Slow revival and costly adjustments


  • Economy
  • Saturday, 13 Jun 2020

IMF now forecasts a rebound – even so, output in 2021 will still be 5% lower than its October 2019 estimates for AEs. The pandemic leaves behind lasting scars, including a deep recession with serious solvency issues and really, really high unemployment. IMF numbers are not pessimistic enough. As I see it, if lockdowns have to be extended beyond 2Q’20 & Covid-19 returns later in a milder outbreak, the overall global hit can be twice as hard!

THE Covid-19 lockdowns have led to a deep economic dive, sending shockwaves around the world. IMF estimates world GDP will fall by 3% in 2020 (down 6.3 percentage points from its earlier forecast of +3.3% in late January).

In 2009, the worst year of the global financial crisis, global output dipped only 0.1%. Advanced economies (AEs) are now expected to contract by 6.1%, and emerging market economies (EMEs) to shrink by 1% in 2020. Both China & India will continue to grow.

IMF now forecasts a rebound – even so, output in 2021 will still be 5% lower than its October 2019 estimates for AEs. The pandemic leaves behind lasting scars, including a deep recession with serious solvency issues and really, really high unemployment.

IMF numbers are not pessimistic enough. As I see it, if lockdowns have to be extended beyond 2Q’20 & Covid-19 returns later in a milder outbreak, the overall global hit can be twice as hard!

Prospects

IMF admits that the impact of the pandemic is devastating – far worse than the 1930s Great Depression.

Assuming recovery in 2021 with above-track growth rates, GDP will still remain below the pre-virus trend, amidst considerable uncertainty about the strength of the rebound. Looking forward, I see no room for complacency: It is definitely a global pandemic, not just China-focused; it peaked in 1Q’20 – officially entered recession in February.

The damage so far is severe: with global supply chains being seriously disrupted; global business confidence since softened and consumer confidence, dented; recovery is unlikely to be V-shaped – depends heavily on when effective treatments & vaccines become widely, readily available. China is recovering; US is re-opening.

Incoherent EU, ageing Japan and ready-to-go Asia are all regaining their footing; and expectation that policymakers will promptly rescue is misguided – central banks are running out of bullets & fiscal policy is reacting too slowly, if at all.

I sense revival will be slow; also, episodic setbacks and costly (& often) adjustments. SMEs will struggle, many won’t survive. There will be skilful adaptors and disrupters, especially in the digital economy; they should emerge stronger.

Above all, watch out for signals of confidence from businesses & consumers.

Impact

The pandemic led to a sharp drop in the markets, record unemployment, and past 7 million Covid-19 cases worldwide, with tragically 400,000 deaths thus far (exceeding 104,000 in US).

Markets believe that this damage is starting to ease, but real recovery will take an extended time. Global economic activity still remains sluggish towards the end of 2Q’20, despite tentative re-opening in many AEs.

In US, there are early signs the economy is, ever so slowly, creeping back to life after a 5% contraction in GDP in 1Q’20. A bigger contraction is expected in 2Q’20, mired in a severe downturn in April & May – with overall business activity falling & layoffs rising. By 4Q’20, GDP will be 5.6% smaller than a year ago.

Current expectations are for the economy to contract by 6–7% in 2020, with a 10.4% unemployment at year-end (3.7% in 2019), lingering in double-digits for a while (13.3% in May and 40 million lay-offs up until mid-May). This has prompted policymakers to respond with unprecedented support.

Still, the outlook remains highly uncertain. US Congressional Budget Office, a nonpartisan agency, estimates that the coronavirus caused a mark-down of its 2020-30 forecast for US economic output by a cumulative US$7.9 trillion, or 3% of GDP, which isn’t expected to catch up to the previously forecast level until 4Q’29.

The US$3.3 trillion stimulus programs enacted by Congress since March will only partially mitigate the deterioration in economic conditions. I guess it will take a long time to heal.

In EU & Japan (fearful of China and uncertain about US reliability), government stimulus has also been huge but mainly reactive. Eurozone’s GDP will contract 8.7% in 2020; even though 2021 growth will improve (+5.2%) – GDP at end-2021 will still be 4% below the pre-pandemic level.

Unemployment will remain high. Asia’s GDP, as expected, contracted in 1Q’20, led by China’s sharp fall; and 2Q will be worse as most Asian economies (including Japan) had extended lockdowns.

After a slow start, most stepped up stimulus support – both monetary & fiscal. Regional growth will probably contract in 2020; but expected to recover in 2021. Worsening demographics and rising debt as well as deglobalisation are key risks, but also offer opportunities.

Enterprises in US in particular, looking for diversification, growth & lower prices will be attracted to Asia (outside China). The scale and speed of US over-reach has no parallel.

