Five reasons why the recovery will take time

With restrictions on economic activity starting to be lifted, and central banks and governments having put in place unprecedented stimulus, optimism is in the air. Certainly financial markets have been partying in recent weeks despite the gloom in the economic data and corporate earnings reports. We are sceptical about the idea of a durable, strong recovery taking shape quickly. A bounce in activity around the middle of this year will most likely be followed by renewed weakness. In this note, we will set out  five reasons to expect the economy to take time to recover.

200511-Global-Monthly-Why-recovery-will-take-time.pdf (293 KB)

Exit will be gradual

First of all, while governments are starting to lift restrictions and have set out timelines to go further, this will be a gradual process. We have set out in the boxes below the exit plans of various governments in the eurozone, China and US. In terms of where we are now, most countries/states appear to have moved from hard lockdown to soft lockdown rather than to no lockdown. The Netherlands (together with Germany) is ahead of the curve, as the lockdown measures were less strict to begin with and the reopening steps seem to go a little faster than in other eurozone countries (see box 1)

According to the various government plans, the exit process is going to be a gradual process in most jurisdictions. In addition, there will likely be a long tail with some activities working at below pre-corona capacity levels because of social distancing measures that will likely persist for several months. Finally, some economic activities will remain closed or severely restricted for longer. This relates to large events and cross-border travel,  which means demand fuelled by tourism will remain subdued.

There are differences in terms of the extent of the drag on economic activity between soft lockdown,  hard lockdown and no lockdown. For instance, the services PMI business activity index in France – experiencing a hard lockdown – stood at 10.4 in April, while in Germany – experiencing a soft lockdown – it stood at 15.9 (see chart below). We also notice sharper falls in car sales in Italy (hard lockdown) compared to Germany. These observations are based on early data. However, what seems to be clear is that whatever the lockdown model, activity is falling at a rapid pace in all cases.

The possibility of stop and start

Second, there is a distinct possibility that the exit process is not smooth, but determined by how the virus data react to the lifting of restrictions. Deteriorations in the virus data could lead to a pause in the process of lifting restrictions or even a re-introduction of some measures. The risks seem highest where the political pressure to open up appears to be running ahead of the improvements needed in the virus data that would justify an exit. In a number of US states this seems to be the case (see box 2 on the US exit process). In the eurozone, governments seem a bit more cautious but also here most countries have not completely fulfilled the easing conditions they had previously set. ‘Opening up our economies’, the European Commission President Von der Leyen said, ‘is conditional on being able to handle a second wave of infections’. This implies not only a replication rate of the virus below one, but also the normalisation of hospital capacity and having large scale ‘test and trace’ facilities in place.  Unlike in China (see box 3) practically no eurozone economy seems to have all three conditions completely fulfilled. As a result, we expect the economic recovery in China to be a best case scenario, while recovery in the eurozone will be much more protracted (see box 4).

A scenario of a pause and re-introduction of restrictions on the back of a second wave would not only restrict economic activity directly but would damage public confidence in their own safety, leading to heightened caution in consumer behaviour.

No silver bullet solution in near term

Third, there is no silver bullet solution to the virus in the immediate horizon. A vaccine looks like not being available in any scale until next year. The WTO said in mid-February that a vaccine may not be available to the public for 18-months. Multiple research groups have designed potential vaccines, however, this is only the start of the process. Tests need to show that the vaccine is safe and effective, it needs to be produced in large numbers and there is a huge logistical challenge involved in inoculating the world’s population. Before a vaccine, the strategy that many governments are employing is ‘test and trace’. Although many governments have ramped up testing over recent weeks, even in the front-runner countries, only a small proportion of the population has been tested. For most large countries, testing per one million of the population is currently in the 20-40K persons range. In terms of contact tracing, mobile technology applications are still being developed to enable broad scale tracing and quarantining potentially infected people.

The lack of a silver bullet solution or alternatively virus trends being very supressed could lead to ongoing subdued consumer behaviour. A possible example here is Sweden, where no lockdown has been implemented but economic activity has still fallen sharply (see chart above). It must be said that Sweden’s services PMI business activity index has for sure not fallen as deeply as it did in Germany and France, however it is still at levels (at 29.9) consistent with sharp falls in domestic demand.

China’s experience points to consumer caution

This brings us on to our fourth point. China’s post lockdown experience also points to a slow recovery in the services sector, with consumers remaining cautious. Our recent note (see here for more details) showed that the recovery in the industrial and construction sectors was relatively rapid. However, the services sector is still operating clearly below pre-corona levels. That is particularly true for consumer-related services, while production-related services are doing better. This reflects that domestic demand has yet to recover, albeit there are some tentative signs of stabilisation. In March, annual retail sales growth was still in contraction territory at -15.8% yoy (Jan/Feb: -20.5%), illustrating that private consumption is still well below pre-corona levels. That partly reflects behavioural changes (consumers have become more cautious and restrict themselves despite the lifting of official restrictions) and social distancing measures. Having said that, consumer confidence bounced back somewhat after China’s reopening, which may signal the potential of consumption to recover after the economy leaves Covid-19-related disruption marks behind.

Second round effects take time to work through

The final reason to expect a slow recovery is that the second round effects from the initial economic shock will continue to weigh on the economy, as these effects take longer to work their way through. Higher unemployment, tighter financial conditions, corporate defaults, corporate retrenchment in terms of capital spending,  supply chain disruption and the synchronised nature of the slowdown across virtually every economy are the key second round effects we have in mind.

We expect the US unemployment rate to peak at around 18%. Although, we judge that it will come down again (as those laid off temporary come back to work), it will still likely be around 10% at the end of this year, compared to 3.5% in February. Eurozone labour market adjustment takes longer. We expect a continued rise in the unemployment rate up to exceed 10% by the end of next year, compared to 7.3% in February. The dire situation in the labour market is likely to depress consumer spending by both pushing up precautionary saving as well as reducing aggregate disposable income.

Meanwhile, financial conditions remain significantly tighter than they were before the Covid-19 shock. This is shown in the chart below on the left that shows financial conditions indexes for the US and the eurozone. Aggressive central bank monetary easing has managed to reverse some – but not all – of the tightening in financial conditions. This tightening will weigh significantly on demand over above the effect of the restrictions on activity discussed above. Similarly, the fiscal stimulus we have seen has been aggressive, but it is still not commensurate to the size of the economic shock that the economy is experiencing.

The corporate sector is experiencing extreme stress. Moody’s expects global speculative-grade default rates to reach 11.3% (compared to a peak of around 14% during the Global Financial Crisis and 4.4% now) reflecting the collapse in earnings and deteriorated debt fundamentals going into the Covid-19 shock. As a result we expect to see corporate retrenchment in terms of reducing payrolls (leading to rising unemployment as discussed above) and plunging capital spending.

Factory closures – starting in China and subsequently spreading across the global economy – have led to significant supply chain disruptions, which will take some time to resolve. This is an area that is difficult to monitor, but one clear indicator comes in a sub-component of the manufacturing PMI surveys. Supplier delivery times usually rise when the manufacturing sector is buoyant and operating at full capacity. In contrast, supplier delivery times have currently surged to record highs despite a deep recession in the sector, which we see as being indicative of profound supply-chain disruption (see chart above on the right).

A final source of second round effects is the synchronised nature of this sharp shock. Covid-19 has impacted every country with a power that is unprecedented outside of peace time. This shock has therefore led to a synchronised hit to every major economy. The weakness in demand in each economy will spill-over and re-enforce the downturns in every other. This will be reflected in a contraction in world trade that is ever sharper than that seen during the global financial crisis.