Avoiding the crash of a second wave?

Last month, we identified four groups of countries based on their experience of the pandemic. These ranged from those who promptly brought the virus under control, to those who were still struggling with the initial wave. Although these still broadly hold, the differences between them have become more blurred. Nations such as Australia and Hong Kong, which had swiftly brought the virus under control, have had to reinstate restrictions after a spike in cases. So have some US states, with daily new cases in the country above 70,000 at times, rivalling the combined increase in Brazil and India.

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.

Meanwhile, China’s GDP rebounded by a sharper than expected 11.5% in the second quarter after suffering a record 10.0% fall in the first three months of the year. That was driven by the industrial sector, for which output stood 4.4% higher on the year, whereas retail sales remained 3.9% down. Although the latest lockdowns will hinder the pace of recovery, they have been imposed to avert a severe second wave.

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.

But despite the risk of another global outbreak and the rising likelihood of a reversal in globalisation, risk assets have continued to march higher. In fact, the global equity MSCI ACWI Index is now just 1.7% away from being up on the year. These further gains have been underpinned by the same factors that we highlighted last month. Namely, additional data show that activity has rebounded sharply after the lifting of lockdowns and recent successes in early vaccine trials. But while equities have rallied from their March lows, haven assets are generally little changed. The 10-year US Treasury bond yield languishes at 0.60%, barely changed from four months ago, whereas the price of gold has topped $1,800 per ounce for the first time since 2011. 

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 US now has a quarter of the world’s reported Covid-19 infections as southern and western states have faced rapidly rising reported daily case numbers. The aggressive initial re-opening in many of these states looks to have been a key factor, while the control of the virus has been impeded by bizarre issues such as the use of fax machines to deliver (delayed and badly formatted) test results. In one example, the Florida Division of Emergency Management said the turnaround time could be as long as 10 days. Restrictions have been tightened in a number of states and travel limited given this worrying trend. For example, there are now 22 states which must quarantine on arrival in New York state. 

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.

Homebase - a business support company - is providing tracking data on US small businesses’ operations, hours worked and footfall. That also points to a levelling in activity, with the number of firms open well below pre-Covid-19 levels. Building in these latest steers, we have lowered our anticipated economic rebound for the third quarter amid the increase in restrictions and the levelling off in real-time activity data. But we have pushed up our forecast for the second quarter, after the stronger than expected activity recovery so far. The net effect is actually a slight upgrade to our 2020 GDP forecast where we see -5.6% this year (previously -5.9%), while the 2021 rebound is now seen at +4.4% (previously +4.2%).

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. 

President Trump has provided little detail on his plans beyond the pre-Covid-19 2021 budget proposal. With the US’s recovery path set to be long, we expect the Fed to persist with its highly supportive stance. We see the federal funds target rate range remaining at 0.00-0.25% for the foreseeable future, potentially also with explicit forward guidance announced later this year. Amid the need to provide continuing support we do not expect the Fed to curtail its open-ended bond buying anytime soon, though the pace of purchases has eased back in June and July. Interestingly, the growth in the balance sheet has mirrored the recovery in equity markets.

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.

Since the peak of the Covid-19 economic hit in April, euro-area indicators have witnessed a rebound in activity. That has been across sectors; industrial output rebounded 12.4% month-on-month in May following April’s decline of 18.2%. Retail sales rose 17.8% and construction 27.8%. Nonetheless, the levels of activity remain hugely below pre-Covid-19 levels. For example, industrial output is still 19% lower than in February. However, it is worth noting that these numbers were for May when lockdown measures were first starting to be relaxed and timings differed across the euro area. As such June should see a further pickup in economic activity, but in all likelihood, pre-crisis levels of activity are unlikely to be regained for a year or more.

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.

ECB policy is set to remain exceptionally accommodative, with President Christine Lagarde suggesting that the central bank’s entire €1.35 trillion PEPP envelope would be used, absent a significant upside surprise. That puts the ECB on course to purchase another €1 trillion of bonds under the PEPP over the next year (purchases will also continue under the original Asset Purchase Program). For now, the ECB appears content that the PEPP has been effective in easing financial market strains, with sovereign yields retreating to pre-Covid-19 levels. As such, the pace of PEPP purchases has been reduced by some 30% to €20 billion per week. Perhaps coincidently, such a pace would see the ECB meet the €1.35 trillion total in June 2021, its proposed end date.

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.

Official figures continue to show a decline in the number of daily coronavirus-related fatalities, with the latest seven-day average standing around 70, compared with a peak of 1,000 or so in April. Reported case numbers have also fallen sharply, despite an increase in testing. The numbers do show a rebound in infections recently, but this may be due to outbreaks in specific workspaces and individual cities, such as Leicester. For now, this does not point to a higher generalised outbreak and at a national level does not threaten the relaxations in the lockdown or related economic activity. A well-cited Covid-19 metric is “Rt” (or “R”), the average transmission rate of the virus per person. Official estimates place Rt in the UK in a range of 0.7-0.9, modestly below the critical level of 1. 

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.

Further ahead the key will be the extent of second-round effects, in particular, how many of the 9.4 million workers on the Coronavirus Job Retention Scheme have no job to return to when it ceases in October. Indeed, unemployment is set to top 3 million if the re-hiring rate is much less than 80%. In his Summer Statement, Chancellor Rishi Sunak tried to smooth this cliff-edge by incentivising employers to retain staff, cutting Value Added Tax in the leisure sector and providing vouchers to subsidise restaurant meals. That ought to help prevent a double-dip recession, but the recovery’s momentum will slow, blunting any “V”-shaped recovery. 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%). 

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.