Global economy in self-isolation
Over the past two weeks prospects for economic growth have deteriorated in dramatic fashion as lockdowns, state-mandated or voluntary, spread like wildfire across the world.
A growth shock of unprecedented proportions
The resulting declines in economic activity look set to be unprecedented. We cut our near-term growth forecasts drastically from where they were only two weeks ago, with GDP contractions in the substantially affected economies - US, China, euro area, UK among them - to the tune of 4-10% in a single quarter. Hence, our forecast for annual GDP growth globally is down to 0.6% from 2.4% for 2020, with a particularly sharp revision for advanced economies, which we now expect to post an outright decline of -1.8% vs slight growth of 0.5% previously. The impact on emerging economies is somewhat milder - we now expect 2.2% compared with 3.6%, but note that while we cover 98% of advanced economies, we only cover 57% of the emerging economies universe and use IMF forecasts (currently from October 2019) for the remainder (based on IMF weights on a PPP basis). In other words, the magnitude of the deterioration in the outlook is much more clearly reflected in our numbers for advanced economies than for the emerging world. The true extent of the hit to the latter could easily be worse than we currently show.
A different sort of recession
The nature of this economic shock means that the roles of some sectors are reversed. Typically over the economic cycle, manufacturing is more volatile than services, and it's manufacturing that most often pushed economies into recession. In this crisis, in contrast, it has been services that have taken the much larger hit, at least to date. In contrast to leisure, travel and catering services, which have been largely shuttered in many places, factories by and large continue to operate. The PMI surveys reflect this with a far deeper slump in services than in manufacturing across key economies such as China, the US, the euro area, the UK, etc.
This has a number of implications. One, unlike during the Great Recession, economies with larger manufacturing sectors (Japan and Germany, for example, and also China) are not likely to be hit as hard as more service-oriented economies (the US, Spain, the UK, etc.). Of course, this will also depend on the extent of the epidemic in each economy and the duration of lockdowns.
Another implication is that the impact on unemployment will potentially be far larger than in previous recessions, given the high labour intensity of services. The extent to which this will materialise depends critically on institutional factors such as the ease of firing and the share of temporary employment, as well as arrangements such as wage subsidies in all forms. Hence, we expect the unemployment rate in the US to surge by around 3pp, compared with 2pp in the euro area. The degree of labour market deterioration will also play an important part in how severe second-round effects on demand are, once the supply-side shock has passed.
That said, it is by no means certain that manufacturing will remain as relatively resilient as it has been. Supply chain disruptions, especially emanating from China, may take a bit longer to trickle down the production chain, even as Chinese factory output should be back up to normal by April. In any case, anecdotal evidence suggests that these are not very widespread. Trade data from key Asian economies (Taiwan, South Korea) support the impression of relatively mild impacts.
Output will rebound for sure, but some damage will be permanent
It is far from clear how long the lockdowns or containment measures will remain in place but, based on China's experience, our working assumption is that these will last 4-8 weeks. That said, the risks are sharply skewed towards a longer duration, with only a minimal risk that they will prove to be more short-lived. During the lockdowns economic activity is likely to slump to perhaps 60% of normal for one or two months, with a relatively speedy recovery over the subsequent two or so months. Again, we use China as a guide, where by late-March the economy is thought to have been back to around 90% of normal activity.
In fact, some purchases are likely to have been merely deferred rather than entirely abandoned, arguing for a temporary jump to above the underlying trend, and a decline in economic activity in the subsequent period when demand returns to trend. However, much will depend on how quickly populations normalise their consumption patterns - a slow normalisation of consumption of leisure and travel activity, for example, could offset back-loaded consumption of other goods and service.
The bottom line is that, although a rebound is certain, part of the loss of output will be permanent. For example, for the euro area we now predict a cumulative loss of output over 2020-2021 of 3.5% compared with our pre-COVID-19 scenario. For the US, we put it at just over 4%.
