Market volatility has sparked fears of a Covid-19-induced recession. To glean insights into the path aheads, business leaders need to take a careful look at market signals across asset classes, but also look beyond the markets to recession and recovery patterns, as well as the history of epidemics and shocks.
Having largely ignored Covid-19 as it spread across China, global financial markets reacted strongly last week when the virus spread to Europe and the Middle East, stoking fears of a global pandemic. Since then, Covid-19 risks have been priced so aggressively across various asset classes that some fear a recession in the global economy may be a foregone conclusion.
In our conversations, business leaders are asking whether the market drawdown truly signals a recession, how bad a Covid-19 recession would be, what the scenarios are for the growth and recovery, and whether there will be any lasting structural impact from the unfolding crisis.
In truth, projections and indices won’t answer these questions. Hardly reliable in the calmest of times, a GDP forecast is dubious when the virus trajectory is unknowable, as are the effectiveness of containment efforts, and consumers’ and firms’ reactions. There is no single number that credibly captures or foresees Covid-19’s economic impact.
Instead, we must take a careful look at markets signals across asset classes, recession and recovery patterns, as well as the history of epidemics and shocks, to glean insights into the path ahead.
What Markets are Telling Us
Last week’s brutal drawdown in global financial markets might seem to indicate that the world economy is on a path to recession. Valuations of safe assets have spiked sharply, with the term premium on long-dated U.S. government bonds falling to near record lows at negative 116 basis points — that’s how much investors are willing to pay for the safe harbor of U.S. government debt. As a result, mechanical models of recession risk have ticked higher.
Yet, a closer look reveals that a recession should not be seen as a foregone conclusion.
First, take valuations of risk assets, where the impact of Covid-19 has not been uniform. On the benign end, credit spreads have risen remarkably little, suggesting that credit markets do not yet foresee funding and financing problems. Equity valuations have conspicuously fallen from recent highs, but it should be noted that they are still elevated relative to their longer-term history. On the opposite end of the spectrum, volatility has signaled the greatest strain, intermittently putting implied next-month volatility on par with any of the major dislocations of the past 30 years, outside of the global financial crisis.
Second, while financial markets are a relevant recession indicator (not least because they can also cause them), history shows that bear markets and recessions should not be automatically conflated. In reality, the overlap is only about two out of every three U.S. bear markets — in other words, one out of every three bear markets is non-recessionary. Over the last 100 years, we counted seven such instances where bear markets did not coincide with recessions.
There is no doubt that financial markets now ascribe significant disruptive potential to Covid-19, and those risks are real. But the variations in asset valuations underline the significant uncertainty surrounding this epidemic, and history cautions us against drawing a straight line between financial market sell-offs and the real economy.
What Would a Covid-19-Induced Recession Look Like?
Though market sentiment can be misleading, recessionary risk is real. The vulnerability of major economies, including the U.S. economy, has risen as growth has slowed and the expansions of various countries are now less able to absorb shocks. In fact, an exogenous shock hitting the U.S. economy at a time of vulnerability has been the most plausible recessionary scenario for some time.
Recessions typically fall into one of three categories:
- Real recession. Classically, this is a CapEx boom cycle that turns to bust and derails the expansion. But severe exogenous demand and supply shocks — such as wars, disasters, or other disruptions — can also push the real economy into a contraction. It’s here that Covid-19 has the greatest chance to infect its host.
- Policy recession. When central banks leave policy rates too high relative to the economy’s “neutral” rate, they tighten financial conditions and credit intermediation, and, with a lag, choke off the expansion. This risk remains modest — outside of the U.S. rates are already rock bottom or even negative, while the Federal Reserve has delivered a surprise cut of 50 basis points. Outside of the monetary policy response, the G7 finance ministers have also pledged fiscal support.
