Dr David Morgan AO is Chairman of Cboe Australia and an Operating Partner and Chairman for J.C. Flowers & Co. Europe and Asia Pacific. Dr Morgan served as CEO of Westpac Banking Corporation from 1999 to 2008.
The purpose of this note is to provide some observations on the world economic outlook (WEO). While there are many global economic forecasts out there, the pre-eminent WEO is produced by the IMF. They bring to bear an unparalleled depth and breadth of economic experience and expertise to the task. The IMF’s WEO is not top down, but the aggregation of 189 individual country forecasts from the respective IMF country specialists. These forecasts are generally (but not always, of which more below) untainted by political pressure.
Baseline forecast
The IMF’s baseline forecast is for a decline in world output of 3% for world output in 2020 and 6% for advanced economies output. This is much worse than the GFC downturn (when world output was broadly flat) and would represent the worst recession since the Great Depression (The decline in advanced economies output in the Great Depression 1929-32 was estimated to be around 16%.)
Usually, the balance of risks around the IMF’s baseline scenario are fairly even as between upside and downside. Not this time around. The IMF notes:
“much worse growth outcomes are possible and maybe even likely ... risks of a worse outcome predominate.” (WEO April 2020, Ch1, pg. v).
It then presents three alternative scenarios:
a) longer coronavirus outbreak in 2020
b) new outbreak in 2021, and
c) a combination of (a) and (b).
These scenarios produce significantly longer and deeper world real output declines, between 3% and 8% worse than the baseline decline of 3%.
Unique nature of this crisis
This crisis is like no other.
First, the shock is very large. The speed and extent of output loss associated with this health emergency and related containment measures dwarfs those associated with the global financial crisis.
Second, under current circumstances there is a different role for economic policy. In normal crises, policymakers try to encourage economic activity by stimulating aggregate demand as quickly as possible. This time, the crisis is to a large extent the consequence of needed containment measures. This makes stimulating activity more challenging and, at least for the most affected sectors, undesirable.
Third, the uncertainty around the outlook is extreme and much greater than usual. The extent and duration of the economic fallout depends on (inter alia):
a) the pathway of the pandemic
b) the intensity and efficacy of containment efforts
c) the extent of supply disruptions
d) the repercussions of the dramatic tightening in global financial market conditions
e) shifts in spending patterns
f) behavioural changes (such as people avoiding shopping malls and public transportation)
g) confidence effects, and
h) volatile commodity prices.
So, we could just throw our hands up in the air and say 'this time around, it's simply too hard'. But, in the meantime, of course we all have to get on with our lives. Having no macro view whatsoever is generally unhelpful for many of those. At a minimum, it makes sense to have some view on at least the mainstream scenario.
Mainstream macro view
I believe there is a mainstream macro view in the market at present. It is probably closest to the IMF baseline scenario. It is often referred to as the 'V-shaped recovery' scenario. It would seem to be the most likely scenario underpinning the US stock market at present (although the 25% weighting of tech stocks, and 15% weighting of healthcare stocks, are also factors in the elevated level of the S&P 500 at present; as of course is the record low level of bond yields).
This scenario may well turn out to the correct. However, in my view, even if its optimism turns out to be correct regarding the pathway of the pandemic, I believe it is overly optimistic regarding the speed and the extent of the recovery in real output.
IMF baseline overly optimistic
The IMF’s baseline forecast is now overly optimistic. First, and mainly, because of developments in the period since the forecasts were finalised on 7 April. Second, as noted, the IMF forecasts are based on an aggregation of individual country forecasts. Those forecasts are too optimistic for emerging market and developing countries taken as a whole, excluding China. These countries comprise about 40% of global GDP. As of 7 April, a number of these countries were extremely reluctant to concede they were facing major coronavirus challenges and economic recession. These countries are not infrequently characterised by relatively weak governance and health systems.
Additional factors indicating longer and deeper recession
In addition to these factors, I believe the baseline forecast is too sanguine in a variety of other respects, including:
a) confidence and sentiment effects
b) the likely responses of firms and households, and
c) rapid structural changes, especially concerning globalisation, digitalisation and automation.
The first key structural shift in the future stimulated by the current crisis will be to a different balance between globalisation and national self-reliance. Of course, global trade tensions were already on the horizon before the pandemic. These focused on China, including their dominance in global manufacturing supply chains. Following the pandemic, these tensions will be accompanied by advanced countries in particular pursuing increased self-sufficiency in key necessities. Supply chains will become more local, less global, more robust. The costs and benefits of globalisation will be reassessed, with a move back in the direction of economic nationalism. This will take time, involve disruption, and lower economic growth.
