The coronavirus pandemic and the economy – a Q&A from an investment perspective – Shane Oliver

The coronavirus pandemic and the economy - a Q&A from an investment perspective - Shane Oliver

Along with the horrible human consequences, the coronavirus
pandemic is having a huge impact on the way we live and as a
result investment markets. This has raised a whole bunch of
questions: why does a big part of the economy have to go into
“hibernation”? how long might it be for? how big will the hit to
the economy be? what does it mean for unemployment? why is
it so important for governments and central banks to protect
businesses and workers? can we afford all this stimulus? This
note provides a simple Q&A for most of the main issues from an
economic & investment perspective. To the extent simple
answers are possible in this environment! 

Why do we need the shutdowns?

This is a medical issue, but it drives everything that follows. The
answer is simple. Something like 15% of those who get
coronavirus need hospitalisation and 5% need intensive care.
And this is not just elderly people. And there is little to no
community immunity to it. So, if a lot of people get it at once the
hospital system can’t cope and the death rate shoots higher.
Italy shows this with a death rate of 11.7%. So, unless we want
to see the same surge in deaths as Italy we have to “flatten the
curve” of new cases so the hospital system can cope. And to do
this we have to practice social distancing which means meeting
up with as few as people as possible which means staying at
home wherever possible. This in turn means a big part of the
economy gets shutdown. 

Which sectors of the economy are most impacted?

Roughly 25% of the economy is being severely impacted and
this covers discretionary retailing, tourism, accommodation,
cafes, clubs, bars and restaurants, property and various
personal services. But there is also likely to be a flow on to
construction and parts of manufacturing as uncertainty leads to
less housing construction for example. Only about 20% of the
economy – communications, healthcare and public
administration – will really get a boost.

How big will the hit to the economy be?

It’s impossible to be precise, but if 25% of the economy
contracts by 50% with other sectors offsetting each other, that
will drive a 12.5% detraction in economic activity mainly in the
June quarter which is basically what we are assuming. This will
the biggest hit to the economy seen since the Great
Depression. Of course, if this leads to collateral or second
round effects as, for example, businesses and households
default on their loans the impact could be much greater and
longer.

But why all the talk of hibernation? 

The hibernation concept is a good way to look at it. As a result
of the shutdown many businesses are seeing a massive loss in
their sales and some must partially, or in many cases fully,
shutdown until the virus is contained and the shutdowns can
end. But rather than shutdown forever the best outcome is for
them and their employees to effectively go into “hibernation” for
a period so they can go back into business and resume their
normal lives once the virus is under control but without being
encumbered with so much more debt and rent arrears, etc, that
they go bust anyway.

Why the need for massive government support? 

This is where government and central bank action comes in.
Since coronavirus became a global pandemic last month and
countries progressively ramped up social distancing policies,
governments and central banks have swung into action to help
economies weather this storm. This is absolutely necessary.
Such support is unlikely to stop a recession or depression like
contraction in the economy. But it’s needed to minimise the
collateral or second round impacts of the shutdowns and enable
the economy to start up again when the threat from the virus
abates. Australia has announced three fiscal stimulus tranches
now totalling around $200bn or 10% of GDP, which is nearly
double that of the GFC stimulus. Other countries have also
announced massive stimulus with the US just signing off on one
package worth $US2 trillion and now talking of another. The
policy response is now of a magnitude that it’s starting to tip the
risk scales against some sort of long depression/recession.

How will it be paid for?

Simple, the Government will issue bonds & borrow the money. 

But can we afford such a surge in the deficit and debt? 

First, to stress it’s absolutely necessary. The hit to the economy
from the shutdowns could be 10 to 15% of GDP. This requires a
similarly sized stimulus program to offset it otherwise we risk
immeasurable collateral damage to the economy and people’s
lives (causing an even bigger budget deficit). 

Second, it makes sense for the public sector to borrow from
households and businesses at a time when they are stuck at
home and can’t spend due to the shutdowns or won’t spend
due to uncertainty and for the Government to give the borrowed
funds to help those businesses and individuals that are directly
impacted. Using the funds to subsidise wages is a particularly
smart move as it keeps people employed and keeps them
linked to their employer. The trick is to curtail the stimulus once
the economy bounces back otherwise the competition for funds
will boost interest rates and create problems for the economy.
So, the support programs are set to end after 15 months. 

Third, Australia’s public debt is relatively low. Net public debt as
a share of GDP is a quarter of what it is in the US. So, Australia
has far greater scope to do fiscal stimulus than other countries.

Fourth, the cost of borrowing for the Federal Government is
very low at just 0.25% for three years and 0.75% for ten years. 

