A world in shock

investment insights

A world in shock

Samy Chaar - Chief Economist

Samy Chaar

Chief Economist
Bill Papadakis - Macro Strategist

Bill Papadakis

Macro Strategist
Homin Lee - Macro Strategist - Asia

Homin Lee

Macro Strategist - Asia
Sophie Chardon - Cross-Asset Strategist

Sophie Chardon

Cross-Asset Strategist
Vasileios Gkionakis, PhD - Global Head of FX Strategy

Vasileios Gkionakis, PhD

Global Head of FX Strategy

Key highlights

  • The COVID-19 epidemic has morphed into a global shock that will inevitably cause deep recessions in many economies.
  • Policy is moving in the right direction and the Chinese and South Korean examples also offer some support for our baseline scenario of a severe but transitory global economic contraction.
  • The US was late to react to the public health crisis but has since deployed massive, indeed unprecedented, monetary and fiscal policy responses.
  • The euro area economy stands to be particularly hard hit, given the extent of the epidemic across the continent and the lack of coordinated fiscal action.
  • After a historic 1st quarter contraction, China is rebounding strongly as the curbing of its COVID-19 curve paves the way for a normalisation of activity.
  • Japan has (so far) been an exception in the flatness of its infection curve and general movement restrictions – meaning that it has a shot at economically outperforming its G7 peers during the inevitable 1st half recession.
The COVID-19 epidemic has morphed into a global shock that will inevitably cause deep recessions in many economies.
  • The conditions for a sustained market rebound are not yet in place – leading us to maintain our slight equity underweight. Elsewhere, we have pursued efforts to reduce portfolio risk and enhance liquidity, moving underweight on emerging and high-yield debt, recommending option strategies, and adding to Japanese yen and gold exposure.
  • At this stage, our baseline scenario of a 2nd half economic recovery, argues for a weaker dollar relative to other G10 currencies – as US yields converge downwards.

 It is clear by now that the current downturn will be neither brief nor localised. The COVID-19 shock is of a global, and profound, nature. Central banks and finance ministries cannot resolve the immediate – public health – issue. Public policy measures to contain the spread of the epidemic take absolute priority. But monetary and fiscal policy can help sustain the fabric of the economy, making sure that markets function, companies are able to access credit, broad-based defaults are avoided, and unemployment costs do not surge.

The path forward will be determined first and foremost by the course of the pandemic. So far, we have seen successful containment efforts in Asia, with the remarkable “flattening of the curve” in countries such as China and South Korea. We are also starting to see some first signs that measures taken by European countries – where the epidemic hit next – are putting downward pressure on the numbers of new infections.

Public policy measures to contain the spread of the epidemic take absolute priority. But monetary and fiscal policy can help sustain the fabric of the economy.

China, having imposed lockdown in its Hubei province on 17 January, lifted it in late March (with the exception of Wuhan, where it is scheduled to last until 8 April). This timeline gives an idea of what may happen if Europe follows a similar path – with the lag implied by the fact that governments in Europe imposed confinement measures in March.

A lot remains to be seen: whether the progress in Italy will persist, whether countries at an earlier stage such as the UK and the US will manage to “flatten the curve”, and whether “second waves” might emerge in Asia.

We have built our baseline scenario around the key assumption that the successes in Asia will be sustained and that they are likely to be repeated elsewhere. In this scenario, the containment process takes several weeks, inflicting pain of a transitory nature (akin to a natural disaster) and followed by a sharp recovery.

We have built our baseline scenario around the key assumption that the successes in Asia will be sustained and that they are likely to be repeated elsewhere.

We also consider a downside scenario of more prolonged and sustained weakness, rather like an open-ended war. This could materialise if containment fails or if economies re-open too soon and then have to suffer new lockdowns. The impact in such a scenario would be much worse.

To give a sense of scale, in the baseline scenario we expect a 2% US GDP (gross domestic product) decline in 2020, with the very steep contraction currently under way followed by a sharp recovery during the 2nd half of the year. By contrast, in our downside scenario, full-year GDP would drop 7% as no sharp recovery would occur in the 2nd half (see chart 1).

Assuming the epidemic is a shock of transient nature, it is certainly possible that the recovery from it will be sharp. This is what happens with natural disasters: a great deal of pent-up demand is released once the crisis ends.

But for this to happen, the right policy measures need to be in place for the duration of the crisis – especially as the current medical emergency is lasting much longer than, say, a hurricane. While shutting down economic activity to fight the spread of the virus is perfectly sensible public policy, it inevitably causes economic harm to households and businesses whose incomes depend on the affected activity. In order to minimise economic loss, it is therefore paramount that policymakers help companies survive the crisis and employees keep their jobs.

Assuming the epidemic is a shock of transient nature, it is certainly possible that the recovery from it will be sharp. This is what happens with natural disasters.

We have seen policy support of unprecedented size. The combined firepower of monetary and fiscal measures put into action has been greater than what we saw during the global financial crisis, and has come together in much quicker fashion. Not all the measures are as well targeted as they should be. The approach adopted by Germany or the UK, allowing companies to keep workers on their payroll during the period of inactivity with the state covering a large portion of their salary (80% in the UK), can be very meaningful in limiting employment losses. By contrast, the US approach of focusing on expanding unemployment benefits may fall short. Tax cuts and favourable business loans may prove useful but insufficient, given the scale of the current crisis.

In order to minimise economic loss, it is therefore paramount that policymakers help companies survive the crisis and employees keep their jobs.

But the determination shown by policymakers to tackle this emergency head-on is an encouraging sign that, even where response has so far been lacking, new and better measures will come into force, limiting the fallout and ensuring a sharp recovery. This is our other key assumption.

China’s example offers some support for our baseline case of a severe but transitory shock. Key Chinese economic indicators that we monitor (e.g. property transactions, coal burn by manufacturing plants, freight activity, traffic and migration trends) took some 40 days to reverse their decline, which had begun in late January. Applying such a pattern to the US and Europe would mean an economic rebound that could start sometime in May.

Importantly, though, that would require following a disciplined and sequential strategy of, first, waiting for the new infection curve to flatten thanks to strict lockdowns; meanwhile, ramping up testing capabilities; and, finally, implementing a systematic testing and tracking system, all the while keeping social distancing measures in place.

In such a scenario, beyond the further weeks of difficult news flow, equity markets would offer material upside and risk premia would normalise in the high-quality credit space – save for assets exposed to the oil market given the ongoing price war between Russia and Saudi Arabia. If, rather, the current efforts to contain the virus are not successful and the world economy goes into a prolonged slump, the implications for investors would obviously be very different. Let us hope that will not be the case.

Read more from our experts on how the Fed and Treasury have gone all-in, why China is still at the forefront and the case for a coordinated fiscal response in Europe.

Note: Unless otherwise stated, all data mentioned in this publication is based on the following sources: Datastream, Bloomberg, Lombard Odier calculation.

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