Fast and furious: policymakers react to COVID-19

The need for speed has never been greater to combat the coronavirus crisis. With the brakes slammed on economic activity in March, financial markets faced an unprecedented liquidity challenge. But the policy response has been equally unprecedented – greater, and faster, than the GFC and comparable only to wartime. Russell Silberston sheds light on the monetary and fiscal response to COVID-19 in this 11-minute read.

Apr 6, 2020

11 Minutes

The need for speed has never been greater to combat the coronavirus crisis. With the brakes slammed on economic activity in March, financial markets faced an unprecedented liquidity challenge. But the policy response has been equally unprecedented – greater, and faster, than the GFC and comparable only to wartime. Russell Silberston sheds light on the monetary and fiscal response to COVID-19 in this 11-minute read.

Central banks have done a lot, says Russell Silberston. But is it enough?

Since its first appearance in Wuhan, Hubei, China toward the end of December 2019, the coronavirus (COVID-19) has spread rapidly across the world, causing widespread strains on society and economies.

Nassim Nicholas Taleb, in his 2007 best seller ‘The Black Swan1’ described three attributes of low probability but large impact events. Firstly, it is an outlier, with nothing in the past that can convincingly point to its possibility. Secondly, it carries an extreme impact, and lastly, an ex-post narrative makes it both explainable and predictable.

Using Taleb’s definition, the global COVID-19 pandemic, currently placing more than 20% of the global population under restrictions2 to their daily lives is not a ‘black swan’ in the strict sense. In 2006, the UK financial authorities carried out a ‘Market Wide Pandemic Exercise’ that ‘highlighted a number of important challenges that would face the financial sector in the event of a flu pandemic.3’ And in 2011, the UK Department of Health published a ‘UK Influenza Pandemic Preparedness Strategy 20114’ in which they stated that “given known patterns of spread of infection, up to 50% of the population could experience symptoms of pandemic influenza during one or more pandemic waves lasting 15 weeks.” So off the radar certainly, but hardly impossible to conceive.

However, the current episode certainly ticks two of Taleb’s boxes. There can be little doubt that the economic and social impact are likely to be extreme. And it seems probable that once the worst passes, the narrative in financial markets and society will be more geared to understanding what happened.

While events are fast moving and unfolding rapidly, it is important to differentiate between problems with the financial plumbing and the wider economic damage caused by the dislocation brought about by placing restrictions on 20% of the population. Financial markets operate on a different time scale to policymakers, as the former move quickly to discount future news and anticipate evolving credit conditions in real time. Policymakers, on the other hand, take a more considered view and so are rarely able to react with the urgency that financial markets scream for. This can often lead to a ‘sudden stop’ as a viscous cycle of higher cash demands sees funding markets dry up, forcing up volatility and margin requirements, which in turn pushes up liquidity requirements further. The circle is only broken once central banks offer enough liquidity for everybody, thus reducing demand, volatility and margin. Four weeks into the current period of extreme volatility, the speed and scale of policymaker intervention suggests the plumbing is being repaired rapidly. The economic fallout, however, is only just starting and the scale of the dislocation is likely to be unrivalled in history, with the possible exception of the Great Depression. However, in an inversion of the usual rules of economic forecast making, the near-term outlook is highly uncertain, but in the medium term, economies are likely to bounce back strongly as normality returns and the amount of policy stimulus in the system gains traction.

Monetary policy addresses the need for liquidity


Market liquidity is easy to define in principal; it is the ability to buy or sell an asset with minimal cost. However, economic history teaches us that it is not constant but rather varies widely. It is thus hard to pin down in practice. It is best considered by focusing on both its supply and its demand. Supply is the ability of investment banks and dealers to warehouse stock and quote competitive two-way prices. The demand for liquidity is dominated by asset owners and investment managers, whose asset base is a function of global saving and global borrowing.

The supply of liquidity is influenced by two broad interconnected factors; ease of funding and confidence. In recent weeks, both have tightened markedly. Given the breadth of potential future outcomes from here, the COVID-19 virus has made near-term forecasting impossible, which in turn has seen precautionary credit lines drawn down, liquidity buffers raised and risk management departments request lower exposure. Despite post global financial crisis (GFC) regulation requiring much higher liquidity buffers, the shock saw money market rates rocket and bid-offer prices widen significantly. Equally, asset owners and investment managers face similar pressures; they need to have enough liquidity for pending outflows, margin calls and cash money to invest in compelling assets. With both the supply and demand for liquidity therefore in disequilibrium, only monetary policy can pump in enough cash to ease the pain. And in recent weeks the scale and speed of the reaction has been unprecedented.

