There is an old maxim in the world of economics and financial markets that one should always expect the unexpected. Coming into 2020, there were grounds for a slightly higher level of optimism relating to the coming year, following on the back of what was quite a challenging 2019 for the global economy.
The slightly heightened level of optimism was predicated on a view that ahead of his re-election bid in November, President Trump would wind down his trade dispute with China and concentrate on ensuring as strong and stable an economy as possible in the run up to the election. This has transpired as President Trump and the Chinese have become more conciliatory and the threats of a damaging trade war have been averted, at least for 2020. 2021 may be a different matter.
However, all has changed over the past month and the escalation of the COVID-19 crisis has thrown global financial markets into crisis and has generated a massive level of uncertainty about the economic outlook. At the moment, the prognosis does not look good, but there will inevitably (or at least hopefully) be a strong and co-ordinated global policy response.
The US Federal Reserve shaved 0.5% off its key interest rate on March 3rd as an emergency measure to address the economic impact of the virus. The real point of note is that this was the first emergency rate cut in the US since the collapse of Lehman Brothers in September 2008. This should send out a clear message of just how seriously global authorities are now starting to take the threat posed by COVID-19. The economic and financial risks are very real.
The Organisation for Economic Co-operation and Development (OECD) has pointed out that global economic growth was already weak, but was stabilising until the Coronavirus hit. It cites restrictions on the movement of people, goods and services, and the various containment measures taken, such as factory closures, as impacting very negatively on manufacturing and domestic demand in China. It went on to warn that the impact on the rest of the world through business travel and tourism, supply chain disruptions, commodities and lower confidence is becoming more significant.
The International Monetary Fund (IMF) has issued a similar prognosis and has created a $50 billion fund to help low income and emerging market countries cope with the negative repercussions of the virus. It believes there will be significant economic fallout from the global health crisis. It is hard to disagree.
COVID-19 is somewhat different than many previous shocks, because it has both supply side and demand side effects. The overall impacts will be felt through voluntary curtailment of activities and from official restrictions to certain activities.
The disruptions to business, particularly in China, has impacted negatively on the supply of materials, particularly intermediate materials for further production. The lockdown of businesses and the imposition of quarantines is having a negative effect around the world, and this is already being reflected in dry bulk shipping of materials and commodities.
On the demand side of the equation, global demand will be affected by the reluctance of consumers and businesses to spend. Business investment will likely be cut back, as consumer demand will be dampened by a potential loss of income; by a fear of contagion; and a basic increase in uncertainty which will cause consumers to spend less.
At the end of the day, economic activity is made up of people buying goods and services; travelling; companies providing goods and services; and all of the billions of other transactions that take place every day. If people and companies curtail these activities due to fears over the virus and engage in voluntary curtailment of their activities or are forced to do so, then economic activity will inevitably suffer. That is now clearly happening and is likely to get worse. The point of course is that 2019 was a poor enough year for the global economy and it was already quite vulnerable coming into 2020 and certainly did not need such an unanticipated shock.
There will have to be a strong policy response to prevent this temporary crisis from turning into something more permanent. There is a distinct risk that many viable businesses and jobs will be permanently undermined due to cash flow difficulties. A strong official policy response at a global level will be required.
The Federal Reserve has already cut interest rates, and the likelihood is that we will see a more co-ordinated monetary policy response from central banks around the world, comprising of interest rate cuts and more extensive asset purchases. However, with interest rates already so low and trillions of euro and dollars pumped in to the global economic and financial system in recent years, it is hard to see how much real impact monetary policy can have, other than psychological impacts. It is akin to pushing on a piece of string.
It is important that banks are given sufficient liquidity and use it to support vulnerable businesses and households for as long as this crisis lasts.
The real response will have to be delivered via fiscal policy. In the EU, the fiscal rules will have to be relaxed to allow governments support businesses, health services and consumers for the duration of the crisis. This support will have to be provided through targeted tax relief, expenditure supports and health service investment. A relaxation of the EU fiscal rules was becoming necessary ever before the COVID-19 crisis hit, but is now an even greater priority.
Examples of policy support to date around the world include the extension of tax deadlines for business, and a wage supplementation fund to help provide financial support to laid off workers in Italy. China has waived social security contributions from business. These sorts of initiatives and more will be necessary all over the world to help households and businesses come through what will hopefully be a temporary disruption. How long is temporary is of course the big question that nobody in all honesty can answer.
At the end of the day, the broad reach of the virus across so many countries, the strong cross-border economic linkages, as well as the large confidence effects impacting economic activity and financial and commodity markets, make the argument for a coordinated, international response very compelling.
Here in Ireland, the economic backdrop was certainly stronger than the rest of the Euro Zone in terms of the growth performance going in to this crisis. However, as a small and very open economy that is very exposed to the vagaries of the international economic cycle, the Irish economy is clearly under a certain level of threat. The lack of a permanent government is not helpful.
The cancellation of sporting events and the Saint Patrick’s Day parades around the country is a tough blow to the tourism and hospitality sector coming in to what is the beginning of the tourism season. These are just early examples of economic activity being cancelled, but we are likely to see a lot more of the same. International tourism is incredibly important to Ireland and particularly to rural areas. If people stop travelling for the duration of the crisis, then tourism businesses will inevitably suffer. On the upside, if less Irish travel overseas, they might just decide to holiday in Ireland, although any congregations of people will be under threat. Hopefully, the peak of the health crisis will have passed before we enter the summer season.
Inevitably, there will also be supply chain issues, meaning that Irish businesses may not be able to access stuff that they import, while export trade might also be adversely affected.
All in all, it is not good news from an economic perspective at a global or domestic level. However, we cannot be terribly prescriptive at this stage because we really have no idea how bad the virus is going to get and inevitably, different people will react in different ways. The hope is that it will peak and pass quickly and that much of the lost economic activity will be a postponement rather than a permanent cancellation.
In the context of financial markets, the reaction to date has been pretty dramatic. Bond yields have fallen a lot further; official interest rates everywhere look set to fall further and remain at historically low levels for a much longer duration; and already stretched equity markets from a valuation perspective, have come under serious and sustained pressure. It would take a brave individual or investor to call a bottom to the markets at this juncture, such is the magnitude of the uncertainty and the unprecedented nature of the COVID-19 shock.
Oil prices have also fallen dramatically. This obviously reflects a belief that the inevitable slowdown in the global economy will hit the demand for oil, but the decision by Saudi Arabia to discount its crude oil prices and increase its production has resulted in the largest one-day fall in crude oil prices since the Gulf War in the 1990s. This move by Saudi Arabia is a direct affront to the Russians who failed to support an earlier proposal by Saudi Arabia to lead an OPEC production reduction to keep prices supported as the Coronavirus crisis gathered momentum in recent weeks. The global politics of oil production, which includes the US shale oil industry, adds a further complication to what is an already very uncertain period in world economic history.
We live in very interesting if not scary times, and it looks set to become even more interesting and potentially scarier over the coming weeks.