Unprecedented policy support won't dent the slump much, but should boost the recovery
Our wholesale forecast revisions reflect the much faster and wider spread of COVID-19 and the greater severity of the containment measures than expected. But the other big change has been the roll-out of aggressive policy measures to deal with the damage. Governments pretty much around the globe have taken decisive fiscal action on a scale that has mostly exceeded expectations, along with many monetary policy moves of unprecedented size. Largely, governments have enacted the appropriate policies, aiming at support for household incomes and corporate cash flow and access to credit, while taking painful steps to contain the pandemic spread. The various measures are far too plentiful to go into detail here, but we are tracking them.
The fiscal and monetary emergency measures will likely have little impact on short-term dynamics which are being pummelled by lockdowns and containment measures. However, income transfers to those who have seen their sources of income disappear - temporary workers, many of the self-employed, etc - should support consumer spending when economies return to normal. Similarly, state aid to companies should sharply mitigate bankruptcies and hence job losses, so that when things normalise there is supply to meet the recovery in demand. In this context, moves by central banks to support the provision of credit to business are a vital ingredient.
Stock markets have validated the aggressive adoption of stimulus measures with a strong weekly bounce. What matters now is the speed and efficiency of policy implementation, which relies not only on public administrations but also on bank and non-bank financial institutions. This will definitely be very challenging, not least given reduced staffing levels as a result of the crisis. But the success or failure of the stimulus depends entirely on implementation, both for the economy and for financial markets.
Another surge in debt levels
The adoption of fiscal support measures, along with the impact of the crisis, mean a dramatic surge in public sector deficits and debt. We expect public sector deficits in 2020 alone to jump by nearly 4% of GDP in the euro area (to 4.6%), by about 5pp in the US (to 10%) and the UK (to 7%). In China, too, fiscal policy has shifted away from the recently-favoured approach of easing via tax and fee cuts and towards more traditional stimulus, i.e. infrastructure and other public investments. China has already announced an expansion in the deficit - albeit unspecified - and a restart of issuance of Special Central Government Bonds (CGB). We predict this is likely to run to CNY1-2tr (1-2% of GDP), although an even larger package is certainly possible. Cutting through the complexities of Chinese public finances, we put the expansion of the overall public sector deficit - including these special funds - at close to 4% of GDP (from 4.8% in 2019 to 8.5% in 2020).
All this will inevitably raise public sector debt levels, although in the euro area we expect a return to relatively small deficits in 2021. Germany, for example, where the swing in the deficit is likely to be particularly large (at 5.5% of GDP) has vowed to return to its balanced budget policy as soon as possible, but we doubt this will be achieved in full over the next four years. Hence, the increase in public sector debt in the euro area of about 8% of GDP is expected to be a one-off event, and the area's aggregate public sector debt ratio is expected to return to a downward trend, albeit a shallower one than before the crisis. In the US, total public sector debt has already been on an upward trend, and we think a roughly doubling of the deficit will push the debt ratio up by another 8pp this year and by another 5pp in 2021. A return to deficits in line with 2019 by 2022 will raise the debt ratio further given our expectation of deficits in the order of 5% of GDP, to 121% by 2022.
The sharp increase in public debt-to-GDP levels (and corporate debt is likely to increase as well initially) naturally raises the question about debt sustainability and an adverse bond market shock. There are strong reasons to doubt this is likely in the near term. First, public sector bond markets have been largely unresponsive to rising debt levels - see the US Treasury market. Two, central banks are once again stepping in with large purchases of bonds. And three, at least in the short term household savings rates are likely to shoot up. That said, whether record-low bond yields can be maintained over the medium term is another question, and even higher debt levels will exacerbate any future adjustment.
Inflation should end up being lower
The pandemic-induced crisis is in the first instance a supply-side shock, and as such it could trigger increased price pressure. In the near term there are concerns that in agriculture harvesting will be impeded as migrant workers will not be available given the wide-spread travel restrictions. This is certainly possible and plausible, and it would cause price increases. Other sectors could face similar short-term pressures. However, there are two powerful forces acting in the opposite direction. One, the slump in oil prices is already feeding through to lower gasoline prices and will feed through to other energy costs in time. Two, while the supply effects will be mostly temporary, the demand destruction points to lower price pressures beyond the near term.
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