COVID-19: The global economy in the age of universal quarantine
COVID-19 forced governments to pause an unprecedented period of at least three months to flatten the new cases and deaths curve. In January this year an outbreak began, which along with a supply shock concentrated in China, caused secondary shock waves in world trade, interrupted supply chains and led to rapid price volatility (declines) in financial markets. Investors realized the imminent recession. Policy makers have taken extraordinary measures to flatten the recession curve. Due to the expected rapid global recession in 2020 in the vast majority of developed and emerging economies with the option of a possible “U” recovery (in the optimistic scenario of the transitory nature of the epidemic), both the ECB and the FED decided on a violent response aimed at saving the economy (EUR 1.1 trillion and USD 2.3 trillion of liquidity delivered respectively). Central banks acting in consultation with governments and legislative bodies, have launched business-friendly fiscal programs, providing 0.5-1.2 percentage points of GDP growth (mitigating the effects of recession) to avoid a cash flow and liquidity crisis and network protection.
In the case of capital markets, for the situation to improve, it is likely to get worse. For enterprises, we expect a 20% increase in insolvency worldwide in the longer term in 2020/2021. Negative news has not yet been fully discounted by the market. We are dealing with a test of extreme conditions, liquidity and the risk of wrong political decisions. Central banks reacted quickly, but the effectiveness of distribution of the offered funds and the way they are used remains an open question. Compared to 2008, the level of debt increased significantly and the assistance offered is not stimulating but stabilizing. To what extent does the assistance offered include entities operating in an effective manner and how far does it enable the temporary survival of zombie entities? The current situation has very far-reaching implications and the longer the lock-down process lasts, the more irreversible its effects will be. We are dealing with an indebted global economy, printing money and redistribution of resources, interrupted productivity, which may rebuild over time, high unemployment and zero interest rates. Policy makers focused on alleviating the severity of the cash flow crisis, avoiding a more serious liquidity crisis and protecting the network. Fiscal programs have been designed to reduce pressure on corporate cash flows through credit lines and public guarantees, as well as to defer spending (taxes, interest, etc.) and to support household incomes by increasing social network security and implementing income subsidies. Monetary policy has gone from ‘everything you need’ to ‘execute’ mode, providing extraordinary liquidity measures and a backward block. Fiscal measures will provide countries from 0.5 percentage point (Spain) to 1.5 percentage point (Germany) and over 1 percentage point of GDP growth (US) – cash to preserve monetary policy transmission and prevent COVID-19 from forming second-round effects for the financial system.
In China, the authorities reacted just as quickly. On the monetary side, since the beginning of February liquidity injections in the form of open market operations (1.7 trillion RMB), medium-term loans (RMB 300 billion) and a reduction in the required reserves ratio (RMB 550 billion) – a total of 2.5 trillion RMB (2.4 % of nominal value of GDP). The highest loan rate was reduced by 10 pp, banks were instructed on the need to provide favorable credit conditions for companies in need. On the fiscal side, local authorities increased bond issue. We estimate that fiscal costs for companies this year will be reduced by RMB 1.5 trillion by cutting tax burdens and social security payments. Overall, we expect the 2020 budget support package to be 4.4% of GDP, compared with 5.7% in 2018-2019. At this stage, fiscal support seems stronger than easing monetary policy, which remains a long-term goal. The priority of Chinese policy makers is to help alleviate the economic outbreak and the effects of potential secondary waves, while controlling the level of debt.
In Europe, governments have launched public guarantees of € 1 tn for the eurozone alone (EUR 500 billion in Germany, EUR 300 billion in France, EUR 100 billion in Spain) to prevent the rapid increase in the number of corporate bankruptcies, increasing fiscal expenditure by EUR 250 billion . The measures include tax moratoriums, partial unemployment and support from national banks. The ECB has launched, in addition to monthly QE purchases of EUR 20 billion and the recently announced (March 12) over 120 billion EUR envelope, a new temporary Pandemic Emergency Purchase Program (PEPP) worth EUR 750 billion (around 6% of eurozone GDP). This gives a total amount to buy for the rest of the year about 1.1 tn Euro, with lifting the limitations of the issuer limit if necessary.
In the United States, the White House has announced a fiscal package worth USD 1 tn (4.6% of GDP), including cash payments for households, paid sick leave, food aid, loan guarantees for enterprises, granting loans, tax holidays and infrastructure expenditure and health care. The Fed reduced interest rates to 0-0.25 bp and solved liquidity problems periodically by announcing on April 9 this year aid program worth USD 2.3 tn. The program in particular consists of: Main Street Lending Program, Municipal Liquidity facility, Paycheck Protection Program Lending Facility and expansion of existing primary and secondary corporate bond purchase instruments (TALF, PMCCF, SMCCF). Those interested in the details of the program launched by the FED are referred to our article on the subject (article link).
Table: Costs of stabilization fiscal programs, their share and impact on GDP growth and fiscal deficit.