- Financial crisis. Financial imbalances tend to build up slowly and over long periods of time, before rapidly unwinding, disrupting financial intermediation and then the real economy. There are some marked differences globally, yet in the critical U.S. economy, financial crisis risks are difficult to point to. Some commentators point to the bubble in corporate credit, as seen in significant issuance and tight spreads. Yet, we struggle with the subprime analogy of the last recession, as corporate credit neither funds a real economy boom (as subprime did with housing), nor is the debt held on banks’ balance sheets. Both factors limit the systemic risk of a potential shakeout in credit, though this risk can’t be dismissed entirely. It’s difficult to see Covid-19 contributing to financial imbalances, but stress could arise from cash flow strains, particular in small and medium enterprises (SMEs).
Looking at this taxonomy, and again at history, there is some good news in the “real economy” classification. Though idiosyncratic, real recessions tend to be more benign than either policy recessions or those induced by financial crisis, as they represent potentially severe but essentially transient demand (or supply) shocks. Policy recessions, by contrast, can be, depending on the size of the error, severe. In fact, the Great Depression was induced by perhaps the largest policy error ever. And financial crises are the most pernicious kind, since they introduce structural problems into the economy that can take a long time to be corrected.
What is the Likely Recovery Path?
Whether economies can avoid the recession or not, the path back to growth under Covid-19 will depend on a range of drivers, such as the degree to which demand will be delayed or foregone, whether the shock is truly a spike or lasts, or whether there is structural damage, among other factors. It’s reasonable to sketch three broad scenarios, which we described as V-U-L.
- V-shaped: This scenario describes the “classic” real economy shock, a displacement of output, but growth eventually rebounds. In this scenario, annual growth rates could fully absorb the shock. Though it may seem optimistic amid today’s gloom, we think it is plausible.
- U-shaped: This scenario is the ugly sibling of V — the shock persists, and while the initial growth path is resumed, there is some permanent loss of output. Is this plausible for Covid-19? Absolutely, but we’d want to see more evidence of the virus’ actual damage to make this the base case.
- L-shaped: This scenario is the very ugly and poor relation of V and U. For this to materialize, you’d have to believe in Covid-19’s ability to do significant structural damage, i.e. breaking something on the economy’s supply side — the labor market, capital formation, or the productivity function. This is difficult to imagine even with pessimistic assumptions. At some point we will be on the other side of this epidemic.
Again, it’s worth looking back at history to place the potential impact path of Covid-19 empirically. In fact, V-shapes monopolize the empirical landscape of prior shocks, including epidemics such as SARS, 1968 Asian flu, 1958 Hong-Kong flu, and 1918 Spanish Flu.
Will There be Any Lasting Economic Consequences of Covid-19?
To understand this, we need to examine the transmission mechanism through which the health crisis infects the economy.
If the taxonomy of recessions tells us where the virus likely attacks the economy, transmission channels tell us how the virus takes control of its host. This is important since it implies different impacts and remedies. There are three plausible transmission channels:
- Indirect hit to confidence (wealth effect): A classic transmission of exogenous shocks to the real economy is via financial markets (and more broadly financial conditions) — they become part of the problem. As markets fall and household wealth contracts, household savings rates move up and thus consumption must fall. This effect can be powerful, particularly in advanced economies where household exposure to the equity asset class is high, such as the U.S. That said, it would take both a steep (more bear market than correction) and sustained decline.
- Direct hit to consumer confidence: While financial market performance and consumer confidence correlate strongly, long-run data also shows that consumer confidence can drop even when markets are up. Covid-19 appears to be a potentially potent direct hit on confidence, keeping consumers at home, weary of discretionary spending, and perhaps pessimistic about the longer term.
- Supply-side shock: The above two channels are demand shocks, but there is additional transmission risk via supply disruption. As the virus shuts down production and disables critical components of supply chains, gaps turn into problems, production could halt, furloughs and layoffs could occur. There will be huge variability across economies and industries, but taking the U.S. economy as an example, we think it would take quite a prolonged crisis for this to feed through in a significant way. Relative to the demand impact, we see this as secondary.
