COVID-19 POSES SIGNIFICANT CHALLENGE TO GLOBAL ECONOMY AND FINANCIAL MARKETS
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.
IRISH GROWTH HEALTHY IN 2019, BUT THAT IS NOW HISTORY
Last Friday the Central Statistics Office (CSO) published the first estimate for growth in the Irish economy last year. There were no surprises and the picture presented is of an economy that experienced decent levels of growth last year. Gross Domestic Product (GDP) expanded by 5.5 per cent, with consumer spending expanding by 2.8 per cent and exports of goods and services expanding by 11.1 per cent. As most people are by now very aware, the GDP numbers are grossly exaggerated by Intellectual Property Products (IPP) and by aircraft leasing activities. When these items are adjusted for, a more realistic growth rate of 3 per cent in Modified Final Domestic Demand was recorded. For people who operate on the ground in the Irish economy, 3 per cent growth resonates much more accurately with the real story on the ground.
There is good news and bad news attaching to these data. The good news is that the year ended with considerable momentum, which would normally set a very solid springboard for the following year. However, the bad news is that given the global and domestic events of the past month, there is now little or no visibility on what the coming months hold in store for the global or domestic economies. The portents are not particularly good right now, which should also come as no surprise.
We have seen a pretty dramatic correction in equity markets over the past couple of weeks; there has been a total collapse in Government bond yields in a number of countries, but not all; we have seen the first emergency cut in US interest rates since the collapse in Lehman Brothers in 2008; the Bank of England followed with a half per cent emergency rate cut this week; and increasingly we are witnessing a significant restriction to many events and activities, much of it voluntary and some of it officially imposed. The latter is becoming increasingly important as various countries seek to contain the spread of the virus.
The world is indeed in a state of chassis now, and anybody who claims wisdom or foresight on how this is going to evolve over the coming months is a charlatan. We are in totally uncharted waters and the blind are certainly leading the blind.
It is astounding to see the level of criticism directed at our Government over both what they have done and what they haven’t done. Earlier in the week there was a clamour to cancel the Saint Patrick’s Day festivities; this has now happened, but some people are still not happy. We must realise that these are totally uncharted waters. At one level there is an ongoing requirement to ensure that the spread of the virus is contained insofar as is possible; but on the other hand, life has to go on, and businesses need to be given as much support as possible and jobs and livelihoods need to be protected. We cannot simply let economic activity collapse, but it is a thin line between success and total failure just now.
There is an intense air of unreality out there at the moment. Conferences and other events are increasingly falling victim to the virus, and we are now starting to see the first impact on schools and colleges. If schools are forced to shut down and younger children are sent home, then there will an onus on parents to stay home to mind them, which in turn will further pressurise businesses. Uncertainty is the byword.
For many businesses, cash flow will increasingly become a big issue. Fixed and other costs simply do not go away, but if revenues collapse, then there is a real businesses survival issue. Banks need to play a role in supporting businesses and households through the crisis, and they need to be given the necessary liquidity to do this. We are also going to have to see the EU fiscal rules relaxed to allow governments spend more money on health and to ease the financial burden on households and businesses. Desperate times require desperate measures.
The hope is that the virus will pass through the system relatively quickly and that the seemingly inevitable recession proves short and sharp, and that growth subsequently rebounds in a strong and sustained manner. Perhaps that is naïve optimism. There is a long road ahead.
The Taoiseach’s address to the nation on Saint Patrick’s night set a pretty perfect tone for where we find ourselves at the moment. It was factual, measured and pulled no punches. The people of Ireland have been left in no doubt about the gravity of the situation, and we can certainly rest assured that the Irish government acted more quickly and more aggressively that our neighbours on either side of us. The facts are that we are certainly in a calm before the storm; significant economic damage will be done; it will likely take years to fully recover; and the crisis still has some way to run. It is difficult to disagree with the prognosis provided by the Taoiseach and indeed things are moving so quickly at the moment, 24 hours can bring dramatic changes.
Financial markets are continuing to go ballistic and we are seeing some pretty dramatic market movements from hour to hour. Market participants are as confused about the implications of the unprecedented crisis that is evolving as the rest of us ordinary mortals and hence market movements are proving very dramatic in all asset classes.
Gold prices are soaring, which never comes as a surprise during periods of intense nervousness. Its safe-haven status is coming to the fore once again. Likewise, the safe haven status of the US dollar is being highlighted, as it makes massive gains against currencies such as the sterling and the euro. Sterling is falling out of bed across the board, which says a lot about how the markets are viewing the disastrous handing of COVID-19 by Boris Johnson, and also the disaster that Brexit represents, particularly given the continued insistence on exiting the transition mechanism on 31st December next. Despite assertions by Dominic Raab, it seems inconceivable that the UK will exit the transition mechanism at the end of the year, and before the end of June we are likely to see the UK seeking a one or two-year extension to the transition mechanism. Or at least that is what logic would suggest, but the behaviour of Boris over the past few weeks would suggest that logic is in short supply between his ears. The images of thousands of commuters in packed London Tube stations on Wednesday really says it all as does the decision not to close schools until Friday this week.
