Perspective

Economies in free fall as hopes fade for a V-shaped recovery


We have always argued that the current quarter would see the worst economic news on activity. Our forecasts already feature a significant decline in activity in Q2 with US GDP contracting by 22% q/q (not annualised) for example, so the latest PMIs should not prompt major revisions.

For us, two factors are key for the path of activity going forward: firstly, the response of governments and the banking system; and secondly, the speed with which lockdowns can be lifted.

Key test for policy and the banking system

First, as the economic storm intensifies it is vital that policy support comes on stream where it is needed. The fall in activity will put severe strain on corporate finances and will result in a significant wave of bankruptcies and layoffs. This is where government support packages will be vital in cushioning the blow and preventing the economy from tipping into a much deeper recession. The danger is particularly acute for smaller companies which do not have the same access to credit as their larger counterparts.

This period will also be a key test for the banking system which will be expected to continue to extend liquidity. It was notable that in reporting JP Morgan’s latest results CEO Jamie Dimon said that companies were drawing on their credit lines at twice the pace seen in the financial crisis of 2008.

Elsewhere, banks have followed government instructions to cancel dividends and build up capital to meet losses and the European banking sector has lost half its value year-to-date.

With shareholders on the hook there will be no direct bail outs of banks this time. Nonetheless, in extending quantitative easing (QE) to commercial paper and corporate credit, central banks such as the US Federal Reserve, European Central Bank and Bank of England are bearing much of the risk. As, of course, are governments through loan guarantee schemes.

Fading hopes for a V-shape recovery

While the first factor concerns the present, the second looks ahead to how quickly credible exit strategies can be developed for the lifting of the lockdown.

Those nations which have been ahead in the process of returning to work have seen the emergence of secondary infections and are having to pursue a gradual lifting of restrictions.

There have also been signs that consumers are reluctant to return to shopping malls and restaurants on fears for their physical and economic health.

It would not be surprising if consumer caution were a feature of the global recovery given the shock to the economy and employment, thus tempering the upswing. Alongside a more cautious consumer we are likely to see slower business spending as ongoing uncertainty will inhibit the willingness to make major investment commitments. Higher savings and lower investment would reinforce slower growth and lower interest rates.

The pressure to lift the lockdowns more rapidly will now intensify as the economic damage becomes more apparent. However, our current thinking is that the V shape recovery is too optimistic and we are likely to be revising down our forecasts for global growth in 2020 in our next forecast round. The recovery will be weaker and delayed, closer to a U-shape.

The hope would be that with a more gradual lifting of restrictions the world economy should be able to avoid a significant second wave of infection and the double dip recession, or W scenario.

The return of inflation… or deflation?

How will inflation play out? As anyone who has tried to obtain a tin of paint during the lockdown can testify, there are bottlenecks in the system as a result of disruption to supply chains. Moreover, there are fears that the scale of the fiscal and monetary stimulus will result in a significant rise in prices in 2021 as the world economy finally recovers. There are also serious concerns over the supply of food, where labour shortages may slow the harvest due to restrictions on mobility.

At this stage though we see little prospect of inflation. Commodity prices are in retreat and will keep inflation low in coming months. Looking further ahead, the recession is likely to keep inflation under control well into next year given the long lags between growth and prices. During this period the risks may run the other way such that we see a spell of deflation as the output gap opens up and puts downward pressure on inflation, which is already below 2% in many economies. Clearly, the reduced likelihood of the V forecast increases the time taken to return to trend and the risk of deflation.

Permanent effects from the crisis: scarring

Although the policy aim is to prevent the pandemic from having a lasting effect, the economy which emerges from the crisis will be different. Travel and tourism, for example, is likely to be considerably weaker, whilst the trend toward greater home shopping and working from home will accelerate at the expense of High Street retailers and offices.

Business is likely to rethink supply chains and its dependence on distant travel links. There may well be a preference to move more production closer to home, although this may mean more automation rather than a big rise in demand for local labour.

Eventually, trend growth may be restored, but more immediately the dislocation will lead to a period of weaker activity as the world economy adjusts to a new equilibrium. Just as we saw after the global financial crisis, significant recessions can have lasting effects on productivity and growth with adverse effects on living standards. In this environment, government debt levels may be permanently higher.

We plan to explore the post-Covid-19 economy further in coming weeks. In the meantime we would emphasise that there is more bad news to come on the economy and confidence in policy support will be tested, thereby intensifying pressure to lift the lockdown. However, whilst we believe policy can help business bridge the financing gap, it will be the difficulties in devising a successful exit strategy which will delay the upswing and turn the V into a U.

 

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