Into the west

Slightly more than a month ago, the market’s focus was squarely on the impact of the coronavirus epidemic on supply chains in Asia. Analysis – ours included – was on the possible ramifications of Chinese economic disruption on the global economy.

Since then, a global pandemic has erupted as the virus made its way across the globe, into the West. Locally transmitted cases in China has mostly plateaued while those outside of China has grown exponentially, driven primarily by infections in Europe and the US.

#flatteningthecurve

Complacency about the risk of contagion has come to roost, as the US and its European partners scramble to contain the virus by shuttering non-essential businesses and implementing social distancing policies. Italy, France, Spain, Belgium and Ireland have announced national lockdowns in a bid to arrest the rise in infections.

In the US, state-level response has been varied. Coastal states like New York and California have banned large group gatherings and temporarily shuttered businesses whilst implementing strict social distancing policies. Other states like Florida have not pushed social distancing policies with the same intensity, even leaving public beaches opened for Spring Break.

In Europe, Italy has been the hardest hit by the Covid-19 pandemic, in large part due to its older demographics. With 23% of Italians aged 65 years or above, Italy has Europe’s oldest population.

As was observed in China, the elderly are the most vulnerable to the coronavirus. The scale of the pandemic has put tremendous strain on Italy’s national healthcare system, forcing healthcare professionals to make tough choices when faced with the option of dispensing treatment between elderly and young patients. Italy’s crisis is a cautionary tale about the steep cost of not containing the infections, and soon.

Governments have to make a choice between bad and worse. To contain the virus, you require social isolation; to keep economic activity going, you need integration. Indeed, the cure for the virus pandemic necessarily incurs huge economic damage.

A near-term recession is almost a foregone conclusion. How deep and long it will be is a matter of debate. Much depends on how the pandemic plays out, the capacity to respond to the health crisis and the time taken to contain the virus.

To this extent, countries like China, South Korea, Japan and Singapore have elicited the praise of the World Health Organisation for the effectiveness of their responses.

In a sense, these countries had learnt difficult lessons in containment and health care during the SARS epidemic in 2003, a tame outbreak in comparison. That has arguably led to better healthcare infrastructure. Such institutional knowledge has been put to great use in responding to the current epidemiological crisis.

By and large, the West was spared from having to deal with such epidemics in modern history.

Amid the crisis, many countries have taken a page out of China’s shock therapy playbook. Countries are locking down cities and enforcing social distancing measures strictly, to ensure that the rate of infections can be kept low so that their healthcare systems are not overburdened by too many patients.

Looking at OECD statistics, South Korea and Japan have the largest health care capacity proxied by the number of hospital beds per 1000 people. Aside from rapid and widespread testing, this capacity to handle huge numbers of patients have contributed to their ability to contain the threat.

By contrast, Western countries like the US and UK may not have the capacity to handle a steep and sudden rise in Covid-19 patients. This underscores the need to employ drastic and draconian measures to reduce the rate of infections so that their hospitals are not overwhelmed.

In the face of these immediate challenges, we might expect governments to ratchet up containment policies to arrest the rise infections, which will only exacerbate the economic pain, especially for economies that depend inordinately on services.

An unprecedented economic crisis

From the outset, the US is a service-driven economy. The sector accounts for about 70% of total GDP. The US is also a consumption-driven economy, with private consumption accounting for about 70% of GDP. What do Americans mostly consume? Services. Consumption of services accounts for about 70% of all gross private consumption. What do services inherently depend on? Human-to-human contact, the very activity governments are clamping down during this pandemic.

The size of the services industry in this US$21 trillion economy is massive and the sector accounts for about 70% of US employment. Consequently, the impact of sudden stops in economic activity, including the weeks-long closure of non-essential businesses as well as the collapse in global demand for recreational and leisure activities, will have an immediate and direct impact on employment and income of key industries like:

1. Food services and drinking places,
2. Accommodations,
3. Performing arts, spectator sports, museums and related activities,
4. Air transportation and
5. Amusements, gambling and recreation.

About 11% of the US labour force is employed in these sectors. More specifically, 7.8% of the US labour force is employed in restaurants and bars. Publicly available data from OpenTable - the online reservation application - has shown a remarkable collapse in table reservations across the globe.

