At this point, economic forecasting can feel like a futile endeavor: The parameters are changing so quickly that even typically forward-looking macroeconomic data is out of date before it’s published. As a result, we have almost no visibility into how global economies are reacting to COVID-19. At this point, the macroeconomic strategy team is operating with several important assumptions that we carry with moderate to high levels of conviction. It’s important to note that these assumptions are fluid in nature and are likely to evolve over the coming weeks, but they form the pillars of our current thinking about the global economy:
- The global economy is likely to grow at a rate that’s consistent with a global recession, with China, Japan, and Germany—the world’s second, third, and fourth largest economies—being the most at risk of experiencing two or more quarters of back-to-back negative growth. If the global economy does indeed slip into a recession, it would be a culmination of four factors: (i) an already weakened economy as a result of protracted trade tensions, (ii) the supply- and demand-side shocks arising from COVID-19, (iii) signs of trouble in the credit markets, and (iv) economic weakness created by substantially lower oil prices.
- We believe the United States is also facing a sizable recession risk, and we expect U.S. growth to contract for at least one quarter. Crucially, we think there’s a chance that the magnitude of demand destruction could be significant—what would typically take place over the course of two quarters could materialize in three months. Whether we’ll see a second quarter of contraction and, therefore, slip into a formal recession will depend on when the virus outbreak peaks out. In our view, we’ve moved from a supply-side-driven economic shock, which markets were likely capable of looking through, to a supply- and demand-side shock, which is far more problematic.
- The risk of a credit crisis is rising. Monday’s oil price decline1 increased the likelihood of issues arising in the credit markets, given that the high-yield segment is particularly energy intensive. In our view, three ways in which the financial markets have evolved in recent years have heightened our concerns on this front: (i) liquidity is more electronic than it has been in the past, (ii) the market has moved from collateralized debt obligations to leveraged loans (a similar product with similar liquidity problems), and (iii) the rise of the exchange-traded fund market.
- U.S. interest rates could be 75bps lower before the end of March. In our view, the U.S. Federal Reserve (Fed) could announce another 50 basis points (bps) intermeeting interest-rate cut and might well lower rates again when it meets on March 18. The Fed will also likely need to be ready to ramp up its liquidity operations to meet the demands of the market; it’s highly likely that the entire U.S. yield curve will continue to trade below 1.0% for the foreseeable future. At this juncture, we could also see central banks turning to unconventional monetary policies such as yield curve control. While years of economic training might have led us to believe that temporary equity buying programs (e.g., Bank of Japan) would be off the table, it might be unwise to write that off completely.
- There’s global coordination among central banks, but the European Central Bank is lagging, and that’s led to a strengthening in the euro,1 further tightening global financial conditions. As we’ve mentioned in previous commentaries, while monetary policy can buy policymakers some time, provide some support to financial markets, and lower some monthly debt costs for households and businesses, it won’t prevent recessions.
- Fiscal stimulus is substantially lagging monetary policy, and crucially, at this point, could be insufficient to prevent recessions in key global economies, including the United States. Fiscal packages announced so far seem focused on public health infrastructure, which is no doubt important, but we’ve yet to see measures that are aimed at cushioning the drop-off in demand, particularly in the United States. Given the long lead time between fiscal stimulus implementation and real economic impact, measures of this nature—assuming they’ll be introduced in the coming weeks—are more likely to influence the strength of the recovery as opposed to arresting the rate of the slowdown in consumer demand.
- There’s a large deflationary shock coming, driven by demand destruction, a strong trade-weighted U.S. dollar, and the oil price shock. We believe central bank inflation targets are seriously at risk in this environment, as inflation expectations become unanchored from official targets.
- We expect a sizable depreciation in the Canadian dollar, as the Canadian economy entered this environment in a position that made it extremely vulnerable to a demand-side shock. In our view, the USD/CAD currency pair could hit the 1.39 level in the near term. Interestingly, the market has priced in fewer interest-rate cuts in Canada than in the United States, meaning there’s scope for more dovish surprises from the Bank of Canada. The drop in Western Canada Select prices,2 while slightly more resilient than Brent, spells further problems.
1 Bloomberg, March 9, 2020. 2 Western Canada Select is a grade of crude oil that’s produced in Canada. Its price is typically used as a benchmark for crude oil produced in the country.
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