Global economic activity is being deliberately frozen to stem the coronavirus pandemic. This initial shock is very sudden and deep. Yet what matters for asset pricing is the cumulative impact of the growth shortfall over time. We believe that policy actions to cushion the impact of virus shock are nothing short of a revolution. Execution remains a risk, but if successful, the cumulative impact of the virus even under the currently most bearish forecasts would be well below that seen in the wake of the 2008 global financial crisis (GFC) — despite the historic scale of the initial shock.
A banking crisis and overextended household balance sheets led to a “lost decade” of deleveraging after the GFC. This time, the immediate shock is much deeper, but the financial system is not in crisis for the moment. The propagation of the shock is directly linked to the evolution of the virus and the duration of containment measures, in our view. Current economic forecasts, including the most pessimistic, imply long-run economic consequences that are much less severe than the post-GFC impact in both the U.S. and euro area, as the chart shows. The cumulative GDP shortfall in the years that followed was ultimately equivalent to 50% of 2007 GDP in the U.S. For the current shock to be on a similar scale, it would have to morph into a financial crisis, in our view. For now, we see the much swifter and greater fiscal and monetary response this time limiting this risk.
The pandemic has triggered an abrupt, deliberate stop to economic activity. We believe the concept of “recession” doesn’t’ apply here because this is not resulting from the evolution of a usual business cycle. See details in How large is the coronavirus macro shock? The current shock is more akin to a large-scale natural disaster that severely disrupts near-term activity, but eventually results in an economic recovery. The large and immediate loss of income needs to be addressed with a comprehensive policy response, including a new suite of policy measures designed to help bridge cash flow pressures by backstopping household incomes and small businesses – without which the economy could suffer permanent damage. We have seen these measures – both monetary and fiscal – coming together quickly and on unprecedented scale, especially in key developed economies. Policy coordination is critical, as we wrote in Time for policy to go direct.
A key risk to our view is policy execution.
A recent example shows the difficulty of delivering the aid to those in need: A $350 billion loan program for distressed small businesses in the U.S. quickly reached its limit, with evidence that the smallest businesses had severe difficulty accessing the program. There is also the risk of permanent damage if the freezing of economic activity lasts for an extended period of time – especially if ongoing policy support loses momentum. An extended interruption could morph into a financial crisis if it were to lead to an unprecedented wave of corporate insolvencies, putting pressure on the banking system. Last week’s oil price collapse – partly caused by the ongoing drop in demand caused by the economic contraction – illustrates the outsized near-term knock-on effects of halting economic activity.
The initial risk asset response in 2020 – with equities down 30-40% across the world – has been on an order of magnitude similar to the financial crisis. The entire range of current forecasts imply the current economic shock is less severe given much greater fiscal and monetary support this time around. Yet effective implementation of such policy support is critical, and we remain cautious over a tactical horizon due to the substantial near-term uncertainty on the evolution of the virus and containment measures. We mostly stick to benchmark holdings on an asset class level, and generally prefer credit over equities given bondholders’ preferential claim on corporate cash flows. We prefer U.S. Treasuries to lower-yielding peers as portfolio ballast. Quality equities and a focus on sustainability also can provide portfolio resilience. Read our latest views on global economy and markets in the Global Outlook.