A second big development will be to accelerate markedly the trend to digitalisation and automation of work. The share of in-person services will decline in retail, hospitality, travel, education, health care and government. For in-person retail, in particular, much of the temporary lockdown will prove permanent. Many retail stores will not reopen. Many low/medium skill, in-person service jobs won’t return. We will be sharply accelerating the move to a much less labour-intensive production function. Hence structural unemployment is likely to increase significantly.
A third development will be heightened risk aversion on the part of business and, particularly, households. One of the remarkable features of this downturn is the extent of the decline in private consumption expenditure. In most downturns, the brunt is borne by major reductions in private investment and trade, with some relatively minor reduction in consumption expenditure (focused mainly on delay of purchase of consumer durables). Private consumption would typically fall in such downturns by less than a percentage point or so.
This time around, the major hit is to private consumption, especially consumption of services. In South Korea’s first quarter GDP (the first major country GDP release after China), private consumption dropped by a staggering 23% at an annualised rate. (US Q1 GDP data came out on April 30, it showed a 4.8% decline in GDP). Moreover, most of this drop in Korea was on consumption of services, which for the most part can’t be made up later, like a delayed new car purchase. This phenomenon is likely to involve a much slower pick-up in consumption expenditure, by far the largest component of GDP in most economies, than in normal cycles.
There will be a major flight to safety, much lower consumption, more saving, and reduction of extremely high private non-financial sector debt loads. A mere message from the government that the lockdown is over won’t get everyone to return to their former habits of spending (including with respect to travel, tourism, hospitality and entertainment).
Companies in particular will see the crisis as a once-in-a-generation opportunity to put through huge cost cuts deemed too draconian in more normal times. The move to remote working during this crisis has provided a great opportunity to see much of what people actually do and who is truly vital to the institution. There are very large numbers who will not be retained.
Implications of record levels of public debt
There is another concern that households and firms could have about debt other than that of their own sector—and that of course is the record levels of public debt being incurred—both by governments and central banks. The record levels of public debt could spook markets. This increase in sovereign borrowing costs, or simply the fear of it materialising, could prevent many countries from continuing the income support assumed in the IMF forecasts. Or have such countries turn to their central banks to directly finance government spending, thereby undermining—perhaps irretrievably—central bank independence from the government of the day.
Indeed, there is a not implausible case that in some countries that Rubicon has already been crossed (notably but not only in Japan). This has been generally a taboo in most advanced economies for many decades. The counterargument to this is that governments really have no option but to 'throw the house' at this crisis. For something of this speed and magnitude, the social contract in advanced economies requires government to step in and keep the connective tissue of firms alive. Perhaps so far so good.
This support can go on for one or two quarters, but if the downturn turns out to be deeper and longer, the sustainability of this strategy will surely be called into acute questioning. How will this public debt be paid down? The denominator effect (that is, GDP growth) will be super important.
There is also re-opening risk as regards the trajectory of the pandemic. (Indeed, the debate is shifting from the depth of the downturn to the speed and extent of re-opening). Re-opening will show the ongoing pressures of the virus. Next time around, we will have better tracing and social distancing. But over time, if there is no herd immunity and vaccine, a second wave is a very distinct possibility. A recent article by the economic historian, Niall Ferguson, documented how most past pandemics had at least a second wave.
Finally, there are political economy concerns. So far, the crisis in Italy, for example, seems to have brought people together. But if the effects of the virus do not diminish rapidly, we will be likely to face the ‘make or break moment’ for the Euro area. The EU (as distinct from the ECB) will need to step in, in a very major way. If they do fail to do so, the leader of Italy's hard-right League party Matteo Salvini and his populist anti-Euro supporters are likely to be back in charge. Obviously, there are also potential political economy concerns in the up to 40% of the world with weak governance and health systems.
Conclusion
Whether it is assumed there are one or two waves of the pandemic in the northern hemisphere, there is a lot of commonality between (a) the IMF’s baseline scenario, albeit with a lot slower and weaker recovery as I forecast above; and (b) the IMF’s scenario 2.
Both are consistent with a 2020 real output decline much worse than during the GFC, and a 2021 real output decline more or less on par with the GFC recession. Either way, the best part of two years of extremely deep recession the likes of which we have not seen since the Great Depression.
Dr David Morgan AO is Chairman of Cboe Australia and an Operating Partner and Chairman for J.C. Flowers & Co. Europe and Asia Pacific.
Dr Morgan served as CEO of Westpac Banking Corporation from 1999 to 2008 and is a former Head of the Australian Bankers Association. During the 1980s, Dr. Morgan worked for the Australian Federal Treasury, where he was appointed Senior Deputy Secretary. Dr. Morgan was Chair of the Future of the Australian Economy Stream of the Prime Minister’s 2020 Summit.
In 2009, Dr Morgan was made an Officer of the Order of Australia for service to the finance sector, corporate social responsibility and economic reform.
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