As at 25 March, the US registered a 100% decline in table reservations. While not the perfect indicator, the data still signals the dire situation of food service industry amid the coronavirus shut down.

Sudden forced closures of businesses operating in these vulnerable industries, coupled with the collapse in global demand, could lead to massive unemployment. And that is even before accounting for job losses from other peripheral businesses that may depend on derived demand in these industries, for instance vendors supplying materials or providing services to hotels, restaurants, bars, recreational parks and so on.

Gig economy workers stand to lose from the sudden collapse in demand as well.

As it stands, applications for unemployment benefits have risen to unprecedented levels in the week ending 20 March, as the devastating impact of the pandemic becomes more evident.

The first order impact seems serious enough. But there is also a multiplier effect to the loss of income by these workers considering that employees themselves are consumers too.

A sudden decline in income leads to less consumption which leads to more pressure on companies, which could lead to bankruptcies and more unemployment and so on, a vicious spiral. An economic crisis triggered by a pandemic shock is quite different from other cyclical downturns in that economic activity grinds to a halt suddenly and this is by design, as governments scramble to contain the virus, as opposed to a downward trend often observed in cyclical slowdown and recessions which is the result of a loss of business confidence and widespread pessimism.

Essentially, virus-related containment policies lead to a vertical drop in economic activity. How low could this go and how long will it persist?

Much depends on the progress on the health side of matters. In this, no one really knows. And this uncertainty has injected a large degree of panic and fear, with markets pricing in the most bearish of outcomes on account of its about 30% decline from February peaks in just a matter of weeks. Data in the coming weeks will offer more clarity in this regard. But the general sense is clear: it’s not going to be pretty.

Indeed, what appeared in the scene as an exogenous shock to supply chains on account of its impact on the health of the labour market, has developed into a huge demand shock, both due to governments’ containment efforts and a general sense of fear of the virus. Containing the pandemic through onerous and seemingly draconian measures is as much the problem as it is the solution. It addresses the health problem at the cost of economic prosperity.

A financial crisis

Heightened uncertainty about global macro-economic prospects in the wake of the pandemic and the potential ramifications on company earnings and balance sheets have led to a widespread, indiscriminate sell-off of risk assets, as markets priced in the worst possible outcomes.

To begin with, US stocks were already trading at steep valuations well into February, hitting fresh all-time highs despite the Covid-19 outbreak in China and the rest of Asia. Investors were clearly complacent about the looming risks of a global contagion.

When the risk of a global pandemic became clear, initial tardiness on both the health and fiscal policy fronts did little to inspire confidence among market participants. Added to that, an oil price war between Saudi Arabia and Russia against a backdrop of already weakened oil demand, triggered widespread panic in regard to the financial health of energy companies.

Volatility spiked as fund managers pared down risk assets in favour of safe havens. Investors were also forced to unwind derivatives and structured products to meet margin calls. Meanwhile, risk-parity asset allocation strategies forced funds to sell down equities and fixed income in view of heightened volatility in both asset classes. Consequently, financial conditions tightened considerably.

At one point, liquidity and funding conditions faced serious pressure as investors sold off US Treasuries and exited short-term credit markets in a mad dash for cash, which strengthened the US Dollar markedly across the board, throwing other currencies into a near free fall. Soaring demand for the greenback led to an acute shortage of US Dollars, which stressed funding conditions further.

The dearth of investors in the short-term commercial paper market meant that there were very few buyers of companies’ short-term debt.

This meant that businesses were not able to roll-over their short-term debt or access financing which they require to fund their daily operations. The sharp rise in the greenback also increased debt burdens for foreign companies borrowing in US Dollars. If sustained, this could adversely impact their ability to service the debt. Left unchecked, such dislocations in the credit market could materially impact the daily functioning of businesses. Meanwhile, the slump in oil prices triggered concerns about the default risks of highly levered energy companies, which saw the price of their product fall to multi-year lows.

It looked as if a health crisis that was already precipitating an economic crisis, was also threatening to trigger a financial crisis. A potent virus indeed. This was unprecedented to say the least.

The plumber and the repairman

Fortunately, central banks have been quick to move to ensure that the financial plumbing remains unclogged. The Federal Reserve has been the leader in this effort, effectively throwing the kitchen sink at the problem.

