It took an extraordinary exogenous shock to produce the fastest and deepest global recession on record. Entering 2020, after a long period of economic expansion, we expected the global economy to move to a post-cycle world where financial market outcomes were determined by the interaction of macro factors, policy, and politics. The current recession has revived the traditional business cycle, but our three-cycle model can still serve as a framework to navigate the post-virus future.
Huge monetary and fiscal packages have been unleashed to offset the devastating impact of the coronavirus pandemic, highlighting the importance of the policy cycle. Political risks are emanating from the upcoming US presidential election and critical elections in Europe, the growing movement for racial justice, and unresolved concerns about Brexit, among others. The biggest change, though, is renewed dominance of the macro cycle as global economies shift to recovery mode.
With the impact of these cycles in mind, we see four key themes to watch as we enter the second half of 2020.
Looking back to the late fall of last year, when we published our 2020 investment outlook, reminds us of how much the Covid-19 crisis has changed the present and future of the global economy. After a record-long business cycle helped along by generous monetary and late-cycle fiscal policies in countries like the US and Japan, we saw a world that was increasingly moving into a post-recovery stage. Growing supply constraints, manifested in the form of tight labor markets and a lack of productive investment opportunities, had put many developed world economies on a growth path that was converging toward their respective underlying potential rates: about 2% in the US, 1.25% in Europe, and 1% in Japan.
We surmised that in such a world, fundamentals had become less relevant in determining financial market performance. Rather, the impact of policy actions – monetary or fiscal – had gained prominence. Quantitative tightening – i.e., the Federal Reserve's attempt to shrink its balance sheet – and its eventual reversal had a greater impact on the US Treasury market than US growth and inflation trends in 2019. Similarly, the European Central Bank (ECB)'s decision last September to restart its asset purchase program was a key catalyst to dispel growth concerns in Europe over the intensifying US-China trade war. Yet in a world where economic policy had moved from sporadically important to increasingly becoming the dominant market driver, due in part to diminishing macro volatility, sudden changes in political priorities could result in sharp swings in economic policy.
We put this all together in what we called, somewhat provocatively, a “Battle of Three Cycles” that would determine financial market outcomes. We argued that the policy cycle, and less so the traditional macro cycle, would dominate in the future, while the political cycle posed the biggest risk to the status quo. Hence, we recommended spending less time tracking the economy and more time assessing the continued policy support from central banks and fiscal authorities and to watch out for political event risks. Barring any sudden spikes in the political cycle, the three-cycle model envisaged a stable world with economic growth at long-term sustainable potential growth rates, with increasing policy support to prevent a potentially damaging decline in asset prices.
Obviously, that stable post-cycle environment didn't last long. It wasn't due to a sudden change in policy priorities; i.e., it wasn't the political cycle where we saw the biggest risks. It wasn't that we were wrong about the growing dominance of the policy cycle over the macro cycle. No, it took an extraordinary exogenous shock to push the global economy back into a traditional business cycle. Our three-cycle model assumed that cyclical growth drivers had been exhausted, leaving only long-term structural forces, such as population and productivity growth, as determinants of an economy's underlying fundamental strength. The exogenous shock of the Covid-19 crisis has pushed the world into recession, which creates a new set of cyclical growth drivers that will strengthen the macro cycle in our model. However, the policy cycle is far from dead, and politics will continue to pose significant risks to the recovery path’s evolution. So, the three-cycle model is alive and well, but the relative dominance has shifted back toward the macro cycle.
It wasn't an imbalance in the economy that forced policymakers to engineer a recession to correct it, as with the fight against inflation in the 1980s. It wasn't a policy error, like the Fed's inflation fears in the late 1990s, which caused the brief recession in 2001. And it wasn't a years-long buildup of leverage (and its inevitable collapse) that overwhelmed policymakers' ability to prevent a recession, as in 2008.
It was a recession trigger that we hadn't seen before. In fact, it wasn't the rapidly spreading virus that caused the “Great Shutdown Recession” either. We have seen virus pandemics before. The real trigger was the fact that we didn’t start reacting to the infection wave until it was already growing exponentially and threatened to (and in some cases did) overwhelm many countries' healthcare systems.
At that point, pressure on governments rose – equally exponentially – to follow the lead of whoever was implementing the most stringent shutdown measures. It was another “whatever it takes” moment, but not necessarily in the best way. Governments, faced with model-based estimates of thousands or even millions of deaths, felt pressure to follow the advice of scientists to protect lives at all costs. In the circumstances there were few other options, even if the path we chose ultimately proves to have been overly costly when weighing its efficacy against the economic damage wrought by the shutdowns. There just wasn't enough time for a more thoughtful interdisciplinary debate.
