most experienced either their steepest or second-steepest improvement on record. Other higher frequency data such as transport use, retail footfall and electricity demand all point to a further marked improvement in July.
The International Monetary Fund (IMF) estimates that another major outbreak in early 2021 would leave the global economy some 4.6% smaller by the end of the year relative to its baseline. This loss is reduced to 1.7% by 2024, albeit with permanent economic supply-side scarring. Ultimately, we still suspect this will not come to pass, but we remain vigilant. We have not altered our forecasts much, having already assumed a degree of lockdown reversal. A key exception is China for which we have brought forward the recovery owing to the robust rebound in the second quarter. Consequently, we now look for a more moderate fall of 3.8% in global GDP for 2020 (previously -4.1%), followed by a firmer expansion of 5.5% in 2021 (previously +5.3%).
Beyond the coronavirus, trade disputes have been rising up the risk spectrum. In particular, Western-Sino relations have been strained by the passage of the new Hong Kong National Security Law. Also, the US and EU are at loggerheads over a long-running aircraft subsidies dispute and France’s Digital Services Tax. But might the pandemic itself lead to the greatest upheaval of all? A number of firms now plan to make their supply chains more resilient after the fragilities of geographic concentrations have become apparent. As a result, most chief economists surveyed by the World Economic Forum (WEF) believe there will be a reversal in global convergence. The implied efficiency loss presents yet another risk to global growth in the medium to long-term.
It also comes despite a reining in of the weekly pace of QE purchases. Among four of the biggest central banks, these had stood close to $600 billion in late March. That was more than three times the previous record pace in April 2013, when the Bank of Japan launched what Governor Haruhiko Kuroda called "monetary easing in an entirely new dimension". A few months later, US Federal Reserve Chairman Ben Bernanke sparked a “taper tantrum” after hinting the Fed was looking at lowering its QE purchases. It is possible that history repeats itself, particularly if investors baulk at the scale of debt issuance. But the flexibility and scale of QE programmes make it less likely than in 2013.
The consequences are visible in real-time activity metrics, where the recovery is levelling off. In California, the state with the most punitive restrictions, the governor has ordered the state-wide closure of all bars, indoor restaurants and theatres. California’s economy is by far the largest of all US states (14.6% of US GDP in 2019), so the squeeze for the US at large is clear. Looking more widely, the 10 states with the biggest case tally per 100,000 of the population over the past week account for almost another quarter of US GDP. So the scope for further restrictions slowing the recovery is significant.
Chart 4 demonstrates our expectation of a long road to recovery, with our post-Covid-19 GDP profile running below our January 2020 projection. On top of the uncertainty the pandemic brings with it, the Presidential election, now just four months away, also adds to the uncertainty over the economic outlook. In the wake of Donald Trump’s 2016 win, the Tax Cuts and Jobs Act provided a notable boost to economic momentum. The more pertinent question for the new - or returning - president will be the shape of fiscal repair plans. Democratic presidential candidate Joe Biden has laid out some details of his plan calling for a 28% corporate tax rate, above the 21% set by Trump’s 2017 tax cuts.
The November presidential election is also on the minds of investors, who have to weigh-up tax and trade positions of the two candidates. On trade, although Joe Biden is pushing “Made in America” and to reduce reliance on China, he is less consumed by the US trade deficit and therefore tariffs. However, investors may well be more concerned about his tax proposals. President Trump will likely seek a more stock market-friendly way to address fiscal issues, we suspect.
In the medium-term, the EU’s Recovery Fund should prove supportive of growth. Amidst somewhat fraught discussions at times, leaders agreed to a €750-billion fund. That will include grants of €390 billion, a reduction from the initially proposed €500 billion, but it comes at a crucial time as it allows the EU to begin distributing funds in 2021. That is important as the fourth quarter of 2020 is likely to see government labour support measures lapse, which could see unemployment rise sharply. Recent first-quarter Eurostat figures showed 4.3 million people became absent from work (but not classified as unemployed), but this is just the tip of the iceberg, as estimates suggest that more than 30 million are currently on furlough-type schemes.