Recessions are predominantly cyclical, not structural, events. And yet the boundary can be blurred. To illustrate, the global financial crisis was a (very bad) cyclical event in the U.S., but it had a structural overhang. The economy rebounded, yet household deleveraging is an ongoing secular phenomenon — household willingness (and ability) to borrow is structurally impaired, and the collateral damage, structurally, is that policy makers find it much harder to push the cycle just by managing short-term interest rates today.
Could Covid-19 create its own structural legacy? History suggests that the global economy after a major crisis like Covid-19 will likely be different in a number of significant ways.
- Microeconomic legacy: Crises, including epidemics, can spur the adoption of new technologies and business models. The SARS outbreak of 2003 is often credited with the adoption of online shopping among Chinese consumers, accelerating Alibaba’s rise. As schools have closed in Japan and could plausibly close in the U.S. and other markets, could e-learning and e-delivery of education see a breakthrough? Further, have digital efforts in Wuhan to contain the crisis via smart-phone trackers effectively demonstrated a powerful new public health tool?
- Macroeconomic legacy: Already it looks like the virus will hasten the progress to more decentralized global value chains — essentially the virus adds a biological dimension to the political and institutional forces that have pushed the pre-2016 value chain model into a more fragmented direction.
- Political legacy: Political ramifications are not to be ruled out, globally, as the virus puts to the test various political systems’ ability to effectively protect their populations. Brittle institutions could be exposed, and political shifts triggered. Depending on its duration and severity, Covid-19 could even shape the U.S. presidential election. At the multilateral level, the crisis could be read as a call to more cooperation or conversely push the bipolar centers of geopolitical power further apart.
What Should Leaders Do in Relation to Economic Risks?
The insights from financial markets and the history of analogous shocks can be operationalized as follows:
- Don’t become dependent on projections. Financial markets are currently reflecting great uncertainty. A wide range of scenarios remain plausible and should be explored by companies.
- Don’t allow financial markets gyrations to cloud judgement about the business you lead.
- Focus on consumer confidence signals, trust your own instincts, and know how to leverage your company’s data in calibrating such insights. The impact will not be uniform, and the conclusions will be specific to your industry.
- Plan for the best and prepare for the worst trajectories. Keep in mind that a V-shaped recovery is the plausible scenario conceptually and empirically, but don’t let that insight make you complacent.
- Begin to look past the crisis. What micro or macroeconomic or legacy will Covid-19 have? What opportunities or challenges will arise?
- Consider how you will address the post-crisis world. Can you be part of faster adoption of new technologies, new processes, etc? Can you eventually find advantage in adversity for your company, clients and society?
‘Do whatever it takes’: Beijing urged to act as China’s economy falters – The Guardian
The US economy is 'nowhere near a recession this year,' says an economist—but 2023 is a different story – CNBC
With turmoil in the markets, high inflation and impending interest rate hikes that will make borrowing money more expensive, many Americans are wondering if the economy is heading toward a recession.
Goldman Sachs chairman Lloyd Blankfein said last weekend that “it’s certainly a very, very high risk factor,” and consumers should be “prepared for it.” However, he hedged his comments by saying the Federal Reserve “has very powerful tools” and a recession is “not baked in the cake.”
Although it is impossible to know for sure, the odds of a U.S. recession in the next year have been steadily rising, according to a recent Bloomberg survey of 37 economists. They have the probability pegged at 30%, which is double the odds from three months ago.
To put that number into context, the threat of a recession is typically about 15% in a given year, due to unexpected events and numerous variables.
The bottom line: “The likelihood of recession this year is pretty low,” says Gus Faucher, a chief economist at financial services company PNC Financial Services Group. However, “it gets dicier in 2023 and 2024.”
What determines whether the economy enters a recession
A recession is a significant decline in economic activity that is spread across the economy and lasts more than a few months, according to The National Bureau of Economic Research, which officially declares recessions.
A key indicator of a possible recession is the real gross domestic product (GDP), an inflation-adjusted value of the goods and services produced in the United States. For the first time since early in the pandemic, it decreased at an annual rate of 1.4% in the first quarter of 2022. Since many economists agree that 2% is a healthy annual rate of growth for GDP, a negative quarter to start the year suggests the economy might be shrinking.