On bond markets, the moves of recent weeks have been similarly dramatic. 10-year bond yields in countries such as Italy and Greece have spiked sharply, as they should. A proper and proportionate response from the European Central Bank (ECB) on the monetary policy front, and from EU governments on the fiscal policy front, which would necessitate a binning of the EU’s fiscal rules, is now essential to avoid an all-out crisis in the Euro Zone, akin to or worse that seen during the Greek crisis a few years back. Countries such as Italy and Greece who have massive debt levels and badly struggling economies are particularly vulnerable at the moment. 10-year bond yields in Ireland are also rising, albeit from negative levels a couple of weeks ago that could not possibly be justified. Thankfully, in an emergency meeting on Wednesday night, the ECB announced a new package of bond buying totalling €750 billion by the end of the year. This is a step in the right direction, but more will be needed.
Equity markets are also in freefall at the moment and one can only surmise that there is quite a distance to go before ‘bottom pickers’ enter the fray. It would take a brave investor to step into markets that have no visibility at the moment.
Whatever way one looks at it, the global economic implications of what is happening look pretty catastrophic. The global economy fell off a cliff in 2008 and it has definitely gone over the cliff edge again over the past couple of weeks and unfortunately, the beach looks a long way down, with some very craggy looking rocks in the way.
For the Irish economy, thousands of jobs are currently being lost and economic activity is effectively grinding to a halt, with the exception of public services, and the very important food-supply chain. I hope at the end of all of this, whenever that comes, Irish people will once again realise the importance of domestically provided food that is produced to the highest safety standards possible. Food safety and security are just so important, but unfortunately it takes a crisis such as this to hammer that message home.
COVID-19 IS AN EVENT WITHOUT MODERN PRECEDENT
They say that a week is a long time in politics, but the past month has definitely been a very long time in the world of economics. All has utterly changed over the past number of weeks. When I presented at the IOD Evening Briefing series on 20th February, I alluded to the fact that 2019 was a difficult year for the global economy, largely due to the trade dispute between the US and China, and of course Brexit. I was moderately optimistic for 2020, based on the premise that President Trump would water down his trade issues with China due to the fact that he faces an election in November that he really wants to win. As a consequence, or so my logic went, he would not want to go into that election against a background of global and US economic difficulties as a result of a trade spat between the US and China. This is how things appeared to be going in the early weeks of 2020 as Trump and the Chinese developed a relationship of reconciliation and they very definitely started to dilute the dispute.
On my list of things to watch in 2020, I included COVID-19 (thankfully), but I did not highlight it as an issue that would blow the world economy apart over a few short weeks. Unfortunately, that is exactly what it has done. Back then I assumed it would be another SARS-type event. How wrong could I have been.
An economy is made up of the millions of transactions that take place every day, and the more transactions that take place, the stronger economic growth is and vice-versa. What we have witnessed over the past few weeks is basically the voluntary or mandatory shutting down of large swathes of most economies and economic activity is collapsing before our eyes.
At this early stage of the COVID-19 crisis, it is very obvious that the economic and financial impact is dramatic. Unfortunately, we do not have a lot of visibility at the moment, but signs that the Chinese economy and society are coming back to life does give some grounds for optimism.
Equity markets have become incredibly volatile over the past month and severe losses have been endured in all markets. In the year to date (up to March 27th), the US S&P 500 has lost 17%; the Dow Jones has lost 19.5%; the FTSE 100 has lost 30.4%; the German DAX has lost 26.4%; the Japanese NIKKEI has lost 16.7%; and the ISEQ has lost 31.4%. Movements of 4 or 5% a day or indeed an hour are not unusual at the moment.
On currency markets, the dollar has strengthened somewhat, reflecting the traditional safe-haven status of the dollar. Sterling has fallen sharply against the dollar and the euro. The weakness of sterling probably reflects a combination of the way in which the UK Prime minister has handled the COVID-19 crisis and Brexit. Neither has inspired confidence. However, just like equity markets, currency markets are also very volatile at the moment.
In terms of economic data releases, we are now starting to see the first indications of the impact in March. The Purchasing Mangers’ Index (PMI) is a monthly survey of business confidence in both manufacturing and services. A reading above 50 means that more businesses expect growth than contraction, and vice-versa for a reading below 50.
• In March the composite PMI in the US fell from 49.6 to 40.5; the UK index fell from 53 to 37.1; and the Euro Zone index fell from 51.6 to 31.4. These declines are without precedent and are truly dramatic. Within the composite indices, services are taking the biggest hit as many service activities are being shut down.
