September 3, 2020

Macro Series

Economics Risks

BY Russell Jones

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Report Contents

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( 6 mins)
  • Viral resurgences further set back incipient recoveries
  • Balance sheet distress intensifies, not least in the EMs
  • Fiscal policy support is withdrawn too soon
  • Real activity takes several years to return to recent highs
  • Near-zero inflation becomes embedded in the euro area
  • A ‘no-deal’ Brexit greatly adds to the UK’s economic woes

OECD: the recovery process faces tough challenges

  • OECD real GDP fell an unprecedented 9.8% q-o-q in Q1 (-10.9% y-o-y), after registering a 1.8% decline in Q1.
  • The pace of the initial recovery from the pandemic-related shutdown of March-May if anything exceeded expectations.
  • However, suppression of the virus was partial, and flare-ups and voluntary social distancing continue to restrain activity.
  • Business surveys have rebounded more strongly than consumer confidence, and credit conditions have tightened.
  • The future trajectory of output will reflect the evolution of the virus; the policy response; confidence; and hysteresis.
  • Continued large-scale fiscal and monetary largesse is likely to prove essential to underpin the expansion.
  • That said, real activity is unlikely to re-attain its pre-crisis (Q4 2019) level for at least several years.
  • Post-crisis patterns of demand stand to be quite different, with large effects on future resource and asset allocation.
  • CPI inflation has recovered somewhat from its 0.7% May nadir but remained at an uncomfortably low 1.2% in July.
  • With central banks in ‘whatever it takes mode’ and bond yields historically very low, risk assets have rallied strongly.

US: the Fed shifts focus as the political environment sours

  • The US economy contracted by 1.3% in Q1, and by a further 9.5% in Q2, largely because of a collapse in activity in April.
  • A relatively early lockdown easing led to a sharp bounce in May and June that has subsequently lost some momentum.
  • Enduring viral hotspots, tighter lending conditions, and high unemployment point to an uneven pace of recovery in H2.
  • The jobless rate peaked at 14.7% and remains historically high at 10.2%. Moreover, the fall in initial claims has stalled.
  • PCE inflation has begun to rebound from its lows, but remains well below target at 1.0% headline, and 1.3% core.
  • The Fed has embraced so far uncodified average inflation targeting, elevating the importance of price expectations.
  • Real Treasury yields have been negative for most of the year, and now corporate real yields have followed suit.
  • Ahead of the Presidential election, the polarised and toxic political environment is redolent of 1968, if not 1860.

Bottom line: an uncertain recovery path sustained by a dovish Fed but complicated by an ugly political and social backdrop.

Watch for: regional dips; social unrest; election chaos; equity falls; more dollar weakness and protection; a yield-curve target.

Economics Risks 1

Euro area: the ECB grapples with the spectre of deflation

  • Real GDP fell 12.1% q-o-q in Q2, after a 3.6% dip in Q1, with particularly marked declines in France and Italy.
  • A sharp overall rebound is in prospect for Q3, although, as with the downturn, the pace of recovery is far from uniform.
  • COVID resurgences in some economies have halted or reversed re-opening plans, and set back spending.
  • Headline CPI inflation slumped to -0.2% y-o-y in August, with the core rate marginally positive at a record low 0.4%.
  • Near zero inflation and tighter credit conditions could result in the ECB extending the envelope and duration of its APP.
  • The EU’s Next Generation Recovery Plan is impressive, focussing on the investment shortfall and levelling up.

Bottom line: a traumatic recession and inflation-undershoot requiring an increasingly dramatic macro policy response.

Watch for: enduring near-zero inflation; 10%+ joblessness; more QE and more negative policy rates; US trade tensions.

UK: a robust rebound but a worrisome yearend beckons

  • UK real GDP fell by 20.4 % in Q2, after a 2.2% decline in Q1. This is by some margin the worst contraction on record.
  • Warm weather, domestic tourism spending, and broadbased policy support all point to a robust rebound in Q3.
  • This may not endure beyond the summer however, as policy initiatives are wound back, and viral resurgence beckons.
  • High levels of unemployment and underemployment, much of it structural, are also likely to weigh on the recovery.
  • The outlook is further clouded by a rising risk of a no-deal Brexit, and renewed calls for Scottish independence.
  • Headline CPI inflation has temporarily rebounded from its lows to 1%, but is likely to slump again in the months ahead.
  • The extra £100bn of QE will push BOE assets up to 45% of GDP, while total fiscal support equals some 20% of GDP.

Bottom line: an unprecedented downturn and substantial risks to the recovery as Britain prepares to face another major shock.

Watch for: pandemic resurgence; a flood of business failures and redundancies; monetary finance; a ‘no-deal’ Brexit.

Asia and Emerging markets: climbing out of a cavernous hole

  • The resignation of Shinzo Abe on grounds of ill-health is unlikely to spark a dramatic policy re-orientation in Japan.
  • COVID aside, EMs have been hit by softer external demand and commodity prices, plus weak tourism and remittances.
  • India had been slowing down for four years, before a harsh lockdown resulted in a dramatic 23.9% contraction in Q2.
  • The US currency’s recent weakness has not extended to the EMs, where high dollar debt is a source of vulnerability.
  • Much increased poverty and inequality, and a cascade of defaults, are likely. More debt relief is sorely needed.
  • On a brighter note, China’s recovery broadened out in Q3, as domestic tourism spending boosted the service sector.

Bottom line: deep recessions, if not more acute economic, social, and political crises, extending to some of the larger EMs.

Watch for: social unrest; humanitarian crises; IMF packages; defaults; SDR issuance; monetary finance; GDP-linked bonds.

Recommended reading

Akhtar. S., Gallagher. K., et al, 2020. The need for debt for climate swaps. 17 August. Project Syndicate.

Brainard. L., 2020. An update on digital currencies. 13 August. Federal Reserve Board.

Buiter. W., 2020. The Fed’s dangerous strategy. 31 August. Project Syndicate.

Itoh. M., Morita. Y., and Ohnuk., M., 2020. Monetary policy in the 1990sMarch. Bank of Japan Discussion Paper 2020-E-6.

Klein. M., and Pettis. M., 2020. Trade wars are class wars. Yale university press.

Leven. T., 2020. Money for nothing. June. Random House.

Lynas. M., 2020. Our final warning: six degrees of climate emergency. Harper Collins.

Nagy – Mohnsci. P., 2020. The quiet revolution in emerging market monetary policy. 18 August. Project Syndicate.

Powell. J.,2020. New Economic Challenges and the Fed’s Monetary Policy Review. 27 August. Federal Reserve Board.

Sandilands. R., 1990. The life and political economy of Lauchlin Currie. Duke university press.

Snyder. T., 2017. On tyranny. Twenty lessons from the twentieth century. Bodley Head. 

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