You Asked Us: The economic impact of the Covid-19 pandemic
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04 May 2020
Introducing our expert panel:
Simon Rubinsohn, Chief Economist, RICS
Sean Ellison, Senior Economist, RICS
Walter Boettcher, Head of Research and Economics – UK & EMEA, Colliers International
Howard Meaney, Managing Director and Head of Real Estate – UK, UBS Asset Management
Peter Cosmetatos, CEO, Commercial Real Estate Finance Council Europe
What are your thoughts on the US government’s apparent policy of printing infinite money – especially given that the dollar is so dominant globally?
Simon Rubinsohn: I am reasonably comfortable with the Fed commitment to act aggressively with its commitment to open-ended purchases of US Treasuries and other bonds. The scale of the crisis is unprecedented and justifies a ‘whatever it takes’ approach. The fact that the dollar effectively remains the world’s reserve currency provides more scope for this assertive response. Moreover, at this point, there is relatively little risk that the expansion in the Fed’s balance (and that of many other central banks for that matter) will fuel any uplift in inflationary pressures. Indeed, at this point, the key risk appears to be in the other direction.
Sean Ellison: Businesses are not struggling financially because they make a poor product or have an uncompetitive business model, they are struggling because a pandemic has forced us to shut down our economies until our healthcare systems can adequately cope with it. Economic policy needs to focus on avoiding a financial crisis by keeping cash in people’s pockets in the short-term, and making sure that businesses are able to continue operating once this passes. The policy risks here are asymmetric – the risks of doing too little outweigh the risks of doing too much.
Once this passes, we will be in an unprecedented situation – both governments and corporates will be carrying extremely high debt levels, almost certainly higher than in the immediate aftermath of the Global Financial Crisis (GFC). The closest comparison is likely the end of World War II. However, unlike in a war there is no capital destruction from a pandemic. Instead, we are left facing a different risk: that of austerity. If governments were to retrench, this could stifle any recovery.
New Zealand is a good example of proactive policy. The country implemented a severe lockdown early and has been cautious in lifting restrictions despite seeing very little increase in new cases. The government has recognized that economic activity is unlikely to snap back to normal once restrictions are lifted. Uncertainty will likely leave consumers hesitant to spend – especially on big-ticket items like automobiles – and businesses hesitant to invest and increase headcount. The New Zealand government has been engaging with the construction industry to see which infrastructure projects are shovel ready and is ready to jumpstart construction as soon as the lockdown is lifted. This type of proactive policy will be essential to support a recovery, and the spill-over effects are likely to be very large. Given the scale of the global infrastructure gap, it is a policy that can be replicated in numerous countries.
Do you think that there is a possibility of inflation of real assets – particularly property – after the dust has settled? Could global quantitative easing cause price increases and inflation in the medium term?
SR: At the moment, the prospect of inflation in real assets seems improbable. However, with money yielding nothing and interest rates set to remain very low for the foreseeable future, it would not be unreasonable to assume that at some point the quantitative easing programme will indeed have an impact not dissimilar to that seen in the post-GFC period. On that occasion, the actions of the central bank did take time to filter through to real assets. With confidence likely to remain fragile for a while to come, that may be the case this time too.
SE: There are two parts to this question. First, if inflation were to emerge, that would generally be a good thing. Inflation would emerge if the weight of demand overwhelmed supply. So, in this instance, inflation would be a sign of robust demand, and likely signal a very quick recovery. The bigger risk now is deflation, which would signal a lack of demand and likely a much slower recovery. Interest rates and asset prices have an inverse relationship. That is, when interest rates fall, asset prices should increase. The most straightforward reason for this is because lower rates change the discount rate and increase the present value of your asset.
The monetary policy response to Covid-19 has been a significant easing, interest rate cuts and in some cases asset purchases and yield curve targeting. Over the medium term, this should inflate asset prices. That is not altogether a good thing or a bad thing. Interest rates have been cut to stimulate economic activity, so as long as easier monetary policy is accompanied by increased business investment, the productive capacity of the economy will increase, pushing up the ceiling for medium-term growth.
However, monetary policy cannot do this alone. The post-GFC decade was characterised by low rates, sluggish growth and asset price inflation. This is in part a structural issue, where businesses appear to have taken advantage of low interest rates to borrow money to buy back their own stock and increase dividends. In principle, there is nothing wrong with this: shareholders of profitable companies should be rewarded for their investments. But when companies are borrowing money for this purpose, it is not profits that they are distributing; it is borrowed cash that will one day need to be paid back.
Furthermore, this type of borrowing does not generate any real economic activity, it just inflates share prices. A policy aimed at stimulating investment in productive resources ends up just inflating share prices and straddling companies with unproductive debt, making them more vulnerable to, say, a pandemic that shuts down large parts of the global economy. This is a structural issue that needs to be addressed. If monetary, fiscal, and regulatory policy can work together they can be powerful tools to stimulate growth in the medium to long-term.
Walter Boettcher: I agree. My greatest hope pre-Covid19 was a recovery of business investment. Hopefully this will recover, but I also think that the size of the global response will unavoidably stoke real asset prices in due course. The period of adjustment – when equities recover and bond prices slip – will be interesting to watch from a property point of view, but the global weight of capital, coupled with depressed interest rates is sufficient to float a lot of asset boats.
Do you think the banks will be able to survive the crisis without governmental support similar to the GFC?
