Will Covid leave scars on the world economy?

The world economy is expected to strengthen significantly later this year as lockdowns and restrictions are lifted. Social distancing and mask wearing are likely to persist, but the reopening of the service sector should bring the fastest GDP growth for a generation.

Such an outcome will be hugely welcome and is widely anticipated by investors, but we wanted to look beyond the rebound and consider what might lie in store as the dust settles.

What will be the longer-run effect of the Covid-19 pandemic on economic activity? Will it leave a lasting imprint on the economy that will affect our growth rate for years to come? Or will the effects of the pandemic be quickly shrugged off, allowing for a faster and sustainable rate of growth; a 21^st century version of the roaring twenties?

Three key questions/ challenges

The deepest recession in living memory might be expected to have a lasting impact. The contraction in the world economy in 2020 has been on a par with the Great Depression of the 1930s. For the UK we have to go back even further: the 9.9% fall in GDP in 2020 is the worst since 1709, the year of the Great Frost when agricultural production largely failed.

US unemployment surged to 14.8% in April last year. In the UK we estimate that true unemployment is around 20% of the working population, taking account of those who are officially unemployed or on furlough schemes.

 If we can rapidly get back to pre-pandemic levels of activity the scarring effects on economic behaviour should be reduced. For example, spending patterns can quickly normalise and on the supply side, skills lost during the downturn can be quickly regained after a short layoff.

In assessing the speed and scope of the recovery, we look at three key questions.

• What was the cause of the recession?
• Are there significant imbalances which need to be corrected?
• Will a disruptive re-shuffling of resources be needed to meet the patterns of spending in the new post pandemic economy?

1.      The cause: different recessions leave different legacies

There is a distinction to be made between recessions caused by external shocks and those which are endogenous or internally generated -  the former tend to see faster recoveries than the latter.

The current downturn is very much an exogenous shock as the Covid-19 pandemic stopped the world economy. In this respect it is similar to a war, where daily economic activity is brought to a halt and all attention is focussed on the more pressing battle for survival from the external threat. Once the “war” is over, the economy should quickly normalise as the threat is lifted.

By contrast, the prior recession in 2008-09, the global financial crisis (GFC), was endogenous as it originated in the financial system as a consequence of an overleveraged banking sector. Recovery from such recessions takes longer as the economic system has to repair itself before being able to resume growth. Recovery was weak after the GFC as banks and households had to strengthen their balance sheets in the wake of the collapse of the sub-prime mortgage and housing markets.

Private spending was constrained by de-leveraging as these sectors cut their gearing levels. Governments also chose to repair their finances through a series of austerity programmes so as to reduce borrowing.

The result was a slow and fragile recovery with economic activity not returning to the pre recession levels of Q4 2007 until 2011 in the US and eurozone, and 2012 in the UK. Within the eurozone, Italy has never returned to its pre-GFC level of activity.

From this perspective, the odds are for a better recovery than 10 years ago. In our current forecasts we see activity returning to pre-pandemic levels in Q2 this year in the US and Q4 next year for the UK; periods of 1 and 2 years respectively. The shorter downturn should mean fewer long run effects where workers lose skills and become permanently unemployed, known by economists as “hysteresis”.

2.      Imbalances: debt and deficits

However, the pandemic has created significant imbalances. The impact on government borrowing has been enormous and similar to the GFC. Figures from the IMF show public debt in the G20 advanced economies to be at levels last seen after the second world war.

For the US, figures from the Federal Reserve (Fed) show a government deficit of more than 15% of GDP and gross debt at over 120% of GDP. Corporate sector leverage has also increased sharply, although household gearing has been relatively stable, reflecting the support for incomes provided by the government and the lack of spending opportunities (chart 1).

Judging from the rhetoric, it would seem that governments have learnt the lesson of the post GFC recovery and are not planning a tightening of fiscal policy to restore the public finances. Indeed, the new US Treasury Secretary Janet Yellen has talked of the need for fiscal policy to “go big” to prevent a repeat of that period, even if it risks higher inflation. The IMF and World bank have both been vocal on the need to keep fiscal support going.

In our view, such a position makes sense, but we should recognise that it will have to be accompanied by an extended period of low interest rates to be sustainable.

UK Chancellor Sunak noted in his recent budget speech that 1% on the cost of borrowing in the UK adds £25bn to the budget deficit. Although this highlights the vulnerability of the government finances, in practice it means that the Bank of England (BoE) and other central banks will be mindful of the effects of their actions on debt sustainability.