What caused the recession was the unprecedented decision by nearly all countries affected to temporarily shut down economic activity to slow the virus’s spread and mitigate the burden on overtaxed hospitals. Not all countries resorted to such drastic actions. Some, like Taiwan, acted early enough to avoid a shutdown, while others, including Finland or New Zealand, were far enough removed from early virus epicenters to control the influx of potential carriers. A few decided against any drastic shutdown measures, with Sweden the most visible example.
While most developed world economies suffered sharp declines in GDP in the first quarter, Sweden's economy stalled but didn't contract, minimizing the early economic damage. But the country paid for the better economic outcome with a mortality rate more than four times greater than neighboring Denmark, which did shut down its economy. All else equal, Sweden avoided a recession but evidently suffered 3,500 more casualties. That alone shows how difficult these decisions were.
Before we can build a new framework to understand where we are going, we need to assess were we are now and what has changed. To do that, we must process four overlapping information waves.
First, there is the virus wave. Most developed world countries seem to have slowed the infection trend sufficiently to say the worst is over. Only a few appear to have eliminated the virus completely, including Taiwan and New Zealand. But most countries have reduced new infections to levels where a re-acceleration would not immediately overwhelm healthcare system capacity. The major exception is the US, where a pickup in the still-high rate of new cases could quickly push the daily infection trend beyond its previous peak. The position on the infection wave matters not so much for the near-term macro outlook (assuming the outbreak continues to ease), but for the assessment of second wave risks. By this metric, the US seems far more vulnerable than Europe or Asia.
Second, there is the policy response wave. In most developed world economies, fiscal and monetary authorities acted swiftly to offset the dramatic economic containment measures. Central banks have cut rates to near zero almost everywhere, and many banks restarted or initiated asset purchase programs. Monetary policymakers had learned the lesson from 2008 and understood that central banks had to become “buyers of last resort” to avoid a financial market crisis that would have greatly exacerbated the evolving economic crisis. Developed world central bank balance sheets have grown by about $5 trillion since the start of the year; that's more than twice the amount we saw during the global financial crisis, and central banks are far from done, as outcomes from the June ECB meeting demonstrated.
Gauging the strength of the fiscal response is more difficult. On the face of it, most countries have enacted significant packages, including direct payments to citizens, credit guarantees for companies with significant Covid-19-related business losses (such as airlines), and paycheck-protection schemes to prevent largescale layoffs. The International Monetary Fund (IMF) estimates that fiscal support among the major developed world economies thus far averages about 12% of GDP. That's not quite the 25% (or one-quarter's worth) of GDP I had estimated was necessary when the crisis started. But what are often overlooked are the automatic stabilizers, which can add another 5%-10% of GDP in fiscal support, if the previous recession is a guide.
While the size of the fiscal policy response seems close to adequate, governments’ ability to build an income bridge from the shutdown to the reopening and beyond will depend at least as much on the fiscal infrastructure. Many European economies with established paycheck-protection programs, for example, are likely to avoid largescale layoffs. This will make reopening easier and potentially avoid the need for companies to hire new workers – and the training costs and loss of accumulated knowledge and experience that come with it. That's part of the typical collateral damage of a recession, and it's one of the metrics to gauge recovery speeds for different economies.
Third, there is the economic data wave. What makes this recession so different from others is its speed. Typically, we only realize that a recession has started when we’re three or more months into it, and its duration is measured in quarters (remember that economists define a recession as two consecutive quarters of negative GDP growth). This downturn can be measured in weeks, not months, let alone quarters. It started in most economies sometime in mid-March and likely ended in late May. That would be a record-short, nine-week recession; of course, the breadth of the economic shutdown will also make it a record-deep recession.
GDP reports are too slow to track progress in and out of the downturn, so the best indicators are the more timely purchasing managers’ indices (PMIs). PMIs registered the collapse in economic activity in China in February and the stabilization in March. They also showed the developed world falling into recession in late March, but are signaling that the path to stabilization is taking longer. May data improved, but stabilization likely won't be achieved until June.
Labor market data is important to gauge the effectiveness of fiscal policy support, while bond yields and equity market prices synthesize the effects of monetary policy support and expectations about the recovery.
