The Outlook: April 2020 Economic commentary

 

Some thoughts on the longer-term economic impact of coronavirus

The lockdowns implemented in a bid to contain the spread of covid-19 are taking a heavy toll on the global economy. The precise extent of the contraction is unknowable at this stage, but with economies being put into a ‘medically-induced coma’ there is broad agreement that global GDP is about to see its worst contraction since the Great Depression. 

In the near-term, the economic outlook hinges crucially on trends in the virus: the speed with which infection curves can be flattened; the timing of when containment measures can be relaxed; whether we see subsequent waves of infection; the rollout of an effective treatment/vaccine etc. 

In addition, the capacity of the economy to bounce back once the virus abates will depend on the degree to which it has been ‘scarred’ by the lockdown: the scale of bankruptcies; the extent to which rising unemployment affects longer-term work prospects; the degree to which business and consumer behaviour becomes more cautious and precautionary savings increase etc. Despite attempts by governments to mitigate these adverse effects, the severity of such ‘scarring’ is likely to increase the longer the lockdown goes on.

Against this backdrop, there is a high degree of uncertainty regarding the outlook during the coming months, and both the economic data and financial markets are likely to be volatile. With this in mind, it is worth taking time to stand back from the noise of the daily news flow and consider what might be the longer-term economic impact of covid-19.

Online living

In some respects, the coronavirus crisis will serve to accelerate trends that were already in place prior to the outbreak. One obvious area is the shift towards moving more of our lives online. The lockdown has seen us turn to our internet-enabled devices to work, shop, socialise, educate and be entertained.

Although social distancing is currently forcing us to find ‘virtual’ alternatives to everyday, ‘real-world’ activities, the expectation is that once people become accustomed to the convenience of online life, there will be a more permanent shift in behaviour. With e-commerce accounting for around 14% of retail sales globally in 2019, the move towards online shopping clearly has a lot further to run. Similarly, only around 3% of the US workforce regularly work remotely, providing scope for further increase.

The market is rewarding the immediate beneficiaries of these trends; the shares of Amazon, Netflix and Zoom have all hit record highs recently. In turn increased traffic volumes will require more online infrastructure. In contrast, such trends would compound the woes of ‘bricks and mortar’ retail and impact on demand for parts of the commercial property market.

Deglobalisation

The coronavirus crisis also carries the potential to accelerate the trend in deglobalisation witnessed in recent years. On some measures, notably world trade to GDP, globalisation ‘peaked’ just prior to the financial crisis. Over the last few years, natural disasters (notably flooding in Thailand during 2011) and increased protectionism (most visible in the form of the US-China trade war) have caused global businesses to rethink their supply chains.

The coronavirus pandemic promises to further push companies towards prioritising resilience of their production networks, even if this comes at the expense of efficiency. For some companies this might mean diversifying away from an over-reliance on Chinese suppliers.

For others, it might mean relocating production back home or ‘reshoring’. Indeed, as part of its recent economic stimulus package, the Japanese government provided some Yen220bn to support companies shifting production from China back to Japan. The experience of national health systems scrambling to secure medical supplies during the covid-19 outbreak might push some governments to strive for ‘self-sufficiency’ in the production of certain goods deemed strategically important.

Moreover, some observers have suggested that health concerns might be used to justify restrictions on travel and migration. Even in the absence of formal curbs, there might be, initially at least, a greater reluctance to travel. This could have a lasting impact on countries dependent on tourism, and universities reliant on the fees of overseas students.

Bigger government, bigger debts, bigger central bank balance sheets

The extraordinary disruption resulting from increasingly widespread coronavirus lockdowns has ushered in unprecedented intervention from both governments and central banks. Governments around the world have introduced a series of measures (including work subsidy schemes, support for businesses and the self-employed, benefit top-ups and one-off payments) designed to soften the economic blow from lockdowns. On some estimates, this policy support adds up to around 5% of global GDP.