As we recently argued in The Zero: why interest rates will stay low: “In this environment, the pressure on central banks to keep rates low will remain strong. Not just to maintain overall policy stimulus, but to ensure that high debt levels remain sustainable”.

We plan to look at government finances in more detail in a forthcoming article, but at this stage would note that fiscal dominance of monetary policy is becoming the new reality.  

For the private sector, households are not under pressure in aggregate given the sharp increase in savings during the pandemic. Gearing levels are within normal parameters, indicating little pressure to retrench. There are exceptions though, and the pandemic has been notable for its effects on lower income groups. Employment among low paid workers in the US has fallen by 20% during the pandemic.

A quiet financial crisis?

The corporate side has raised more concerns and Carmen Reinhart, Chief Economist at the World Bank, has spoken of a “quiet financial crisis” where lenders have to grapple with an extended period of non performing loans (NPLs).

Financial institutions around the world have allowed grace periods for repayment of existing loans during the pandemic, while governments have introduced special lending facilities to help those most affected by the crisis. The aim is to tide these firms and households through the worst of the crisis so they can resume normal payments once the economy recovers. However, it will leave a legacy of NPLs which will need to be cleared up.

While this is a concern, we would note that the banking sector is now better capitalised to absorb losses as a result of the regulation introduced after the GFC. The Fed recently noted how a more resilient financial system has helped the economy and how the solvency of banks has not been in doubt during the pandemic. Indeed, strong lending in the housing market has helped support activity.

Alongside the aggressive easing of monetary policy, a sounder financial system will also have helped prevent financial stress becoming the sort of cascading event which can cause a liquidity crisis in the economy as in the GFC.

The St Louis Federal Reserve stress index tracks a range of financial variables which reflect risk in markets. After a spike at the beginning of the pandemic last March, it has fallen back to pre-crisis levels. Meanwhile, bank lending conditions have also returned to pre-pandemic levels (chart 2).

The commitment of governments to support activity through this channel remains high.  Programmes are being extended where necessary to prevent a cliff edge where all support is withdrawn at once.  Nonetheless, the NPL issue means that governments will end up with more debt on their balance sheet as they are forced to nationalise private sector losses. For example, the National Audit Office has estimated that the UK will write off some £31bn in government-backed loans.

Corporate resilience

Looking at the US corporate sector data also suggests that these concerns over a crisis may be misplaced. The sector is currently in a small financial surplus after deducting investment spending (chart 2).

In the past a deficit has proven to be a timely warning that business is about to retrench, which is not the case today. The fall in interest rates is helping to keep gearing levels low and corporates have raised record levels of capital in the bond markets. Moreover, the current position of surplus has not been driven by a cut in fixed investment. It instead owes much to the recovery in activity which has already boosted cash flow and profits.

This marks a key difference with the global financial crisis where capex collapsed and was the biggest contributor to the downturn in 2008 and 2009 (chart 4). This time around business investment did weaken in the initial downturn, but it is now strengthening, with surveys suggesting that this will continue in coming months (see chart 2 above).

Looking at the sector breakdown, spending on tech hardware and software have strengthened during the pandemic and have offset weakness in other areas such as non-residential construction. The accelerant effect of Covid is important here, as businesses have had to step up their digitisation processes during the pandemic to meet the surge in online demand (chart 5).  Extra corporate investment to facilitate working from home is also playing a significant role through strong sales of laptops and headsets. We discuss the disruptive effects of these trends on the retail sector below. 

The improving picture in capex is important for another reason: it suggests that the damage to the supply side of the economy will be limited.

Analysis from the European Central Bank shows that after the GFC the loss of capital stock was the main drag on potential output growth. The current revival in capex suggests that workers will not be short of equipment and consequently their productivity will be less affected.

Our analysis so far suggests that the prospects for a return to normal growth rates looks promising, given the relatively rapid bounce back in the world economy, the absence of major imbalances and the revival in investment. The rise in government debt could challenge this. And we would be more cautious should policymakers decide to head down the austerity route and squeeze the economy as after the GFC.

3.      Disruption: how will post-pandemic spending look?

The remaining challenge is how much re-shuffling of resources will be needed to meet the patterns of spending in the new post pandemic economy?

We are looking beyond the initial spending surge as consumers are released from lockdown and thinking about a new equilibrium. How will the experience of the pandemic affect what we buy and make as we move through the 2020s? Are we looking at significant disruption as businesses close, capital is scrapped and workers made unemployed?

Anticipating future demand is always fraught with uncertainty, not least because we do not know many of the products that will be created or how future shocks might affect spending.