As I see it, the Fed’s shifting into overdrive through monetising government debt and providing a credit backstop for corporate America are essential to cushion the blow from three simultaneous crises: a pandemic threatening human life, large-scale lockdowns causing massive supply-chain shocks, and freefall in oil prices upsetting commodities markets.

“Uncle Fed” did what it had to do: pull-out all the stops to stave-off a 1929-style depression and a gut-wrenching market meltdown.

While welcoming this decisive response, investors worry that it has essentially created a new moral hazard by “socialising” credit risk.

The price distortion resulting from the past decade’s quantitative easing (QE) has not only failed in its original intention to tackle subpar economic growth, but also significantly boosted asset prices, decoupling them from the real economy – causing asset bubbles and accentuating income and wealth inequalities.

This led to three sets of concerns: (i) debt monetisation in US and Europe, where huge government borrowings rushed to provide extensive support to businesses and employees.

With central banks buying this debt, interest rates are anchored in the zero-bound range, with the attendant mispricing of risk. It sows the seeds of toxic double-digit inflation, like that in the 1970s; whether economic growth will resume soon enough to sustain the current earnings multiples, and put to rest the spectre of secular stagnation; and whether investors’ traditional navigation tools are being diluted – markets are now being moved more by central banks’ utterances than by developments in the real economy. Today, asset prices are increasingly being disconnected from their fundamentals.

Market fundamentals

Equity investors are getting ready for another slump in stock markets, feeling uneasy that surging prices do not reflect the economic problems ahead.

In essence, equity markets do not account for the job losses and the insolvencies ahead globally. As I see it, prices cannot diverge from fundamentals for too long.

Despite a slew of bleak economic data – including an expected record contraction in US and eurozone in 2Q’20, the S&P 500 has surged almost 40% since its trough in March, leaving it down just 3% for the year. The index is now trading in excess of 22 times expected future earnings, taking the common valuation measure back to levels not seen since early 2000s.

I believe investors will soon discover that the so-called “Fed put” – that the Fed will step-in to support markets – may be reaching its limits.

Of course, it is entirely possible that there will be a fourth quarter reckoning, where a second wave of job losses and a prolonged period of business failures tests equity sentiment.

Also, there are threats in the trend towards “deglobalisation” (which could drive inflation higher) and growing political interference in the technology sector (which could hurt shareholder returns). Of late, amid some signs of calming, investors have become more confident economic activity will improve with the ebbing of coronavirus infections and additional government stimulus.

Overall, I know many fund managers are still reluctant to bet outright against stocks in the face of huge stimulus efforts from Fed and ECB, both with much firepower in reserve.

Nevertheless, investors will continue to ignore the three P’s – pandemic, protests and politics – and are instead focused on the coming together of a better than expected recovery; and with it, a quicker revival of earnings as well.

US dollar outlook

Of late, many strategists, including myself, have turned bearish on US$, after a wave of optimism over the global recovery from coronavirus had pushed the greenback lower against its peers.

On June 2, the trade-weighted dollar slipped to its weakest level since mid-March, continuing a five-day losing streak. I sense US$’s long rally could be finally over, after more than two years of near-uninterrupted gains.

Indeed, in full display is the “US$ Smile” – dollar tends to rise in value against other currencies when its economy is extremely weak or very strong. It goes up at either end of the spectrum, just like the smile on the face.

US$ hit one end of “the smile” when it rallied 8.3% from March 9-20, reflecting a flight to safety. US$ is safe haven – it has the world’s biggest economy, deepest bond markets and strongest military.

In March, as concerns over the viral outbreak reached their peak, US$ spiked as investors stockpiled the greenback in a scramble to pay debts and to find safety in the principal reserve currency.

As the global economy powered down, US$ surged to a record high against currencies such as Brazilian real and sterling, as stock markets tanked. Since then, other big economies, including China’s had begun to reopen; while the Franco-German proposal for EU recovery boosted the euro by easing fiscal concerns.

Indeed, brighter sentiment over global growth, as lockdowns were eased, had become a “key driver” of US$ sell-off. The situation reversed on March 23 as the Fed cut interest rates to near zero and US$ become less attractive.

The US dollar started to drop and money flowed back into stocks and other riskier assets. US$ started to “smile” from the other side. Still, investors struggle to find alternatives.

As I see it, US$ could now face a long stretch of weakness. A wild card is China. Some investors took solace that Trump didn’t impose tariffs following China’s latest move on Hong Kong.

But China has also guided its currency weaker in recent weeks. Should tensions between the two escalate, US$ could well climb again. Potential for a resurgence in infections and the recent worst US civil unrest in decades, could also drive the return to safe assets.

Deflation ahead?

