The key question, as I see it, for the markets, is whether we will have a slump, recession, or a recovery. Is it an L-shaped, U-shaped or V-shaped economic outlook?
Initially, when this crisis hit in China, the view was that it would have a V-shaped economic impact globally. In previous shocks, including SARs, this has been the profile taken. The hit to the economy lasting one or two quarters (the downward leg to the V) before economies naturally recover, as the crisis passes, and helped by policy.
However, as this crisis has spread, recovery hopes have faded. It now looks more likely to be a global recession: the U-shape. At the start of this year, China and the rest of Asia were expected to account for two-thirds of the growth in the global economy in 2020. In Q1 China’s economy plus supply chains and trade across Asia were at a standstill. There is tentative evidence China has passed the worst, in which case there will be a gradual return to normal during Q2. It is still, naturally, premature to be certain about this. Meanwhile, the US, UK and Europe look set to be at a standstill in Q2, with second-round effects lasting into Q3. While this crisis initially hit supply-chains there has been a negative impact on demand, as trade, spending, investment and confidence falls. Thus, the world economy is likely to be in recession in Q2 and Q3, before recovery.
The markets’ fear is a L-shape slump. Why? Economies are weak, the policy response may be poor or the levers that can be pulled are limited. Also, firms may be forced to cut costs. There are no inflation risks. In fact, the fear is deflation with prices falling, squeezing margins. China accounted for 80% of the increase in demand for oil last year, and its economic standstill initially contributed to the collapse in oil demand, which has been compounded by the decision of Saudi Arabia to boost supply and the US ban on European flights. Oil prices have collapsed, putting immediate pressure on oil exporters, before any eventual benefit to oil importing countries and consumers feeds through.
There are similarities with the 2008 Global Financial Crisis (GFC). Then it was only when we were clearly past the worst in terms of the financial risks (meltdown of the system) that markets could focus on future economic recovery. Then, policy pulled us back from the brink of depression, but there was still a global recession in 2009. This global recession should not be as deep as in 2009, but this is a Global Health Crisis (GHC) and it is only when we are past the worst of the health crisis in each country that we can genuinely focus on the economic recovery ahead.
So far the economic and policy response to the GHC has varied across countries. Over the last decade, monetary policy globally has been the shock absorber, with low rates and bloated central bank balance sheets. While monetary policy has an important role to play now, because rates are already so low, more of the heavy policy lifting needs to be carried by governments through fiscal policy.
The US Federal Reserve cut interest rates by 0.5% this week and the markets, correctly, expect, more cuts to follow. That will help a US economy that appeared robust immediately ahead of this crisis. In contrast, the euro area entered this crisis looking fragile and it is in need of a bigger policy boost. Unfortunately, the initial signs are not encouraging. The European Central Bank did not cut rates this week, as rates are already negative, but they provided assistance to European banks, which was necessary as that sector appears fragile. There is disagreement in the EU over the likely fiscal response, but we expect some countries, led by Italy, to relax fiscal policy.
In contrast, the most impressive economic policy response so far has been in the UK, with a whole of government approach seen over the last week. The Bank of England cut interest rates from 0.75% to 0.25% and rates look set to remain low for some time. Prudential policies were eased to help lending. Alongside this, there was a huge fiscal stimulus, aimed both at providing help now in the face of the crisis, plus longer-term infrastructure spending. As welcome as the stimulus was, it is unlikely to be able to prevent the UK falling into a technical recession in Q2 and Q3, and further fiscal stimulus may be needed as the crisis unfolds.