With taxation revenues also set to fall sharply, this suggests that much higher public debt burdens will be a lasting legacy of the corona crisis. The IMF estimates that, globally, net public debt is on course to rise from 69.4% of GDP in 2019 to 85.3% in 2020. In much of the developed world, increased borrowing will, in the near-term at least, effectively be financed by central banks; the US Fed, European Central Bank (ECB) and the Bank of England (BoE) have all restarted or stepped up their quantitative easing (QE or buying bonds) programmes in recent weeks.

This new-found ‘co-ordination’ between governments and central banks has the potential to influence policy long after the virus has come under control. Now that governments have discovered the “magic money tree”, it will become increasingly difficult for politicians to resist “worthy” demands for increased public spending. In the UK, for example, there will no doubt be pressure for a big increase in spending on the NHS, and surely doctors and nurses (some of whom saved Prime Minister Boris Johnson’s life) might expect a decent pay rise. With covid-19 having exposed a lack of preparedness to fight a pandemic, there will be calls to strengthen defences against other existential threats, not least climate change. All of this points to an increased role of the state.

Who will ultimately pick up the tab for increased government spending? With the coronavirus crisis having exacerbated income inequality, tax increases on the wealthy might be politically expedient. However, there is a good chance that the increase in debt will just be left to sit on central bank balance sheets.

Notionally independent central banks will deny that their purchases represent monetary financing of the budget deficit. However, central bank balance sheets are likely to be permanently larger and there will be pressure on policymakers to keep interest rates negative in real (i.e. inflation-adjusted) terms to cap debt servicing costs. To get an idea of how far western central banks could go, it is instructive to note that the Bank of Japan’s balance sheet currently amounts to around 108% of GDP - much higher than that of the Fed (27%), ECB (43%) and the BoE (22%). There has been speculation that the Bank of Japan’s policy of yield curve control – under which the bank buys bonds in sufficient quantity to peg 10-year bond yields at zero – could also be emulated by other central banks.

Deflation now, inflation later

With coronavirus containment measures giving rise to steep declines in economic activity, the near-term outlook is deflationary. Just how one measures prices when many services (e.g. restaurants, cinemas etc.) are not even available is a moot point. However, with Brent Crude currently trading more than 50% below year-earlier levels, the drop in oil prices alone could send headline inflation in some countries into negative territory during the coming months.

However, further out, there is potential for inflation to pick up. Economists of a monetarist persuasion point to the jump in broad measures of money supply as a source of future inflationary pressure. Fiscal and monetary stimulus could potentially combine with pent-up demand to lift prices when lockdowns are eased. A wave of bankruptcies during the coming months might enhance the pricing power of those companies that survive. Moreover, going in to 2021, the drag on headline inflation rates from low oil prices is likely to fade.

Over the longer-term, a gradual reversal of globalisation and the rise of economic nationalism could result in less efficient production processes and reduced competition. In addition, increased hiring in the state sector and higher pay demands for low-paid ‘key workers’ could put upward pressure on unit wage costs across the whole economy.

Developed economies are not about to experience a bout of hyperinflation akin to that seen in Germany during the 1920s. However, there is every chance that the post-covid era will usher in a period of above-target inflation. Indeed, following an extended period during which inflation has undershot official targets (generally around the 2% mark) in the US, Japan and the eurozone, some central bankers might positively welcome a period of above-target price increases.

Needless to say, government bond markets in the developed world are not currently priced for such an outcome. For example, in the US, bond markets are pricing in expectations for inflation to average around 1% over the next 10 years. Central bank buying of government bonds and a possible move towards yield curve control would suppress nominal bond yields, with the result that a rise in inflation expectations would lead to even more negative real interest rates. As a result, the appeal of assets that offer some degree of inflation protection would be enhanced.

17 April 2020

This article is for generic information only and is not suggesting a suitable investment strategy for you. You should seek independent financial advice that takes your individual circumstances into account prior to proceeding with any course of action.