By Philip Lawlor, managing director, Global Markets Research
As attention starts to shift towards when and how the lockdown exit will be implemented, there are a litany of important questions and themes that need to be considered in a post-lockdown world. In this blog, we pose ten questions, which are top of mind for market participants.
1. From a macroeconomic perspective, the most fundamental question is what will be the long-term economic impact from Covid-19 on growth?
Looking at the long-term historical trend, the moving average of US nominal GDP and bond yields over a fifty-period shows that the US, like many other economies, have encountered four major economic regimes: In the 1970s, the US economy experienced a period of significant inflation; then followed a period of so-called Great Moderation under Paul Volcker, which stripped inflation out of the system; then encountered 10-year of Goldilocks under Alan Greenspan, with nominal GDP averaging about 6% p.a.; and finally, a new normal, post global financial crisis, which have seen nominal GDP averaging about 4% p.a.
The close relationship between bond yields and nominal GDP and the continued decline in bond yields suggest that the US economy could be ratcheting towards a fifth lower trend growth regime.
US Nominal GDP Growth vs US 10-Year Govt Bond Yield
Source: FTSE Russell / Refinitiv. Data as of April 2020. Past performance is no guarantee to future results. Please see the end for important disclosures.
income data lags equity markets, the Fed is well aware that, if equity weakness persists, it could create a vicious spiral.
2. In a lower for longer economic growth environment, what does this imply for Climate and Carbon Emissions Targets financing. Could lower growth result in lower carbon output levels?
Lower trend growth could do a lot of the heavy lifting by way of carbon emissions reduction. However, one of the main consequences for moving towards a lower growth trend trajectory is that it exacerbates debt financing and solvency issues.
3. Will there be many more years of financial repression?
As learnt post the global financial crisis, negative real interest rates combined with central bank balance-sheet expansion had crowded out savings, which has been a persistent theme since then and could have a long duration.
4. Will central banks further extend asset purchases to equities and turn Japanese?
There is a strong relationship between US households’ net worth and equity performance. With US consumption representing 70% of GDP growth, the Federal Reserve is acutely aware that US households’ net worth is very important to its economy. While household
Source: FTSE Russell / Refinitiv. Data as of April, 2020. Past performance is no guarantee of future results. Please see the end for important legal disclosures.
5. What firepower do central banks still have to deploy?
Central banks have already undertaken massive liquidity injections in response to the Covid-19 shock and both the Fed and ECB have extended their QE asset purchases from government bonds, to include mortgage-backed securities, municipals, investment grade, and more recently, high-yield (fallen angels) credits.
Using the Bank of Japan as a proxy, the Bank of Japan has been by far the most aggressive to date, with the size of its balance sheet rising to 110% of its economy (see chart below). Even allowing for recent expansion, the Fed, ECB and BOE still have comparatively significant room in their balance sheets to expand QE programs substantially.
Central Bank Balance Sheets as a Percentage of GDP
Source: FTSE Russell / Refinitiv. Data as of April, 2020. Past performance is no guarantee of future results. Please see the end for important legal disclosures.
6. Therefore, this poses second order questions, such as will central banks end up monetizing debt (helicopter money)?
Given that fiscal deficits are likely to easily surpass levels seen in 2009, post GFC, this infers that central banks might need to embark on some debt monetization process, where debt is transferred to the balance sheets of central banks.
7. How worried should we be about inflation as supply shortages kick in?
The recent upturn in Chinese CPI forecast has shown that supply-chain disruptions could induce some price increases. However, referencing 2010 and 2011 when this last occurred, the period resulted in negative real earnings growth, which ended up being disinflationary. Therefore, central banks will be most concerned about declining household income and deflationary risks.
8 & 9 Will there be an intensification of localisation (versus globalisation) to build more resilience into supply-chain mechanisms? Will business strategies adopt Just in case’ not ‘Just in time’ inventory model?
Manufacturing processes have been finely tuned to minimize the working capital tied up in inventories. Will this business model still be suitable given the disruption risks to supply chains?
10. The recalibration to working from home is going to highlight the need for major business adjustments (i.e., real estate, airlines, transportation).
The biggest themes in coming months will be identifying winners and losers?
This article, first published on May 4, appeared on the FTSE Russell blog.
Photo Credit: Yuri Samoilov via Flickr Creative Commons
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