Figure 1: Pace of US Federal Reserve balance sheet expansion (US$ millions)
Source: Bloomberg, NY Fed Statement issued Monday as at 27 March 2020

The US Federal Reserve (Fed), for example, is on track to add $2 trillion within four weeks of the market dislocation taking hold, a significantly faster pace than seen during the GFC. In an effort to ease shortage of US dollars outside of the United States, they have activated swap lines with major central banks, lending $80 billion into the eurozone and $130 billion into Japan.

The European Central Bank (ECB) has also been aggressive by launching a €870 billion quantitative easing programme, lending cash at -0.75% and easing bank capital requirements – a trio of measures that could add nearly €3 trillion of liquidity to markets. Given their balance sheet assets stood at €4.7 trillion at the end of 2019, this package marks a significant offset to the liquidity and economic headwinds.

The corporate bond market has grown massively in recent years, as finance managers take advantage of low interest rates to refinance existing debt, fund share buybacks and undertake mergers and acquisitions. Much of this debt has ended up with long-term investors, serviced by investment managers. Given that many of these buy-side firms offer same day liquidity on their pooled funds, the demand for liquidity has increased in line with the growing borrowing. The magnitude of the increase in corporate debt can be seen below, based on data for credit to non-financial corporations, supplied by the Bank for International Settlements.

Figure 2: Outstanding non-financial companies (US$ billions)

Source: Bank for International Settlements & Ninety One calculations as at 30 September 2019

With $16 trillion outstanding and market liquidity non-existent, the Fed has resurrected its GFC playbook by operating a number of special purpose vehicles, capitalised by the US Treasury and leveraged up to ten times in order to support both primary and secondary corporate bonds and money market instruments. With initial capital of $50 billion, this gave the Fed $500 billion of buying capacity. But the recent adoption of the US Phase Three emergency legislation onto the statute book, the Treasury has earmarked an additional $150 billion of capital across three of these special purpose vehicles, giving the Fed potential buying power of $3.6 trillion (3*150bn*8x leverage). It can be no surprise, therefore, that corporate bond spreads have begun to normalise for illiquidity, if not yet for the economic fallout.

Including quantitative easing as well, as at 31 March 2020 we tracked a total of $7.6 trillion in market specific measures from the US that are aimed at improving liquidity and price discovery.

A possible path for macro data in the coming months


The expenditure measure of gross domestic product (GDP) is the simple sum of household and government spending, business investment, exports less imports and an adjustment for inventories. It generally grows around a trend, with only recessions seeing a material deviation from this trend. The trend itself also moves, but this a function of slowing moving factors such as population growth and the productive capacity of the economy. It is easy to forecast in the short term, but much harder in the long term. The COVID-19 crisis, however, turns forecasting ability on its head; it is going to be exceptionally hard to calibrate the near-term economic path, but in the medium term, we can have a high degree of confidence of a reversion to trend growth.

One way to think about the coming economic slump is to consider the contributions of each expenditure item listed above. Taking the UK, for example, household consumption comprised the vast majority of the average 0.4% quarterly GDP growth in recent years, with a 5-year rolling growth rate of 0.4%, while business investment grew 0.1% and net trade detracted 0.1%. The consumer, as is the case in several large economies, is the lynchpin of GDP. Using the latest data on consumer trends, published by the Office for National Statistics, we can see the breakdown of this spending by category for 2018, and from that begin to pencil in a possible economic impact, as in Figure 3.

Figure 3: Potential lockdown impact on consumer trends spending

 

Amount, £millions

% of total

Note

Estimate of lockdown impact

Weighted impact

Housing 

347462 

25.88% 

Rent, inputted rent & utility bill  

None 

0.00% 

Transport 

183896 

13.70% 

 

80% reduction 

-10.96% 

Misc goods and services 

173740 

12.94% 

 

80% reduction 

-10.35% 

Recreation and culture 

149854 

11.16% 

 

50% reduction 

-5.58% 

Restaurants and hotels 

126692 

9.44% 

 

90% reduction 

-8.49% 

Food & drink 

104378 

7. 77% 

 

None 

0.00% 

Clothing & footwear 

67499 

5.03% 

 

50% reduction 

-2.51% 

Furnishing and maintenance 

65576 

4.88% 

 

50% reduction 

-2.44% 

Alcohol & tobacco 

44434 

3.31% 

 

None 

0.00% 

Education 

31190 

2.32% 

 

10% reduction 

-0.23% 

Health 

26528 

1.98% 

 

None 

0.00% 

Communication 

21528 

1.60% 

 

None 

0.00% 

           

Sum 

1342777 

100.00% 

   

- 40.57% 

Source: ONS Table 02.KN, Consumer Trends, UK July to September 2019, released 20 December 2019

As will become immediately obvious, it is possible that UK consumer spending could fall 40% on an annualised basis, or 10% of GDP over three months. If the lockdown lasts six months, the impact could be 20%. Assuming similar spending patterns in other major economies, we can expect to see massive and immediate collapses in economic growth. There is little to no precedent to compare this period to any other in economic history, other than, perhaps, the Great Depression in the United States, where industrial production fell a cumulative 70% and unemployment rose from 2.1% in December 1929 to 25.2% in December 1932.