Source: RCieSolution Research
In emerging markets, some might benefit from fiscal space and quantitative easing. In Asia, moderate public debt burdens (with the exception of India) allow freedom of fiscal policy – South Korea, Taiwan, Hong Kong, Singapore and Malaysia have already announced fiscal stabilization measures. In general, the good fiscal situation in the developing countries of Europe and significant sovereign wealth funds will allow governments to increase spending freely. Larger economies in these regions have announced significant stabilization packages. This will increase budget deficits and the burden of public debt. Public debt spreads of unstable foundations have grown, making financing more expensive – Romania, Hungary, Turkey, Oman and Bahrain. South Africa, Brazil and crisis-stricken Argentina have less room for fiscal stimulus, while the rest of Latin America has some freedom. Countries with limited room for maneuver may seek the assistance of the IMF and the World Bank, which have announced that they will be ready to support countries affected by COVID-19 worth USD 50 billion and USD 12 billion, respectively. As regards monetary policy, the impact of recent currency devaluations on inflation is expected to be moderate in most Central European countries, especially as the fall in oil prices will (partly) offset pressure on price increases. And because inflation is generally under control in Asia and Latin America, monetary easing in these regions is likely to continue in the coming months. In developing countries, Europe generally has less freedom in monetary policy because interest rates are already low and real interest rates are negative in many places.
Uncertainty may be compounded in the second half of the year in connection with the US election, continuation of Brexit and a combination of higher inflation and higher taxes to absorb the transfer of liabilities from the private sector to the public sector in time. This will most likely be associated with a change in the way the world economy works. There is still a high risk of re-evaluation of the debt of BBB-rated companies, whose weight in the credit market has increased significantly over the past few years. Issuers constituting the so-called the lower threshold (BBB-) represents 11% of the global corporate bond index, which corresponds to a volume of USD 1.3 tn. Any major re-evaluation would mean huge flows in a market segment with already limited liquidity.
Risk of liquidity crisis
The longer the COVID-19 shock lasts, the more the current liquidity crisis can turn into a full-fledged debt crisis involving businesses and home debtors, their private lenders and public authorities – treasuries or central banks. A number of market indicators show that investors are afraid of this risk: corporate spreads have increased, as has Libor-OIS (overnight indexed swaps). CDS rates increased, as well as expected yields on commercial papers. Shares of banks were one of the most affected by the discount, as well as shares of asset management companies. More and more signals indicate that the supply of liquidity on financial markets is severely limited (the ability to quickly transform assets into liquidity at low costs). This is especially true in the bond market, where supply is mainly provided by financial intermediaries (market makers). Liquidity crises usually first appear in peripheral market segments, for example in government bonds of small euro area countries. Spread volatility also increased. Investors are trying to reallocate physical positions, but liquidity inflow is very low. This highlights the risk of so-called liquidity bifurcation, where liquid market segments become more liquid and non-liquid segments become more non-liquid. In the case of the euro zone, this can have similarly destructive effects as an increase in the spread due to budgetary risk, because for smaller countries this means a risk of losing access to the financial market. Bad performance of specific entities, especially in the area of asset management, should be monitored. The basic question arises about the level of competence. Is the managerial license really required in some countries (e.g. Poland) to ensure the required level of competence? Can the answer to this question be found in the results of the asset managers?
What awaits us at the end of this road
There are definitely more questions. One day it will be time to talk about it extensively. The optimistic scenario provides for a 3-5 month blockade combined with quarantine. Chinese data for the period January-February this year. suggest that each month of imprisonment resulted in a 13% decrease in consumer spending, a 20% decrease in investment and a 16% decrease in exports. It is difficult to estimate the expected date of return to activity. Maybe it will be Q4 2020, maybe 2021. We have refrained from presenting model projections of GDP and global trade dynamics, because such projection may be burdened with a big error (duration of the epidemic, risk of secondary waves of epidemics, interruption of supply chains, efficiency of allocation and utilization of aid funds, reallocation of wealth). At this point, we will limit ourselves to saying two things: the world economy will probably find itself in a deep recession (perhaps it will be a long-term depression lasting at least 3 years), the probability of conducting a deep reset of the financial system and creating a new one, which (we hope) will not will be based on such a large polarization of income and wealth of the society (a small percentage controls 95% of wealth), as has been the case so far.
There may and will be difficulties related to the reactivation of the economy and the tail risk of wrong political decisions. The answer to this crisis is the systematic support of private entities by reliable institutions, states and central banks ready to do everything necessary, even exceeding their mandate. As a result, restarting the economy will require precise, collaborative, transparency and mutual trust movements to enable prices to be discovered in reactivated markets and supply chains. Trust will be crucial for re-opening borders and economic exchange and how people will relate to each other remains an open question and crucial for the future of the economy and globalism as such.
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The views expressed in this document do not constitute research, are not investment or commercial advice and do not necessarily reflect the views of all management teams. They change over time.