The coronavirus lockdown has pummelled the US economy, with some 40 million jobs destroyed and trillions of GDP and wealth lost. Compounding the havoc is an economic affliction that has gone unnoticed: deflation.

Unlike coronavirus, it appears to be nudging its ugly head. Prices are falling. March personal consumption spending fell at a 7.5% annual rate, while consumer prices in April fell by more than in any month since December 2008.

Of concern is the trend in commodity prices: oil prices have plummeted, reflecting a rapid fall in global demand; but the relative shortage of global US$ liquidity appears to be adding to the pain. Virtually all commodities are seeing declines.

The leading commodity price index (the CRB) is down one-third since January. Similarly, yields on Treasuries and Tips (Treasury Inflation-Protected Securities) are well below the Fed’s 2% inflation target.

Market inflation has been averaging barely over half that rate (1.1%). For all practical purposes, there is no inflation. Is deflation coming back?

Deflation entrenched during the 1930s Depression (when rapid price declines drove the economy to its knees) is well known as a killer of prosperity.

Real labour costs rise, which shrinks hiring and drives up unemployment. Deflation strikes fear among central bankers as it’s much harder to flight than inflation.

But today, even as markets signal flashing deflation, academics and the Fed are still more worried about inflation. There is talk of a coming inflation as the economy recovers. Rather strange when 10 & 30-year bonds are trading at yields around 0.8% & 1.5% respectively.

The eurozone is on the brink of sliding into deflation after the coronavirus disruption dragged price growth in the bloc down to 0.1% in May, its lowest level for four years.

The fall in inflation – which turned negative in 12 of 19 eurozone countries in May – has added to investors’ expectations that ECB will inject more monetary stimulus into the economy.

Economists worry that a prolonged period of deflation would be painful for the eurozone as it would make high corporate and government debt levels even harder to manage.

Also, high debt could trigger a dangerous spiral between the fall in prices and that in aggregate demand. Further price growth diverged between Europe’s largest economies, with less than 0.5% inflation in Germany & France; but prices fell less in Spain & Italy.

Falling energy prices were the main reason behind low inflation in April & May.

Lockdowns in Europe brought many activities to a standstill, and are expected to lead to a record post-war recession this year. French household consumption had fallen 20.2% in April – the most on record.

Germany continued to come through in better shape; still retail sales fell 5.3% in April.

The ECB has since flooded the financial system with cheap money to stimulate activity, and keep inflation from falling further below its just below 2% target.

At some point, the combination of ECB money-printing, extended government deficits, and lacklustre productivity growth, will induce an inflationary challenge. Inflation is a nebulous phenomenon: part mechanics and part psychology, and where expectations play a vital role.

The deflationary narrative of disruptive technology also runs deep.

Automation and fears of human redundancy roll together into concerns about demographics and falls in demand. The undertone from these forces is strong; and are well understood and discounted. Even so, there are cracks.

The speed of a turn in prices is unknowable. Any return of inflation should not be feared. Deflation is unlikely to be back to haunt the real economy.

What then are we to do

I spent the past 60 years as a central banker and as a corporate strategy consultant. Never have I seen so much money being created by central banks in so little time. QE has just gone berserk: the Fed even buys junk bonds; Bank of Japan bought so much equity that it now owns one-fifth of large Japanese corporations.

Not to be outdone, ECB has just been cleared to go on a bond (& corporate debt) buying spree. So, it’s only natural that money creation on this scale is bound to spark fears of inflation.

Too much money chasing too few goods and services. The pandemic has constrained production – forcing factories, offices & shops to close, and limiting commerce and trade.

Concomitantly, much of the “helicopter money” ended in households’ bank accounts: they are saving more and spending less, reflecting a lockdown that has resulted in high debts, high unemployment (jobless rate of 20% in US by end summer), and less spending since it is really hard to consume with lockdowns everywhere.

Ironically, the pandemic & low demand have brought with them falling prices (including for oil & commodities) – an economic malady that has gone-on rather unnoticed.

This creeping deflation is keeping a lid on wages – overall US wages & salaries fell by 8% so far, as labour markets remain depressed. The immediate risk I reckon is not too much inflation but too little – enough to keep deflation at bay.

All this amid a slow economic recovery in the face of a still painful pandemic. Economies will emerge from it all with huge debts, needing policymakers not to withdraw stimulus pre-maturely (as ECB did in 2011 by raising rates) – and keep interest rates low & liquidity ample, since inflation is not a threat now. As I see it, the time has not yet come to let go.

Kuala Lumpur, June 10,2020

* Former banker, Harvard educated economist and British Chartered Scientist, Prof. Lin of Sunway University is the author of “Trying Troubled Times Amid Trauma &Tumult, 2017–2019” (Pearson, 2019). Feedback is most welcome. The views expressed here are the writer’s own.

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