Fortunately, policymakers are well aware of their economic history and are doing all they can to ensure that the short-term disruption does not lead to a wholesale destruction of capital and employment. The fiscal response has been fast and aggressive, with US direct fiscal loosening, for example already standing at $1.5 trillion, and with another $500 billion shoring up the Fed’s efforts to stabilise financial markets. This already exceeds the $1.7 trillion enacted across three stimulus packages during the GFC and yet members of Congress are debating further measures.

In the United Kingdom, the Chancellor of the Exchequer has been quick to underwrite 80% of employee pay, up to £2,550 per month, reverse engineered through the Pay as You Earn (PAYE) employee tax system. We are currently tracking fiscal spending at £500 billion, or 21% of GDP.

The eurozone, unfortunately, has displayed its structural weakness, with no cross border fiscal policy to accompany the impressive actions of the European Central Bank. But at a country level, the response has been more impressive, with widespread loan guarantees, tax deferrals and mortgage guarantees. In aggregate, the range of packages sums to a little over €2 trillion, or 17% of eurozone growth.

Asia, the first region to be hit with the virus, has seen a much more subdued policy response to the crisis, with China and Japan implementing combined monetary and fiscal easing of 3% and 5% of their GDP respectively. In the case of China, the authority’s ability to direct banks to lend can be seen as the ideal model to overcome the dislocation in western markets.

The combined monetary and fiscal responses of the major economic block can be seen below.

Figure 4: Summary of key stimulus measures to date (US$ billion)

Source: Bloomberg. Federal Reserve websites and press releases, ECB website and press releases, UK Government website, speech transcripts and March 2020 Budget. ML ‘China Economic Watch’ as at 31 March 2020.

Figure 5: Summary of key stimulus measures to date (% of region’s GDP)

Source: Bloomberg. Federal Reserve websites and press releases, ECB website and press releases, UK Government website, speech transcripts and March 2020 Budget. ML ‘China Economic Watch’ as at 31 March 2020.

Relative to the measures G20 enacted during the GFC, which the IMF5 calculate as 2.1% of GDP, the fiscal response has been impressive. The monetary response is also approaching GFC levels, which the IMF calculate as 29.8 % across the average of G20 countries.

But this isn’t the GFC. Banks are much better capitalised, household debt is manageable and only corporate debt levels appear elevated. The impending fall in GDP will be historically large but it is important to remember that it is temporary. Once countrywide lockdowns are lifted, it seems highly likely that household spending will pick up again, especially if this coincides with a Northern hemisphere summer. If governments can avoid widespread unemployment and the destruction of viable businesses through no fault of their own, then normality will return, perhaps quickly. For now then, it appears that policymakers are reacting quickly enough and with enough targeted measures to avoid the most devasting outcomes.

Looking forward, it seems hard to envisage an exit from the current super-loose monetary and fiscal policy, many of which are on war-like settings. Historically, the response to this was financial repression through capped interest rates, credit controls and the limited movement of capital. Of course, this is exactly what China does now and given the huge dislocations seen in markets in recent weeks, and the taxpayers’ money it has taken to calm them down again, one wonders whose financial system has it right?

Conclusion


The COVID-19 crisis is the most dislocating episode to strike society and economies in decades. It has inverted our usual forecasting horizon, with limited near-term visibility but reasonable confidence in the medium term.

Economies are likely to experience an historic lurch lower, followed by a fast recovery, dependent on how quickly the virus is brought under control.

Monetary and fiscal policy has attempted to offset the worst of this, and the huge amounts of stimulus they have already pumped into the financial system and wider economy will aid this recovery.

In the medium term, if the labour market is relatively insulated and productive capital not destroyed during the following months, the global economy will recover much of its lost growth.

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Notes

  1. The Black Swan, Nassim Nicholas Taleb, Allen Lane, 2007 978-0-713-99995-2
  2. The Guardian, accessed 30/Mar/20
  3. UK Financial Sector Market Wide Pandemic Exercise 2006 Progress Report. 2008 update. Accessed 30 Mar 2020
  4. UK Department of Health UK Influenza Pandemic Preparedness Strategy 2011. Accessed 30 Mar 2020
  5. IMF Fiscal Monitor, May 2010

Authored by

Russell Silberston

Investment Strategist – Macro-Economic and Policy Research

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