Finally, there are the reopening waves. One of the more fascinating aspects of this crisis is the lack of differentiation with which the varying outcomes are judged. Maybe it will take more time before polls show greater gains and losses in political confidence. So far, there is little difference in terms of political costs in countries where governments were more successful in containing the virus crisis, such as Germany, Austria, or South Korea, and those that fared worse, such as the UK, the US, and countries such as Sweden that openly followed a different path. If the outcome of the crisis response doesn't matter, then there is little incentive for more differentiated reopening strategies. And that's essentially what we are seeing: Most countries are following a phased-in approach, with timing differences between countries of a few weeks, not months. It seems clear that by July, the start of the third quarter, all developed world economies will be in the recovery phase.
The relative synchronicity with which the crisis hit most developed world countries and the resulting broad-based, large-scale policy support suggest that differences in the speed and completeness of recovery won't depend too much on cyclical macro trends. Most countries are reopening within a few weeks of each other, and most have enacted sweeping fiscal stimulus to help build an income bridge to prevent largescale household and business bankruptcies. The rebound in economic activity, at least in the near term, will be driven by re-engaging idled resources, whether that means getting workers in service industries back on the job or restarting production facilities in the manufacturing sectors. We know that second-quarter GDP growth rates will be the worst on record in the same way we believe the third quarter could set records for strength. Only after that initial recovery phase will differences in fundamentals become informative again in identifying expected growth differentials.
Every recession produces some structural changes in consumer behavior or business regulation. But some issues that existed before the crisis will persist. One is the importance of the policy cycle, which will likely only increase post-Covid – referring not to the massive increase in government debt, but rather the risk of withdrawing fiscal stimulus too early. That would repeat the policy error that held back growth in the last recovery, when authorities in the US and the UK switched way too early from fiscal stimulus to austerity. But there is an added risk this time around: strained state and local government finances. This is a problem mostly in the US, but also applies to Europe.
In the US, much of the cost of healthcare spending in hospitals dealing with Covid-19 cases and then the surge in unemployment benefit claims fell to the states. The problem is, states have to balance their budgets. So, unless more federal spending can offset the fiscal tightening already underway at the state and local level, US fiscal policy could tighten next year. That is probably the biggest risk to the US recovery.
The situation is similar in Europe, with some key differences. In the EU, individual member states' ability to run deficits is capped. Yet the EU has temporarily suspended its deficit rules and is not likely to reinstate them in the next year, and it is also set to run a large stimulus plan to offset rising fiscal pressures in countries like Italy and Spain. In contrast, the next US stimulus package that could address the risk of abrupt fiscal tightening may get tangled up in the rapidly approaching presidential election.
That's a good segue into the continued importance of the political cycle. The US presidential election in November may already be impacting the effectiveness of the US fiscal policy response. A potential change in power next January could reset policy priorities, with fiscal policy in the crosshairs. A Republican win could lead to more serious spending cuts, while a Democratic win could result in tax hikes. In any case, the election will be critical in calibrating the outlook for the next few years.
Important elections are also on the horizon in Europe, with Germany looking to replace long-term Chancellor Angela Merkel, who has been an anchor of stability for the EU, especially during the past few crises. And we can’t forget Brexit, which remains unresolved despite the UK's withdrawal from the EU.
Predicting near-term economic trends can be done with a fair degree of conviction. While quantifying the decline in GDP in the second quarter and the subsequent rebound in the third will be difficult, the overall trajectory seems quite clear. In the near term, the macro cycle will dominate. What happens in the fall will depend on the interaction of the policy and political cycles. The US election could lead to a pause in fiscal policy support and uncertainty about policy priorities next year. The continuation of the third-quarter rebound in Europe is threatened by Brexit uncertainties and the potential for renewed tensions between the EU member states if new debt and deficit projections show differing degrees of fiscal pressure. China has been in the lead in this business cycle, but it won't be able to really return to normal until global trade revives. And the Covid-19 crisis is still intensifying in many of the major emerging markets, indicating that parts of the global economy still face growing economic costs.
Our best guess is that global growth will still be about 5% below the 2019 level by the end of next year and will not exceed previous highs before 2022. Inflation is not an issue in a world with a renewed large negative output gap. That will allow central banks to maintain highly favorable monetary and financial conditions for those able to borrow, including businesses and households, and for monetary policy to start to take the baton from fiscal policy as the main growth driver by the middle of the next year. That is when more significant growth differentials are likely to reappear – but that’s a story for our 2021 investment outlook.
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