While the daily number of coronavirus infections has fallen, the virus remains the key risk to the recovery, with the potential for renewed outbreaks and new lockdowns. While such measures may be more localised looking forward, they nonetheless have the potential to impact economic activity. Notably, if you take Spain and Portugal as examples where localised lockdowns have been reintroduced, the recovery in mobility has been curtailed, and in the case of Spain, has even fallen back. Our broad assumption is that mass lockdowns don’t happen and the economic recovery can take hold in the second half of the year. Consequently, our GDP growth forecasts stand at ‑7.5% for 2020 and +5.3% for 2021.
While the ECB has been more active in utilising asset purchases over the crisis period, interest rate policy may need to be examined again. The two-tier deposit rate system is a particular issue. When it was implemented in September 2019, it aimed to limit the cost to banks by exempting a proportion of excess reserves from attracting the -0.50% deposit rate. However, with the huge increases in QE and ECB liquidity operations, the level of excess reserves has now risen €1 trillion to €2.8 trillion, with the level of reserves remunerated at the deposit rate now greater than when the tiered system was introduced. The “exemption multiplier”, which currently stands at six times minimum reserve levels, is therefore likely to be revisited sooner rather than later.
Since risk sentiment hit a low in late March it has improved markedly – the S&P 500 is now mostly flat on the year. The impact on currency markets has been some weakening in the US dollar as the demand for dollar-denominated haven assets has diminished. The euro and pound have been beneficiaries of this, although the latter has faced Brexit-related headwinds (see UK section). The euro itself has risen 5% against the dollar over the last two months, hitting an 18-month high of $1.1547 thanks to the EU’s agreement on the Recovery Fund. We suspect that the euro will retrace some of its gains near term when the US Congress reaches a deal over another round of fiscal support, boosting the dollar. Our fourth-quarter 2020 euro-dollar forecast remains at $1.14.
But Rt is not a holy grail and as with the raw data, requires careful interpretation. One limitation is that it ignores the speed of the spread. Another is that it fails to account for the dispersion of transmission rates across people or groups. Indeed for any given Rt, a cluster in individual communities might be easier to control via local measures. Such a measure of divergence is termed “k” (the lower the level of k, the more concentrated the spread). Research by Imperial College suggests, excluding clusters in care homes and hospitals, R in May was 0.57, implying that the wider coronavirus threat may be lower than government estimates.
In terms of the economy, GDP rose by 1.8% on the month in May, following declines of 20.3% in April and 6.9% in March. The pick-up was considered disappointing by many, casting doubt on the shape of any recovery. But we would raise the point that there was only a modest lifting of restrictions between April and May, the most significant arguably a re-opening of DIY centres and garden centres (some construction firms also resumed work). A muted May rebound is consistent with our high-frequency indicators. These also suggest a more robust rise in activity in June, which chimes with the re-opening of England’s non-essential retailing on the 15th, which should lift GDP in both June and July.
The Office for Budget Responsibility’s new central scenario puts the deficit at £322 billion this year. At some stage, there will be a need to address the fiscal position. But economic fragility may well result in more stimulus, not tightening, at this autumn’s Budget. The Bank of England has now slowed the pace of QE gilt purchases to £6 billion per week, and these do not cover net gilt issuance. But as the BOE’s Monetary Policy Committee noted in June, gilt market liquidity conditions are now more stable compared with March. UK government bond yields are currently negative out to seven years maturity. Markets are pricing in as much as a 60% chance of a 25 basis-point BOE interest rate cut in 2021, but our view remains that rates will remain above zero at 0.10%.
A good essay question might be: “The pound is an indicator of global risk appetite, modified by concerns of a no-deal outturn with the EU – discuss.” Chart 6 supports this assertion for 2020 so far. We do not picture these drivers altering materially over the second half. Indeed, trade talks have not been productive so far and they are soon set to be adjourned until 17 August. Accordingly, it seems as likely as ever that the autumn will witness creeping angst over the risks of not reaching an agreement. Our base case still envisages sterling dropping to $1.20 and 94 pence against the euro, before recovering towards the end of the year as a last-ditch UK-EU trade deal is reached, albeit possibly in “bare-bones” form.