The US central bank has introduced a raft of measures including the following:

• In two steps (3 March and 15 March), the Federal Reserve lowered the target federal funds rate by 150 basis points to the 0-0.25% range
• The Fed relaunched asset purchases, or quantitative easing, but had only recently changed the terms of the policy, leaving it open-ended in regard to the quantum of asset purchases and the length of the programme. This effectively means the Fed’s QE policy is unlimited in scope. It also broadened the assets that could be purchased to include agency commercial mortgage-backed securities.
• The Fed reactivated crisis-era temporary lending facilities that allow foreign central banks to borrow US Dollars in exchange for an equivalent amount in local currencies to ease the shortage of greenbacks.
• In addition to these policy moves, the Fed announced a number of other targeted programmes to support liquidity in various markets, from money market funds to the short-term commercial paper market.
• Other central banks have followed suit, cutting interest rates to record lows and introducing asset purchase programmes to keep the financial plumbing intact. Lessons on moving expeditiously and decisively have been learnt and internalised from the 2008 financial crisis episode and have been put to very good use. While market conditions have improved, we’re certainly not in the clear yet. After all, monetary policy is a blunt tool to deal with a health crisis. Central banks cannot do this alone.

Macro policy response is akin to maintaining a house.

Central banks have gone all-in to ensure that the utilities are fine – the water is running, and electricity is flowing. Yet, this alone does not prevent an empty house from collapsing if its foundations are starting to crack. You need fiscal policy to ensure the pillars are strong enough to withstand the pressure and keep the house standing until its occupants return.

In this regard, the government has to alleviate the pressure on businesses and workers with fiscal policy. Essentially, the plumber and the repairman -- the central bank and the government -- have to come together to ensure the house -- the economy -- is stable by any means necessary.

The potential economic problems wrought by the pandemic is particularly acute, such that even a traditionally tight-fisted economy like Germany has introduced a rather generous fiscal stimulus package worth over EUR 750 billion to support virus-stricken businesses and workers.

The UK has responded with a GBP 330 billion rescue package which included government-backed loans and guarantees for firms suffering from the crisis and took a page out of the Mario Draghi’s playbook and pledged to do “whatever it takes to support the economy”. France’s fiscal package carried with it a EUR 45 billion price tag as well.

The US’ recently agreed coronavirus rescue package eclipsed all others with a US$2 trillion price tag, about 10% of its GDP. The plan even dwarfed former President Barack Obama’s US$787 billion “American Recovery and Reinvestment Act”, the follow-up stimulus bill to his predecessor President George Bush’s US$700 billion Troubled Asset Relief Programme, commonly known as the government bailout of 2008.

• The new legislation offers US$500 billion in assistance to companies ravaged by the coronavirus. In particular, the package sets aside US$25 billion for airline companies, which face the threat of bankruptcy without government intervention, US$4 billion for air cargo carriers and US$17 billion for other distressed companies related to critical national security, such as Boeing, the aircraft manufacturer. Such assistance come with strings attached, as companies receiving these loans will have to comply with numerous conditions set forth in the bill, including a ban against stock buybacks for the length of government assistance and limitations on executive compensation.
• An additional US$367 billion in the form of loans and grants will be set aside for small businesses, or companies employing 500 people or less.
• Individuals will also receive a check for US$1,200. Couples will get US$2,400 and each child will receive US$500. Unemployment benefits will increase by US$600 a week for four months.
• Hospitals will receive funding of about US$100 billion, while the bill also requires the government to boost medical supplies in the Strategic National Stockpile.

Damage control, then stimulate

The recent market rally on the back of the Federal Reserve’s and Congress’ all-in rescue packages might offer a false sense relief. We’re certainly not out of the woods just yet.
For one, the word “stimulus” used to describe the steep increase in government spending seems rather misleading in the current context. It conjures up a mental image of busy streets, machine cogs turning and workers rushing to their offices, when it is in actual fact, just damage control in the near term.

The purpose of the spending is to limit, as much as possible, the damage wrought by the collapse in global demand and sudden stops in economic activity. Even cash pay outs to American individuals might not spur consumer spending all that much amid social distancing measures and the overall cautious environment.