Another factor is rising inflation, which has recently shown signs of slowing down. But it’s still well above the Fed’s 2% target benchmark, with a year-over-year rate of 8.3% in April, according to the most recent Consumer Price Index numbers.
With a high rate of inflation, higher prices outpace wage growth, making things like gas and rent more expensive for consumers. For that reason, the Fed imposes interest rate hikes, as they did in March and May, with five more expected to follow this year. These hikes discourage spending by making the cost of borrowing money more expensive for businesses and consumers.
While many economists still expect the GDP to grow in 2022, the rate by which inflation is decreasing is less clear.
Signs of economic strength
However, there are positive economic indicators to consider as well. Job numbers continue to look good, as the U.S. economy in April had its 12th straight month of job gains of 400,000 or more. And employment levels and consumer spending remain strong, for now, despite interest hikes and inflation.
“Ultimately, inflation in terms of rising prices needs to work its way into actual spending behavior,” says Victor Canalog, head of the commercial real estate economics division within Moody’s.
He points out that consumer expenditures in the U.S. rose by 2.7% last quarter: “People are still spending more, but at what point will they start spending less?”
Despite these positives, risks remain. The Federal Reserve is walking a fine line with its monetary policy, says Faucher, as doing either too much or too little to control inflation could further hurt the economy.
“Rising interest rates are designed to cool off growth, hopefully without pushing the economy into recession,” says Faucher. But he says that if the central bank “raises their rates too much, that can push the economy into recession.”
“That’s why I’m more concerned about 2023, or 2024, because we’ll have felt the cumulative impact of all of those interest rate increases that we’re going to be seeing over the next year and a half.”
‘Difficult to believe’: Biden’s economy plan a tough sell in Asia – Al Jazeera English
Phnom Penh, Cambodia – US President Joe Biden’s arrival in Seoul on Friday marks not only the start of his first visit while in office to South Korea and Japan, but the beginnings of an economic initiative aimed at deepening United States ties across Asia.
Though many of the Indo-Pacific Economic Framework’s details have yet to be finalised, the Biden administration has made one point clear – the plan is not a traditional trade agreement that will lower tariffs or otherwise open access to US markets, but a partnership for promoting common economic standards.
While many of China’s regional neighbours share Washington’s concerns about the burgeoning superpower’s ambitions, the IPEF’s lack of clear trade provisions could make it an uninspiring prospect for potential members, especially in Southeast Asia.
“You can sense the frustration for developing, trade-reliant countries,” Calvin Cheng, a senior analyst of economics, trade and regional integration at Malaysia’s Institute of Strategic and International Studies, told Al Jazeera. “There’s always talk about engaging Asia, the idea, but what exactly is it – and what are the incentives for developing countries to take up standards that are being imposed on them by richer, developed countries?”
Since announcing the IPEF in October, the Biden administration has characterised the initiative as a way of promoting common standards under the pillars of fair and resilient trade; supply chain resilience; infrastructure, clean energy, and decarbonisation; and tax and anti-corruption.
A fact sheet distributed by the White House in February describes the framework as part of a wider push to “restore American leadership” in the region by engaging with partners there to “meet urgent challenges, from competition with China to climate change to the pandemic”.
Nevertheless, Biden’s decision not to pursue a major trade deal harks back to the protectionist leanings of former US President Donald Trump, and, in particular, his administration’s abrupt pullout from the landmark Trans-Pacific Partnership (TPP).
Trump, whose antipathy towards traditional alliances sparked anxiety in many Asian countries, scuttled that agreement in 2017 despite sharing the deal’s aims of countering expanding Chinese economic influence.
But even without clear benefits to boost trade, Asian leaders have, for the most part, reacted favourably to the prospect of renewed US engagement in Asia.
Longtime allies Japan and South Korea are expected to be among the first to engage with the IPEF, as are Singapore and the Philippines.
From Vietnam, Prime Minister Pham Minh Chinh said at the recent US-ASEAN summit that Vietnam “would like to work with the US to realise the four pillars of that initiative”.
