The global economy is in the midst of a major contraction. The pandemic has resulted in varying levels of shutdowns across developed and emerging markets. This has caused a sharp deceleration of economic activities, countered with an unparalleled magnitude of monetary easing and fiscal stimulus. Now, parts of the economy are being reopened and it is likely that economic activity will pick-up gradually as more lockdowns are eased. Still, economic activity remains at suppressed levels and we estimate it will take well into 2022 for the economy to recover to pre-Covid-19 levels. Financial markets took a hit as the economy slowed. Generally speaking, risky assets nosedived as economies were shut and safe havens appreciated as investors fled to safety. Since mid-March markets have stabilized; some specific pockets of the markets have rebounded, but the overall picture is that risky assets still trade below pre-Covid-19 levels.
From shutdowns to unprecedented central bank fiscal responses
Across the globe, Covid-19 spread containing measures have caused a severe slowdown in many segments of the economy. Some sectors – such as tourism, entertainment and air travel – faced an abrupt cessation of activity, whilst other sectors remained open at lower activity levels. Both the pace and magnitude of the loss of economic momentum are extreme.
First quarter economic data revealed that almost all major economies contracted in Q1. Despite the fact that the contractions were the largest in recent history, the numbers fail to capture the depth of the virus shock as full lockdowns were only implemented at the end of the quarter. Second quarter economic data is far worse as several major economies were in lockdown for a large part of that period. The low point in economic activity was around April. The policies in many developed and emerging countries have now eased as observations of high-frequency mobility data show. Also, leading economic indicators are pointing towards a pick-up in economic activity.
The shutdowns had an immediate effect on labor markets around the world. Millions of people lost their jobs in a matter of weeks. In the US alone, more than 30 million employees filed for unemployment benefits since the outbreak of the virus. The job losses unwind more than 20 years of job creation, putting the number of employed workers back to levels seen last in early 2000. Europe is seeing a similar situation, where more than 40 million workers have been furloughed during the shutdowns.
Given the massive scope of the contraction, fiscal and monetary authorities have stepped in and adopted a "whatever-it-takes" response. Governments have announced large fiscal packages to aid the industries and workers most affected. The fiscal response to the Covid-19 crisis (including short-time work schemes, public credit guarantees and other direct and indirect support for firms and households) is helping to cushion the impact of the crisis. At the same time, most central banks have rapidly deployed a wide range of policy tools to ease credit conditions and provide liquidity. Central bank balance sheets have already increased to levels higher than during the 2008 financial crisis. Recent remarks suggest central banks will not hesitate to further expand the scope and depth of their policy actions if needed. These programs aim to avoid a structural loss of economic capacity and to support a recovery once the situation improves.
A rocky road ahead?
The economic outlook for 2020 and beyond is very uncertain and highly dependent on the virus developments. From an economic standpoint, it is of course not the virus itself which is inflicting the most economic damage, but rather the reaction of policy makers and the population. The economy-wide lockdowns were likely necessary at the time, but they are also a very blunt instrument with collateral damage. As we are now slowly learning more about the virus and how it behaves, targeted measures which balance the economic costs versus the health risks are more probable.
Clearly everyone is hoping for a quick and effective vaccine. We also will see better treatment protocols, contact tracing tools and other innovations which can limit the economic damage experienced during the lockdown phase. It's hard to forecast which of these will be most effective, however considering the amount of innovative ideas being researched globally, we are confident that some of these will yield positive results. That said, some sectors will not fully open until a vaccine is available and there will be a more permanent impact as many companies default and people lose their jobs.
Speedier recovery possible
There are basically two key differences between this crisis and previous crises, which might imply a speedier recovery. Firstly, the crisis is not caused by an economic imbalance which needs to be rectified. Therefore, once the virus is beaten, the economy could more quickly revert to its previous state. Secondly, fiscal and monetary authorities have been much more proactive, which limits more permanent damage to the economy.
Still we expect a serious economic contraction in 2020. A rebound is expected to gain momentum over the summer in line with removal of the most severe lockdown measures. No matter what, it seems unlikely that all economic loss until now can be regained quickly and that it will take well into 2022 to recover from the current contraction.
Another consequence of this crisis is the sharp rise in government debt. Deficits can reach levels of 10 to 20% in developed economies and will likely remain high next year. This will imply that government debt levels will far exceed 100% of GDP in many developed economies. Any sharp rise in interest rates, would make this debt unsustainable and would lead to an economic contraction. To prevent this, central banks will be forced to keep interest rates below inflation levels for a prolonged period of time. This form of "financial repression" was already common in Japan and the eurozone, but now the US will also be dependent on central bank support.
Emergency interventions to stabilize markets
Once investors absorbed the full implications of the pandemic crisis by mid-February, market liquidity in securities markets dried up and investors looked for safe havens. Asset prices corrected quickly and market volatility was very high. At times, pockets of the market were not functioning properly. By mid-March central banks announced major emergency programs and governments stepped-up fiscal efforts which provided a certain comfort to most markets. Since then, most markets have stabilized.
All major central banks have employed emergency programs to provide liquidity to markets, governments and corporations. This has pushed interest rates for the safest investments even lower. Credit spreads on government bonds with a higher risk profile – such as periphery bonds in Europe and government bonds of emerging markets – increased. In the corporate bonds space, credit spreads increased as the economic outlook for companies deteriorated and default risk increased. When central banks announced to step-up their monetary efforts – by increasing the scale and scope of their credit buying programs and via large scale liquidity programs – spreads stabilized (and even contracted from the record highs). Currently, there are two very strong dynamics at play in the bond markets. The unparalleled monetary policy programs have a downward pressure on yields, whereas the weaker fundamentals and large supply push spreads up.
Despite the recent recovery in equity markets, most major indices are still down. Global equity markets have been crushed with the S&P 500 experiencing its, fastest-ever descent into bear market territory from a record high. By mid-March most indices bottomed at around -30% and have since made-up some of the losses. The return dispersion between sectors is remarkable. Stocks in the financial and energy sector were hit hardest, trading at half of the price vs the start of the year. In contrast, IT and healthcare companies, which account for a larger part of the equity market in the US than in Europe, have seen their stock price go up. The sector dispersion partly explains why US indices have performed much better compared to European markets.
The coronavirus crisis has rattled the commodity markets, with oil prices plunging this year, and benchmark prices reached an historic low in April, even trading at a negative prices. The lower oil prices reflect lower demand and have been exacerbated by uncertainty around production levels among major oil producers. Also, the halt in economic activity has taken a toll on cyclical- and industrial commodities such as copper and zinc. Gold prices, on the other hand, have risen as buyers have sought safety amid financial market turbulence.
A mixed bag going forward
We expect sovereign rates to stay around their current low levels for a prolonged period of time as central banks will have to ensure favorable financing conditions to support any recovery.
Current spread levels provide sufficient compensation for default risk in the medium term. Especially, investment grade spreads are attractive as this asset class is also supported by central bank purchase programs.
Equity markets have run a long way from their March lows. In the short run, they will clearly react strongly to any developments surrounding the virus. Valuations are, especially compared to fixed income, still reasonably attractive for most sectors.
Mainly the technology sector is now trading at elevated multiples. however the Covid-19 crisis has accelerated the trend towards online shopping and working. These companies are therefore likely to cannibalize part of the earnings which used to go to other smaller companies. Earnings growth for the technology sector is therefore likely to remain high in the medium term. So betting against this group of companies, only based on their valuations, is likely to be a costly endeavor.