Leading Indicators: Covid-19 and the new economic rulebook

Fears surrounding a second wave of Covid-19 infections persist. Nonetheless, there is a sense that the economic numbers will begin to pick-up over the coming months. Analysis from Morgan Stanley shows two-thirds of economies are now seeing driving activity back up to three quarters of the normal volume. Meanwhile in China, hotel occupancy climbed above 70% towards the end of last month.

That is all welcome news, but it would be a mistake to conflate this improvement with a return to business as usual; the pandemic will leave some lasting scars. Unemployment is likely to rise over the coming months as retention schemes wind down. Uncertainty about the longer-term outlook will weigh on corporate behaviour, particularly big capex decisions. Existing commitments to the public sector may be reviewed in the face of increased pressure on resources.

Against this uncertain backdrop, policymakers around the world remain on the front foot. Additional stimulus measures, designed to drive the recovery even as signs accumulate that economies have bottomed out, have been pushed forward. In the US, there are strong signals that the Senate will soon promote another relief package, which could provide around US$1 trillion of additional fiscal support. To add context, this would lift the US fiscal deficit to some 24% of GDP – the highest since 1943.

In Europe, the ECB has announced an expansion of its Pandemic Emergency Programme (quantitative easing by another name) from €750bn to €1.35bn. More significantly, the European Commission looks likely to win the argument with northern member states and create a Recovery Fund worth €750bn. The importance of this should not be underestimated. The fund will provide a transfer mechanism primarily built around grants (with loans playing a lesser role) to support the hardest hit economies in the EU. It is also sends a clear signal that the taboo around bond issuance from the centre (mutualised debt) has been broken.

Significantly, it is not just in the west where policy activism remains assertive. In Japan, the Cabinet has approved a larger-than-expected supplementary budget draft, lifting the fiscal deficit to 14.2% of GDP (versus 2.8% in 2019). And in China, the government recently unveiled an upgraded stimulus package worth 4.5% of GDP. This means that around RMB 1 trillion will be added to deficit spending this year. Moreover, the state is also issuing an anti-virus special bond worth a similar amount which will not be accounted for in the fiscal numbers.

How this plays out in terms of the economic data going forward remains to be seen. Inevitably, the attempt to recapture the lost ground will take more time in some parts of the world than others. McKinsey’s latest survey of American and European business leaders suggests it could be 2022 before the corporate sector returns to where it was at the beginning of this year. For APAC, the sense is that things could turnaround a little more quickly.

A key element in this will be the response of policymakers to ballooning budget deficits and bloated central bank balance sheets as the recovery takes hold. It remains to be seen whether measures adopted over the past few months are in any sense a precursor to a revival of inflationary pressures. Any such pressures would likely have ramifications for the future course of monetary policy.

My sense is that at current time, the bigger threat is actually one of deflation with overall demand at a global level likely to remain deficient. Recent analysis from the investment bank Jefferies shows around a quarter of items in the basket of goods that captures inflation in Europe and America to be posting year-on-year declines. However, I would also be mindful of the risk highlighted in a forthcoming book by Charles Goodhart and Manoj Pradhan that this may not remain the case – at least in the west. They point to the shifting balance of bargaining power away from employers and towards workers which will manifest itself in a distributional struggle over income in the coming years. That would be a challenge to the ‘Japanification’ narrative that is widely viewed as providing a helpful playbook as to how events might unfold in the post-pandemic world.

Where that latter theme might be more relevant is in terms of the absorption of public debt issuance. Gross government debt in Japan currently stands at around 230% of GDP. For the record, it has been on an upward trajectory since the financial crisis of the late-1980’s, although the trend has begun to flatten in recent years. Critically however, more than two-thirds of outstanding debt is held by the central bank. This helps to explain how outsized levels of borrowing have been achieved with interest rates remaining low or, as now, negative. After the global financial crisis, central banks elsewhere began moving in this direction with quantitative easing initiatives. The major expansion of these programmes over the past few months has pushed holdings closer to those of the Bank of Japan.

This is helping to relieve any immediate pressure on the authorities in terms of funding. It is also likely to provide an attractive choice, when compared to the alternatives: searching for private sector buyers, or materially paying down debt. It does also raise a question about the future role of government in the economy, and what that is likely to mean for the medium-term growth environment. This is a subject that I will return to in a future commentary.