• The German Ifo survey of business confidence in March fell from 96 to 86.1.
• Initial jobless claims in the US increased by 3.28 million in the week to 21st March. This is the largest weekly increase ever recorded, with the previous highest increases of 672,000 in 1982 and 659,000 in 2009.
The official policy response around the world has been quite dramatic and inevitably there will be more of the same over the coming months. The following is a sample of the official actions already taken or being considered:
• The Bank of England has cut interest rates from 0.75% to 0.1% and has committed to a further £250 billion of official bond purchases;
• The UK government has introduced a massive fiscal stimulus package;
• The US administration has got approval for the largest ever fiscal stimulus package seen anywhere, totalling $2 trillion;
• The Federal Reserve has cut interests to zero in two emergency moves. The last time there was an emergency rate cut in the US was in the immediate aftermath of the collapse of Lehman Brothers in September 2008. The US central bank is also supplying massive liquidity to the markets;
• The German government has announced a fiscal stimulus package of €156 billion (equivalent €10% of GDP);
• The EU has effectively ditched the EU fiscal rules. I argued at the IOD briefing in February that the EU would have to re-visit those rules in any event in 2020, given the extreme weakness of the Euro Zone. COVID-19 has obviously increased the requirement for such action;
• The EU is giving consideration to the issuance of an EU-backed ‘Corona Bond’. This would help control sovereign risk, which is very important in the context of countries like Italy and Greece, but the Germans are opposed; and
• The EU is giving consideration to utilising the precautionary credit line available under the European Stability Mechanism (ESM). This credit line is intended to help countries with sound economic fundamentals, which are affected by an adverse shock beyond their control. This mechanism would be equivalent to around 3% of GDP, but this could be increased.
The aforementioned is just a sample of the monetary and fiscal policy response seen to date. The key problem is that the global economy was already quite vulnerable before COVID-19 hit, so the impact is proving pretty dramatic to date. The other problem is that given the pre-existing low level of interest rates everywhere and the liquidity that has been injected into the world economy over recent years through quantitative easing (QE), the monetary policy armoury was already limited. Consequently, there is a massive onus on governments to use aggressive fiscal policy measures. Thankfully this is now happening to varying degrees around the world.
The official policy response to date is impressive and does suggest that policy makers stand ready to do whatever is necessary to support global banks, households and businesses. It is imperative that what is currently an economic shock and crisis, is not allowed morph into a banking crisis, which was the distinguishing feature of the 2007/2008 crisis. That is why it is essential that central banks pump liquidity into the banking system and that loan default rates are controlled through government support for businesses and households.
The global economy will see a massive contraction in activity in the second quarter, but the timing of recovery will depend on how quickly the virus is brought under control. This is a medical uncertainty, rather than an economic one. It will be important for policy makers to do whatever is necessary until a vaccine is developed.
There is likely to be a number of longer-term implications flowing from the current crisis. The Brexit transition period will simply have to be extended, but the Prime Minister is, in a logic-defying manner, ruling this out; there will be political fallout, affecting those who did well in handling the crisis and those who did not; there will be a massive government debt legacy; there is a risk of an even greater move towards economic nationalism, with tighter borders; food security and safety should become more important; and the model of capitalism will likely come under serious scrutiny. Proper investment in health services will have to be given priority everywhere. One hopes that out of the current crisis, some positive lessons will be learned.
For the Irish economy, thousands of jobs are currently being lost and economic activity is effectively grinding to a halt, with the exception of public services, and the very important food-supply chain. I hope at the end of all of this, whenever that comes, Irish people will once again realise the importance of domestically provided food that is produced to the highest safety standards possible. Food safety standards and security are just so important, but unfortunately it takes a crisis such as this to hammer that message home.
It is pretty obvious the economic devastation that is being rained down on Ireland at the moment. Tourism is the biggest casualty; non-retail grocery is probably next in line; but most sectors of the economy.
The imperative for policy makers in Ireland is to ensure that those businesses that were viable before COVID-19 struck, will be around to pick up the pieces once life starts to return to normal. For example, pubs, hotels and restaurants will be essential to rebuild the tourism sector, but without strong official support, many will not be in a position to re-open. The reality for many businesses is that cashflow has collapsed, but many costs are still there. This is not a sustainable situation.
The banks will need to support businesses through this; the Revenue Commissioners will have to give breaks on VAT and other tax payments; commercial rates will have to be frozen and central government will instead have to provide funding to local authorities; rents will have to be frozen; and businesses will have to be subsidised directly to keep cashflow alive.
It is vital to recognise that while households will have to be supported, without viable businesses it will not be possible to rebuild our economy. The Irish government package of €3.7 billion is a step in the right direction, but I strongly suspect much more will be needed over the coming weeks.
COVID-19 will eventually pass and what we have to ensure is that businesses and households are kept alive both literally and metaphorically.