Finally, the budget blowout may risk a downgrade in Australia’s
AAA sovereign debt rating, but Australia’s public finances will
still look better than others. And I would rather a rating
downgrade than a deep depression/recession any day. 

When the dust settles Australia will be left with higher net public
debt at maybe around 45-50% of GDP. It will be the price we
paid to (hopefully) minimise the loss of life from the virus and at
the same time minimise the hit to people’s livelihoods from the
shutdown. This may necessitate forgoing the next round of tax
cuts or a new deficit levy. And it may put a burden on future
generations as wartime spending did. But I reckon that’s a cost
most Australians are prepared to wear. 

Why is monetary stimulus necessary? Low interest rates won’t get us to spend when we are stuck at home

Yes, people can’t spend much now, but as with government
stimulus much of the central bank easing has been aimed at
“protecting” the economy. This has three key elements: 

lowering interest rates to make it easier for borrowers to
service their loans – eg, the RBA has cut interest rates and
targeted lower bond yields to cut long term borrowing costs; 
pumping money into financial markets to make sure they
keep functioning. As the crisis intensified bond yields
perversely started to rise (as fund managers had to sell their
liquid winning assets to meet redemptions) and corporate
borrowing rates surged as investors feared defaults so the
Fed pumped money into the US bond and credit markets to
push yields back down. The ECB has done something
similar in Europe by buying Italian bonds; and 
ensuring cheap access to funds for borrowers – eg, the RBA
has provided funding for banks for 3 years at 0.25% which
has enabled the banks to cut rates and offer debt payment
holidays. The Fed is even undertaking direct lending. 

How does quantitative easing help the government stimulus measures? Won’t it cause inflation?

Quantitative easing – which the RBA has now joined the Fed,
ECB and Bank of Japan in doing – involves using printed money to buy government bonds in order to help keep interest rates
down. The central bank buys these bonds in the secondary
market (eg from fund managers) so it’s not directly providing the
money to the government and those bonds must still be paid
back when they mature. So, it’s not really “helicopter money” –
which would see the RBA print money and give it to the
Government which it would then spend. But of course, it is
aiding the government’s stimulus program by helping to keep
bond yields down. In the meantime, the balance sheet of the
RBA will rise as it holds more bonds, but this is not a major
issue unless inflation starts to rise due to all the extra printed
money in the system. The Fed, ECB and Bank of Japan have
been doing QE for years with no rise in inflation, so the RBA
has a long way to go before it becomes a problem. Put simply
there is no magical right or wrong level for the RBA’s balance
sheet so if you are worried about it, just ‘chillax’.

How high will unemployment go?

We see unemployment rising well above 10% in the US
(possibly to even 25%). But in Australia, there is a good chance
that the Government’s wage subsidy scheme will keep up to 6
million workers in the most affected parts of the economy in a
job and this may contain unemployment to below 10% here.
The decline in unemployment though will likely be slow though
depending on the shape of the recovery. 

Will the recovery in the level of economic activity look a V, a U or an L? 

Much will depend on how long it takes to control the virus. An L
shaped (or no real) recovery is unlikely given: evidence that
shutdowns will slow down the number of new cases as
occurred in China and may now be starting to occur in Italy; the
chances of a medical breakthrough; and all the stimulus which
should aid some sort of recovery. By the same token a quick V
style recovery is unlikely given that absent a quick medical
solution the shutdowns will be phased down only gradually (with
international travel being perhaps the last restriction to be
removed). This suggests a U-shaped recovery is most likely.

Could anti-virals or a vaccine improve the outlook? 

Put simply yes. A study of past epidemics and the medical
response to them by my colleague Brad Creighton shows an
ability of governments working with scientists and the medical
community to rapidly speed up the development and
deployment of anti-virals and vaccines. There is now a massive
global effort on this front and some drugs are promising. So, it’s
not out the question that there is a breakthrough enabling a
quicker relaxation of shutdowns.

When will shares recover?

The historical record of share markets through a long litany of
crises tell us they will recover and resume their long-term rising
trend. The massive global policy response to support
economies in the face of coronavirus driven shutdowns is
starting to tilt the risk scales against a long depression scenario.
This is why share markets have started to get some footing
over the last week or so after seemingly being in free fall for a
month. Key things to watch for a sustained bottom are: signs
the number of new cases is peaking – with positive signs
emerging in Italy; the successful deployment of anti-virals; signs
that corporate and household stress is being successfully kept
to a minimum – too early to tell; signs that market liquidity is
being maintained and supported as appropriate by authorities –
this has improved; and extreme investor bearishness – investor
panic is already evident but it can get worse. 

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