March 30, 2020
Mark Minchin

The Economic Scale of COVID-19

Coronavirus is affecting the global economy to a greater degree than any previous event. 

Global supply chains are so interwoven that the initial disruption in China triggered a meaningful slowdown in World trade and economic activity. Since then, the virus has spread to all the major economies of the World and governments are responding in unison with draconian measures – further exacerbating the reduction in economic activity.

To offset this extraordinary decline in economic activity governments are launching unprecedented stimulus measures.

In the GFC, central banks bailed out the financial system. Liquidity was pumped into the system via unconventional quantitative easing as trillions of dollars of financial assets, including sovereign bonds, corporate bonds and residential mortgage-backed securities were purchased from banks and other financial organisations. This liquidity coupled with all-time low interest rates saved the global economy from a multi-year depression scenario.

In the current crisis, it is labour – the workers and consumers – who must be bailed out, just as the financial system was bailed out in the GFC.

Whereas in the GFC, most of the work to bail out the financial system was done by central banks (through the lowering interest rates and purchasing of assets); in this current crisis central banks have less fire power at their disposal. They entered this crisis with very low interest rates already, and thus have “run out of rope” to lower them further.

In Australia for example, we entered this crisis with cash interest rates at 0.5% (when the GFC started cash rates were at 7.25%). Since the start of the crisis the RBA has cut rates to 0.25% but this small cut will have minimal effect. Thus, it is Fiscal Policy (ie government spending) that must play the major role in saving the economy.

How do Governments Borrow?
In order to unleash unprecedented stimulus measures, governments will have to borrow big (circa 10% of GDP as a starting point). They will do this by issuing bonds to the market. Or, put another way, they will borrow from investors ‘at large’ via the bond market. That is, investors will lend governments money by buying their bonds and in return they will be promised a set interest rate for the term of the loan (the bond) after which the loan is repaid (the bond matures).

A government’s ability to borrow money, and the rate of interest they are required to pay are influenced by their credit rating – the bond market’s opinion on how safe a bet that government is.

So, much in the same way a home loan borrower needs to demonstrate to their bank that they have the capacity to repay the loan, so to governments need to demonstrate to the bond market that they are able to pay the interest on their bonds and ultimately repay the principal at maturity.

How well placed is the Australian Government?
In this regard, Australia is in pretty good shape. Our Government has good income earning potential and their existing level of debt is relatively low.

A commonly used measure for looking at this is the ratio of “Government Debt to GDP”. On this measure Australia sits in good company at around 41% (Switzerland is 39%, South Korea is 41%, Sweden and Norway are at 37%), hence our AAA rating.

Aside from New Zealand, none of our closest peers are in quite as good shape as we are right now: New Zealand 28%, United Kingdom 86%, Canada 88%, United States 107%, Singapore 109%.

This means that our Government’s capacity to borrow and stimulate our economy is considerable. AAA government bonds are still sought after, and our government isn’t having difficulty in raising the funds.

Spare a thought for Italy, Spain and Greece (Debt to GDP of 133%, 96% and 174% respectively).

Governments Unified in “All In” Approach
For some of the more fiscally challenged governments, it is possible that their central banks may have to purchase the bonds of their own governments – or put another way, they may need to print the money rather than raise it via conventional means.

Either way governments of the World have unified to take an “all in” approach to settle the economic disruption and if institutional investors are reluctant to step up to buy meaningful swags of government bonds at the current low yields, central banks are standing ready to be the buyer of last resort.

How is this time different to the 1930’s and what have we learned?
It must be said that this synchronised and rapid fiscal response is very different to that which occurred in the 1930’s. When the Great Depression of the 30’s hit governments took years to properly respond and stimulate their economies. And to make matters worse they became more protectionist, further reducing global trade and economic activity. Economic theory today is far more evolved, and we have learned from our past mistakes.

Similarly, the GFC has been a tremendous dress rehearsal for the current crisis.  In 2008 the Federal Reserve and other central banks, initiated a series of unconventional and untested measures that involved a massive expansion of their balance sheets as they acquired sovereign bonds and all kinds of distressed assets through QE (quantitative easing) and targeted programs such as TARP (troubled asset relief program).  At that time economists were divided about the long term viability of these initiatives – including whether they would subsequently result in inflation – but alas all these initiatives proved successful and the QT (quantitative tightening) that followed QE saw the Fed reduce its balance sheet in an orderly and effective way.

Is there anything to be optimistic about?
When the coronavirus is finally referred to in the past tense and things return to normal, there will be a lot of soul searching. But financial markets along with all aspects of life will ultimately normalise.

Amidst this emotionally charged atmosphere, with the media squarely focussed on the shock and awe, it is easy to become overly negative. However, when we pan out and look at the longer-term picture – things don’t look quite so bad.

Most researchers predict a severe economic impact in the short term, but minimal long-term economic impact. For example, MorningStar predict that the global economy will see a 1.5% hit to GDP in 2020, but they don’t see the impact being significant in the longer run. They suggest that long-run GDP will be reduced by a more tolerable 0.2% of GDP (relative to their expectation prior to COVID-19).

Fatality rates in the developed world appear to be on an ultimate trajectory of around 0.5% of those infected, with most deaths being among the elderly or those with significant, pre-existing medical conditions.

Finally, it is worth bearing in mind that economic recoveries almost always surprise on the upside.

What does Capitulation feel like?

The one thing we know with certainty with bear markets is that they will eventually end. The problem of course is working out when. In market speak, “capitulation” is the point where everybody has had enough, when investors can take no more pain, the bears have sold everything they had [Read More]

March 31, 2020