However, he added that Vietnam needed more time to study the framework, as well as to see more “concrete details”.
Thailand has also demonstrated interest, while leaders in Indonesia and India have yet to take a clear position.
Huynh Tam Sang, a lecturer of international relations at the University of Social Sciences and Humanities in Ho Chi Minh City, said Hanoi wished to avoid antagonising either the US or China – a common position for Southeast Asian states attempting to stay clear of great power struggles while avoiding being dominated by their northern neighbour.
“The Vietnamese government has been rather prudent not to showcase any intentions to join the IPEF or not, though I think there are many benefits to joining,” Sang told Al Jazeera, listing clean energy and reliable supply chains as common interests.
Sang said, however, that other standards, such as those related to taxes and anti-corruption efforts, could be a step too far for the Vietnamese government.
“I think Vietnam could be really reluctant to join that pillar for fear of the US intervening in Vietnam’s domestic politics,” he said.
“The anti-corruption campaign is definitely going on, but many Vietnamese are very sceptical of this view of cooperation, especially with the US when the Biden administration has prioritised democratic values when fostering ties with regional countries.”
Such concerns could undercut the renewed US engagement, particularly when China has made a point to engage in trade without such values-based strings attached. The Regional Comprehensive Economic Partnership (RCEP), a free trade deal that went into effect at the start of this year, is a testament to that hands-off approach to some observers.
China played a key role in negotiating the RCEP, which also includes Japan and South Korea, plus all 10 of the ASEAN member-states – Brunei, Cambodia, Indonesia, Laos, Malaysia, Myanmar, the Philippines, Singapore, Thailand and Vietnam – as well as Australia and New Zealand.
In total, the RCEP covers some 2.3 billion people and an estimated 30 percent of the global economy. The partnership is widely seen as being more focused on promoting trade by removing tariffs and red tape, with a less holistic approach to raising economic standards than the TPP or its successor, the reassembled Comprehensive and Progressive Agreement for Trans-Pacific Partnership (CPTPP).
Cheng described the CPTPP, of which the US is not a member, as the “gold standard” for trade deals in the region, noting its commitment to expanded trade access as well as provisions to safeguard labour rights, promote transparency and address environmental issues and climate change.
“So the IPEF is pretty much that, but taking out the trade deal aspect of it, leaving just the standards,” he said.
It remains to be seen how far the standards-only method will go in terms of winning acceptance across Asia.
Already, Malaysian Prime Minister Ismail Sabri Yaakob and international trade minister Azmin Ali have said the US should take a more comprehensive approach.
Ali described the framework proposal in an interview with Reuters as a “good beginning for us to engage on various issues” and said Malaysia would decide which IPEF pillars it would consider joining. At the same time, he made clear the IPEF was not a replacement for the more-comprehensive TPP.
Some of the most straightforward public criticism of the new framework on that front has come from prominent former ministers in Japan, one of the region’s most steadfast US allies.
Earlier this month, former foreign minister Taro Kono and former justice minister Takashi Yamashita spoke at an event in Washington of the new framework’s lack of hard commitments, an aspect they found glaring in the context of the abrupt collapse of the TPP. In their comments, the two maintained the IPEF would only serve to undermine the CPTPP.
“Now the Biden administration is talking about the Indo-Pacific Economic whatever, I would say forget about it,” Kono said.
Hiroaki Watanabe, a professor of international relations at Ritsumeikan University in Kyoto, said the US withdrawal from the TPP had undermined Japanese perceptions of the IPEF’s stability. Though Biden may promote his framework while in power, Watanabe said, there was no guarantee the next president would.
“Right now, it’s the Biden administration, but we don’t know what will come next – it could even be Trump again,” Watanabe told Al Jazeera.
“From a non-American perspective, it’s really difficult to believe what America is saying when it says it wants to commit itself to these plans,” Watanabe added. “There are many challenges to the logistics of this, and then the US may just throw away the kind of commitment as measured by the IPEF in the future. Practically, it’s not meaningless, but it’s not significant either.”
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