Aside from spending on necessities, which might increase with the lock down, American consumers are unlikely to spend the cash windfall on account of the weak employment outlook. Likewise, companies are unlikely to invest until the coast is clear. For now, both firms and consumers are in survival mode. Animal spirits begone.

Economic activity is unlikely to normalise until, and unless, the virus threat is contained. Only then, will the actual stimulus impact of the expansionary fiscal package work through the economy.

Also, the passage of the rescue package is only one side of the equation. The US government must still work out the logistics in delivering financial assistance to both companies and individuals.

Implementing the legislation itself is far more difficult than writing it, especially on account of the vast physical expanse of the US economy. The speed at which such financial assistance is disbursed does matter greatly for families and companies already desperate for a lifeline.

At the same time, there is still a lack of clarity if the US$2 trillion rescue package is enough, particularly because there is a great deal of uncertainty about how much economic activity will suffer.

Hard economic data has yet to catch up with the new realities of social distancing measures and business stoppages. If sentiment gauges like the recently released Markit Purchasing Managers’ Indices (PMIs) are any indication, the market will have to contend with a constant drip of very weak hard economic data in weeks and months ahead. This could test the confidence in the stimulus, if it is in fact enough to help the economy tide through a difficult time where output is likely to plummet.

Essentially, the global wave of seemingly coordinated expansionary fiscal and monetary policies helps to mitigate the damage in the near term, but it is unlikely to stimulate strong growth ahead, not until the invisible enemy is slayed.
This is because the root of the problem is not deficient demand as per a typical cyclical downturn.

It is the virus that is the proverbial boulder blocking economic activity. Until infections peak or a vaccine is discovered, we are still some distance away from the return of economic normalcy. Policy is only a form of damage control, rather than stimulus, for now.

Containment, then recovery

Indeed, the rescue plan for the global economy can be divvied in two phases.

The first is the containment phase. Here, health policy takes primacy to ensure the virus threat is neutered and quickly, so that the economic fall-out can be minimised. Expansionary economic policies, both on the monetary and fiscal fronts, are mainly to mitigate the near-term economic damage that comes from such strict containment policies. The first phase ends when the virus is successfully contained.

Once the coast is clear, economic activity may resume. Hence begins the second phase of the process – the recovery phase. If the pandemic was short-lived and permanently resolved in the span of weeks, we could expect a sharp recovery in economic activity as pent-up demand finds an outlet and the government stimulus offer a jolt to the economy. Of course, the crucial assumption here is that the current pandemic is short-lived and remains a one-off, exogenous shock.

However, the potency of the virus has led many researchers to conclude that this might not be as simple as a one-and-done crisis. The removal of social distancing measures could result in the re-emergence of the epidemic.

A vaccine would be a permanent solution but we’re far away from this being a possibility in the near term. This increases the risk of a start-and-stop pandemic cycle, for which each cycle comprises a containment period and then a recovery phase. Each go around will also require some form of government stimulus to limit the damage during containment and stimulate demand in recovery. A very expensive crisis indeed.

The middle ground, and most likely outcome, would be a slow normalisation in economic activity after the virus is contained as social distancing policies will likely have to remain in place for a while to decrease the risk of another massive outbreak as businesses start to open and the economy becomes active again. In the absence of systemic dislocations in the broader economy and a lack of precarious financial imbalances, we should not expect the recovery from this crisis to be as laboured as it was after the 2008 Global Financial Crisis (GFC).

Unlike the current pandemic, which is a seasonal crisis, the GFC was a paralysing debt crisis, driven by grave financial imbalances in the broader economy. Systemic damage led to a weak recovery. The lack of these systemic problems means that pent-up demand should still lead to a recovery in economic activity after the coast is clear. How robust the recovery will be depends on the state of the threat and the need for containment policies.
Much is still uncertain about how this crisis will play out. We’re clearly in the containment phase of this health crisis. The coordination of decisively dramatic fiscal and monetary policies should help tide the global economy over this difficult and turbulent period. Time will tell if these policies are sufficient. Policymakers have said that they are ready to respond with more support should the need arise.

Until then, instead of wringing our hands, we should be washing them frequently, and maintaining a safe distance from people.