Our lack of understanding of the coronavirus has added to the challenges confronting politicians and policy makers in recent months, and this in turn has fed the uncertainty impacting financial markets. There are six broad areas influencing markets: the virus itself; the economic picture; the corporate outlook; policy; second-round effects; and lessons from the past.
1. The virus
Various approaches have been adopted to tackle the virus. The speed with which countries tackled the virus immediately, plus their ability to track and trace any spread of the virus, have proved critical factors, but so too have a host of other areas such as the different age profiles and population densities within countries.
Even in East Asia, seen as better prepared than western countries, the picture varies, as we can see from Vietnam and Taiwan that tackled and controlled it well, to Singapore and Japan, where the virus has re-emerged in recent months. One size has not fitted all. So, it is likely to prove the same in the west, and elsewhere, too.
For now, though, the focus is on unlocking and easing controls that were put in place to contain the virus. The challenge for all countries is that we are in a vaccine gap. Thus, there is a need to live with the virus until a vaccine is widely available. For the markets, the focus is on whether it is possible to unlock and open up economies, thus allowing them to return to normality while keeping the virus under control. There has been much focus on China, not only because of its size and increasing global importance but also because its ability to keep the virus under control may be seen as a benchmark for others. This unlocking is now being followed across western Europe.
Here in the UK, meanwhile, the unlocking phase has begun. Several aspects of this are welcome and indeed it follows many of the steps that Professor Paul Ormerod of University College London and I outlined when we incorporated the behavioural aspects of economics with epidemiological models. In particular, the government is set to unlock in a phased approach. This will allow it to assess the effectiveness and safety of each phase before it proceeds to the next. It is also unlocking by economic activity and sector, which makes sense, as opposed to unlocking by age group. The government is also stressing the importance of behaviour, with its focus on being alert. There needs to be increased testing, alongside the ability to track and trace those with the virus; and, very importantly, behaviours need to be different to before the crisis.
If behaviours reverted to previous norms, then a second wave would be likely. But if people behave differently, focusing on hygiene and distancing, and firms take measures to safeguard their customers and staff then there is every reason for unlocking to allow economies to come back to life. But, in the absence of a vaccine, localised outbreaks are always possible.
2. Economic data
With the economic data the picture is clear. All economies have been hit hard and we are in a global recession. China and East Asia suffered badly in the first two months of the year. The good news is that China has seen a rebound in March, which has been sustained in April, but its recovery may lack momentum given people are cautious and global trade is weak.
Also, deflationary pressures are evident as firms cut costs and from prices in China. This deflationary aspect is evident, too, in global oil prices, whose fall highlight the slump in global demand. While oil producing nations have agreed to cut output, there is a supply glut that will persist for some time. In the current environment, the beneficial aspects of low oil prices for consumers are not evident.
Meanwhile, the picture in the US, UK and Europe is similar. Data shows economies contracting in the first quarter. Large collapses are already expected for the second quarter. The question, then, is how much of this downturn is temporary or whether permanent damage will be seen.
Initially, markets were expecting the shape of the global recovery to be ‘V-shaped’, but as the virus spread a ‘U-shaped’ global recession looked more likely with contraction in the second quarter. While growth may rise in the third quarter it will still be weak before recovery in the last three months of the year. The fear, though, is an ‘L-shape’ recovery with the collapse in activity not followed by an early rebound, as the combination of the scale of the economic contraction plus continued cautious consumer and business behaviours trigger cost cutting and cutbacks.
3. Corporate news
The corporate news very much reflects the unveiling economic picture. This naturally feeds market valuations. Business models are effectively witnessing a real-life stress test, just as the banks were during the global financial crisis. Then the banks had to be bailed out. Likewise, now, many businesses need support because of the collapse in demand and income.
There is much focus on how business models will need to change as a result of this virus. It is premature to draw too many conclusions yet. I remember at the time of the 2003 SARs outbreak there was much talk about similar issues. Within 18 months the data suggested things had returned to normal; what did change, though, was that governments across East Asia put in place contingency plans for future outbreaks.
Such risk planning may become a feature of policy in the west now. Meanwhile, many of the features in place before this crisis, such as the fourth industrial revolution and technological changes will continue to disrupt business models and create new opportunities. In this context, one question is whether current equity market valuations can be sustained.
4. The policy framework
In this crisis the scale of monetary and fiscal easing has been huge, aimed at limiting the collapse in economies. Despite this policy stimulus, a rise in unemployment has been unavoidable. ThE International Labour Organisation recently reported that, globally, working hours are likely to fall by 10.5% in the second quarter of 2020 compared with the final quarter of 2019.
In recent years, one recurring theme has been that monetary policy may not have sufficient scope to cope with any new economic shocks. That was because over the last decade monetary policy had been the shock absorber, with rates dropped to low levels and central bank balance sheets expanded. Despite that, monetary policy has still been eased further across the globe during this crisis.
“Unlimited” is what the head of the US Federal Reserve called it, with the Fed’s balance sheet ballooning. Or unorthodox, in the view of the market. Fiscal policy, too, has had to be relaxed significantly, seeing budget deficits and debt levels rise.
For now, markets are not yet factoring in the longer-term consequences of this, in part because they are not clear-cut. The immediate likelihood is that rates and yields stay low as demand is weak and inflation subdued. Questions include whether inflationary pressures will re-emerge, as supply side capacity is reduced by the crisis and because of the scale of policy easing. The UK will be left with a high rate of debt to GDP following the crisis, but we would not advocate austerity to address this. Instead, we would recommend reducing debt to GDP steadily over time.
5. The second-round effects
The second-round effects of a crisis can often be unforeseen. The 1997 Asian economic crisis, for instance, triggered turmoil the following year in Russia, Brazil and in US markets with the collapse of the hedge fund, Long-Term Capital Management. Now, in the current crisis, one second-round effect is already evident: rising geopolitical tensions between the US and China. This in turn could feed pressures to de-globalise, leading to production and supply chains shifting.
Other second-round effects could include a swathe of areas, some market linked such as challenges in the commercial real estate sector in the UK while tensions have also been evident in the eurozone, with increased focus on the sovereign debt spreads between Italy and Germany.
6. Historical lessons
We can always learn from the past, and there has already been much attention on the lessons learnt from previous pandemics. One example is how previous bear markets for equities often have a phase when markets rally. The important lesson, however, is to step back and look at the broad picture and longer-term learnings.
There is no doubt that a crisis that sees such a collapse in economic activity will have a profound impact, but as we better understand the virus itself and countries learn to cope with it, then economies will start to recover, albeit taking time to do so and requiring continued policy easing and low policy rates for some time.