Nick Kounis

Head Financial Markets Research

Five reasons why the recovery will take time

4 June 2020 - With restrictions on economic activity starting to be lifted, optimism is in the air. We are sceptical about the idea of a durable, strong recovery taking shape quickly. A bounce in activity around the middle of this year will most likely be followed by renewed weakness. We set out five reasons to expect the economy to take time to recover.

Exit will be gradual

First of all, while governments are starting to lift restrictions and have set out timelines to go further, this will be a gradual process. In terms of where we are now, most countries/states appear to have moved from hard lockdown to soft lockdown rather than to no lockdown. According to the various government plans, the exit strategy is going to be a gradual process in most jurisdictions. In addition, there will likely be a long tail with some activities working at below pre-corona capacity levels because of social distancing measures that will likely persist for several months. Finally, some economic activities will remain closed or severely restricted for longer. This relates to large events and cross-border travel, which means demand fuelled by tourism will remain subdued.


The possibility of stop and start

Second, there is a distinct possibility that the exit process is not smooth, but determined by how the virus data react to the lifting of restrictions. Deteriorations in the virus data could lead to a pause in the process of lifting restrictions or even a re-introduction of some measures. The risks seem highest where the political pressure to open up appears to be running ahead of the improvements needed in the virus data that would justify an exit. In a number of US states this seems to be the case. A scenario of a pause and re-introduction of restrictions on the back of a second wave would not only restrict economic activity directly but would damage public confidence in their own safety, leading to heightened caution in consumer behaviour.

No silver bullet solution in near term

Third, there is no silver bullet solution to the virus in the immediate horizon. A vaccine looks like not being available in any scale until next year. The WHO said in mid-February that a vaccine may not be available to the public for 18 months. Multiple research groups have designed potential vaccines. However, this is only the start of the process. Tests need to show that the vaccine is safe and effective, it needs to be produced in large numbers and inoculations need to be carried out. Before a vaccine, the strategy that many governments are employing is ‘test and trace’. Although many governments have ramped up testing over recent weeks, even in the front-runner countries only a small proportion of the population has been tested. In terms of contact tracing, mobile technology applications are still being developed to enable broad scale tracing. The lack of a silver bullet solution or the inability to sufficiently suppress the virus could lead to ongoing subdued consumer behaviour.

China's experience points to consumer caution

China’s post-lockdown experience also points to a slow recovery in the services sector, with consumers remaining cautious. The recovery in the industrial and construction sectors was relatively rapid, but the services sector is still operating clearly below pre-corona levels. That is particularly true for consumer-related services. This reflects that domestic demand has yet to recover, albeit there are some tentative signs of stabilisation. This partly reflects behavioural changes and social distancing measures.

Second-round effects to take time to work through

The final reason to expect a slow recovery is that the second-round effects from the initial economic shock will continue to weigh on the economy, as these effects take longer to work their way through.

We expect the US unemployment rate to peak at around 18%. Although we judge that it will come down again (as those laid off temporarily will come back to work), it will still likely be around 10% at the end of this year, compared to 3.5% in February. Eurozone labour market adjustment takes longer. We expect a continued rise in the unemployment rate to a level above 10% by the end of next year, compared to 7.3% in February. The dire situation in the labour market is likely to depress consumer spending by both pushing up precautionary saving as well as reducing aggregate disposable income.

Meanwhile, financial conditions remain significantly tighter than they were before the Covid-19 shock. Aggressive central bank monetary easing (such as asset purchases) has managed to reverse some - but not all - of the tightening in financial conditions. Similarly, the fiscal stimulus we have seen has been aggressive, but not yet commensurate to the size of the economic shock.

The corporate sector is experiencing extreme stress. With regard to speculative-grade bonds (a riskier segment of the corporate bond market), rating agency Moody’s expects global default rates to reach 11.3% from 4.4% now (peak was around 14% during the global financial crisis), reflecting the collapse in earnings and deteriorated debt fundamentals going into the shock. As a result we expect to see corporate retrenchment in terms of reducing payrolls and plunging capital spending.

Factory closures have led to significant supply chain disruptions, which will take some time to resolve. Supplier delivery times usually rise when the manufacturing sector is buoyant and operating at full capacity. In contrast, supplier delivery times have currently surged to record highs despite a deep recession in the sector, which we see as being indicative of profound supply-chain disruption.

A final source of second-round effects is the synchronised nature of this sharp shock. The weakness in demand in each economy will spill-over and re-enforce the downturns in every other. This will be reflected in a contraction in world trade that is ever sharper than that seen during the global financial crisis.

Nick Kounis - Head Financial Markets Research