We assume that the pandemic ends and the virus becomes endemic; always with us but not the same threat to everyday life. The strong performance of the industrial sector through the pandemic means that the focus will be on recovery in disrupted sectors such as retail, travel, accommodation, arts and entertainment.

WFH to persist

Here we may see some permanent changes as the lockdown has demonstrated that people and businesses can function remotely working from home (WFH).

Surveys from Global Workplace Analytics suggest that the remote working experience has been positive and 76% of people globally would like to continue WFH two days per week.

This may not come to pass, but could have many effects, an immediate one being a 40% reduction in commuting. Such a development would not just affect train and bus companies, but also the retail outlets which cluster around transport hubs. Businesses will also question the amount of office space they need, thus putting pressure on towns and cities to reinvent their commercial districts. On a more positive note, WFH makes it easier for many to join the workforce given commitments and constraints which would normally limit their ability to commute, potentially increasing the labour force.

Travel will come back, but to where?

International travel can be expected to pick-up, but will be constrained by concerns over new variants of the virus which will rule out many destinations. And cost conscious businesses will ask whether such meetings can all be done using services such as Zoom.

There is also a big question over how much and under what conditions countries will be prepared to re-open, particularly those which have been pursuing a “zero Covid” strategy. The new world will be one of vaccine passports and certificates.

We also have to consider the supply reaction. Some businesses will fail, which will reduce the capacity or supply potential of the economy. However, industries such as airlines and hotels with considerable fixed overheads will be looking to maximise passengers and guests. This could result in a combination of stronger volumes and lower prices and may spur productivity as firms will need to price as competitively as possible. If these sectors do not recover then there would be a significant amount of capital which will have to be scrapped, such as aircraft and transport infrastructure.  

Covid the accelerator

For the retail sector, the pick-up in online spending has accelerated a trend which has been in place for some time. There have been several high profile stores which have said they will not fully re-open once restrictions are lifted.

Layoffs will increase unemployment and exacerbate the problems in town centres. From a macro perspective, though, unless there is a significant fall in retail spending, productivity will increase. In the UK the retail sector has been a bright spot in the productivity figures as a result of this trend toward online.

The pandemic is also likely to give productivity a further boost through the adoption of Artificial Intelligence and robotics, the so-called fourth industrial revolution. The desire to bring supply chains closer to consumers and reduce the risks associated with labour (robots do not get ill) is another route through which Covid is accelerating existing trends.  

Greater disruption in the 1980s and 1990s

However, the benefits to growth from stronger productivity would be eroded if we see a significant rise in unemployment and loss of capital investment.

In gauging the potential disruption the BoE recently published estimates of how much task reallocation would be needed in the labour market as a result of changes in expenditure patterns. Assuming that Q3 2020 represents the new normal for spending as the first lockdown was lifted, the BoE estimates that there would be an above-normal level of task reallocation. This would test the flexibility of workers to acquire new skills and move sectors. However, it also notes that even such an extreme scenario would require much less task reallocation than occurred during the 1980s and early 1990s, when employment in manufacturing fell by 10 percentage points.

On the capital side, much IT and communications equipment can be easily re-deployed. It is also possible to repurpose buildings, turning office to residential for example. Although many will be in the wrong place. The challenge comes in more specialist areas such as transport, discussed above, where it is difficult to repurpose equipment and can lead to scrapping.

Conclusions

There will be scarring effects from the pandemic and most economists expect trend growth to be reduced as firms close and some workers become long-term unemployed. For example, the BoE expect the UK’s supply capacity to be 1.75% lower by the end of 2023 than it would have been in the absence of Covid-19.

Although we acknowledge the uncertainties around this, we are more optimistic. Particularly in economies like the US and UK, which have flexible labour markets able to reallocate labour more easily than, for example, the eurozone.

Moreover, economies have faced greater structural changes, for example the shift in manufacturing away from the West to the East.

More generally, lessons learnt from the GFC mean that we are not experiencing a systemic liquidity or credit crunch and the authorities recognise the need to keep monetary and fiscal policy support in place. Recovery should be faster as a result, limiting the ultimate impact on trend growth.

On the productivity side the reallocation of resources will be painful, but it will enable firms to be more efficient, no doubt increasingly aided by new technology.  

The announcements in retail are an example of this and the turn in capital expenditure suggests that firms are already looking to adapt to a new more digital and probably more remote future.

Although there are still considerable uncertainties over the path of the pandemic and the global vaccine roll-out, these factors point more towards a brighter path for the world economy than experienced after previous recessions.