SE: Yes, I do. Not all of the underlying problems in the lead-up to the GFC have been addressed, but policymakers did succeed in making banks more resilient to future crises by increasing the amount of capital buffers they are required to carry. The way these work is fairly simple: in good times the banks need to carry more emergency cash than is necessary, so that in bad times regulators can loosen restrictions and banks are able to enforce loan covenants etc. less strictly until the bad times have passed. Although there is some confusion about how banks can ease covenants and work with clients to make it through a rough patch, thus far it does seem like the additional capital buffers have been doing their job – both in shoring up the banks’ financial health and in avoiding mass defaults.
What can we say about different economic impacts across different nations and regions of the UK? Will depression and/or recovery be evenly distributed across the country?
WB: Since the vote to leave the EU in 2016, I have tracked the performance of the ‘real economy’ (production, distribution and consumption) and compared it to the ‘balance sheet economy’ (finance, professional, investment, fund management, etc.). This has shown that, by last reckoning, the real economy has been outperforming the balance sheet economy for 11 consecutive quarters. One of the reasons I have tracked this is that there is a strong regional component to production and distribution functions in the UK, which is distant from the epicentre of the balance sheet economy – the City of London.
While the importance of the ‘real’ economy has become apparent in the last two months – and landlords exposed to tenants who operate in this part of the economy seem to have fared better in terms of recent rent collection rates – I’m not sure that it will continue to outperform. The balance sheet economy has benefited from positive deal flows running through March; from what I can see, remote working has allowed an awful lot of deals to progress.
The parts of the economy that service the non-discretionary needs of the population will continue to perform and this will remain focused outside of London. Hence, I do not think that the regions will suffer a contraction that is any more catastrophic than London. In fact, I could envision regional retail and hospitality re-opening more rapidly than London, primarily because of the lower density of footfall and congestion comparative to London.
SR: The ability of the government to stick with its levelling up agenda in the face of major challenges around the ballooning in public debt will be critical. This will help the recovery process and ensure that wider disparities across the country are not exacerbated as a result of the pandemic.
Does the success of remote working demonstrate that we don’t need traditional office space? Could we see a drop in demand and maybe the emergence of new usages?
Howard Meaney: I would say that the structural changes which were expected to take place over the next decade could now take place in two to three years. Cultural resistances have been broken. The office will still be there, but the necessary workspace per employee could come down as agile working has been proved to function reasonably well. What is lacking, however, is the benefit of face-to-face interactions which will stifle business generation and should give confidence in the ongoing need for offices as the place for businesses to thrive. UBS researchers have looked closely at this issue – you can read their conclusions here.
Peter Cosmetatos: Based on my own experience, and my sense from friends and colleagues, I think we will probably value the office, and the time we spend there, more after this is over. Having said that, many sectors and businesses that had resisted flexible and remote working previously, have now discovered that it really is an option. A renewed appreciation of the value of resilience and agility over efficiency should mean many more office workers enjoying some remote working and greater flexibility over hours. If we’re lucky, it might also encourage a drive to make offices more pleasant and spacious places, enabling safe collaboration and interaction.
Will the crisis prompt a renewed focus on smaller retail cores in our towns and cities, and could that vacuum be filled by residential developments?
PC: I suspect that the pandemic will eventually leave a stronger legacy of people wanting the physical connection of community than of people fearing it – even if social practices and laws adapt to a more cautious view of public health and safety. We were on the path to smaller retail cores and more town-centre residential stock even before this crisis. I think that this general direction of travel will continue. The main thing the crisis changes is the speed and severity of the transition – it threatens to destroy large numbers of high street businesses that we would probably like to see survive – not just those that were already weak or failing. Good government policy interventions can help to limit that damage.
HM: The UK is thought to be as much as 30% over-supplied with retail space. The cities, towns and schemes that survive will be those that dominate their catchments and are close to key centres of consumption, though I expect this to evolve as consumer shopping habits continue to change. The ongoing problems faced by retailers seems inevitable, but rationalisations of portfolios and rental reductions will be critical to their success.
Residential schemes which incorporate a variety of living, leisure and community uses can provide the answers in some locations, although many towns which are struggling are not seeing particularly high demand for living space either. Land values will need to get to a certain level to justify any development. Mixed use is certainly the way forward, although this will vary depending on the needs of the catchment.
Can you advise on how the degree of gearing on real estate investments is likely to influence the economic recovery of different real estate sectors?
HM: The early indications suggest that retail and hospitality uses will be impacted the greatest by Covid-19. Many will close, forcing occupiers to seek solutions from landlords over their rental obligations. Valuations have reacted accordingly with these sectors looking to have suffered most. This is set to worsen as non-essential retailing and leisure uses come under further pressure. Debt covenants will be tested as valuations decline, with some effectively obsolete assets already being put in the hands of administrators. Industrial and office investments have been less affected so far but will not be immune if economic conditions continue to decline.
PC: Unlike the GFC, this crisis is not the product of cyclical over-exuberance or excessive lending/leverage. Indeed, the commercial property lending market has been remarkably stable in recent years, marked by diversity of supply and generally sensible behaviour from both borrowers and lenders. However, even a healthy market will be severely tested by the exceptional challenges we face. High gearing is a factor that can make things harder.
A bigger factor will be the impact of the economic lockdown. At this stage, it seems clear that hospitality, leisure and non-food retail are most impacted – in the case of retail, adding to the huge structural challenges the sector was already facing. The resilience of student accommodation and serviced offices, in particular, is likely to be tested over the coming months. Data centres, supermarkets, urban logistics and residential should fare well.
In every sector, firms that were well capitalised, without excessive debt, and more generally well managed should have the best chances of riding out the storm.