Covid-19: Three economic scenarios
At Charles Stanley, we have developed three scenarios as to how things might play out. John Redwood outlines them and provides his view on the possible economic consequences and market reaction.
Markets are governed by the duration and impact of the many measures being taken to limit and reduce the number of people contracting the COVID-19 virus. This was the week when the western advanced world changed dramatically, with the governments deciding to ban or advise against all events, tourism, entertainment and hospitality outside the home. The badly affected sectors will lose all or most of their turnover, leading to heavy losses and the need to take offsetting actions.
Without cash aid from the government, businesses will have to cease paying dividends, cancel capital spending, lay off many people and seek to negotiate better deals with landlords and suppliers. France has produced the best package so far to try to limit cash losses with state programmes. The USA and UK are working on ideas that could help but have not yet announced direct support for employment. The UK has cancelled all business rates for a year and offered direct cash grants of £25,000 to the smaller companies.
At Charles Stanley, we have developed three scenarios as to how things might play out. The ‘best case’ is where the virus numbers peak soon, allowing an early return to more normal conditions. An early peak with visibility of an end to special measures would lead to a dramatic rally in share prices but this seems rather unlikely. On our ‘base case’, we will have at least one quarter with a much bigger quarterly downturn than in past recessions, followed by a recovery. In this scenario, there will soon be buying opportunities but probably from lower levels of the market than today. There is still plenty of bad news to come out and more investors and commentators to adjust to the new conditions. The third scenario is ‘worst case’, where the virus lingers on for longer, controlling measures stay in place for longer, and the damage spreads to a wider range of businesses, with more bankruptcies and worries spreading further in credit markets.
Government packages and Central Bank action
Yesterday we heard of a $1 trillion package proposed by President Trump for the USA. The markets initially liked this, but share indices then fell away today on disappointment that there is little detail and it all depends on the Congress approving a viable package. There is likely to be more joint party working than usual in a brutally partisan House of Representatives controlled by the Democrats, with scope for some amalgamation of the Democrat preferred package offering more food and money to the poor and unemployed, alongside cash help for people in work and for their companies favoured by the Republicans.
The President has promised a $50bn package to help the airline industry and a $250bn package for small businesses. In the UK, the government came up with loan guarantees for some £330bn of possible lending to business to keep companies going, with zero interest for the first six months. Business groups asked for more by way of grants, as adding more debt to fill the hole created by an absence of turnover is not ideal. The UK government said it was exploring ways of offering cash support for companies having to carry employees against a background of little or no income. So far it is offering £32 bn of cash help to deal with virus related problems, which equates to 1.4% of GDP.
The Central Banks have hurled everything at the problem, with Quantitative Easing programmes in the USA, Euro area and Japan, lower rates in many places and cheap money to keep banking systems liquid. They now look to governments to offer money to stressed businesses and to offer guarantees for new loans to reassure and persuade banks to make them in difficult circumstances. Despite all this liquidity, which would normally drive asset prices higher, there has been a flight into cash, leaving shortages. Many sellers of bonds as well of shares have emerged, worrying about down ratings of companies facing a poor trading outlook. Even gold has fallen as people raise cash.
Signs to look out for
If we look as if we have reached ‘peak virus’ with reasonable prospects of some recovery through relaxation of the controls, markets should rally. Alternatively, if we reach the point where government and central Bank action is so large that it will keep companies and economies going through the bad period, we might get a rally before the virus peaks. In the meantime, we need to live with forecasts coming down, real economy data deteriorating rapidly, and question marks over the duration and intensity of the downturn. Investors and banks are becoming nervous about the solvency of some businesses taking the largest hits to their turnover.
Major changes of policy
In the USA the Republicans will adapt to the need to subsidise people and businesses to help them through the downturn. Though they will have more of a tax-cutting emphasis whilst the Democrats more of benefit spending emphasis, both will accept the need for a bigger government involvement and a large budget deficit.
In the EU the member states are taking more of a lead on both the health and the economic issues. The EU’s two binding Treaty-based commitments to open borders and strict fiscal discipline have been at least temporarily suspended. Borders are being closed. States are announcing major fiscal expansions despite the Maastricht budget rules. It is not clear when and how the Treaty disciplines will be reasserted. The European Central Bank seems to have been happy under its new leadership to see fiscal expansion by Italy and France as well as by Germany, though the first two are going above limits.
In Japan, the government is continuing with fiscal and monetary activism. China is seeking to gradually resume more normal working after a big loss of output when they clamped their economy.
Short term patterns to demand and profits
During the virus crisis period, people buy the basics, stockpiling some food, medical and hygiene products and relying on home energy, telecoms and internet downloads. The profits of the staples companies should mostly be fine. The worst affected will be businesses in transport, leisure, sports, hospitality and tourism that face a collapse in turnover.
Oil too has been badly damaged by the outbreak of a price war between the big three producers of Russia, Saudi Arabia and the USA. Capital Spending will be cut back sharply by most businesses, affecting resources and construction. Retail property will be under more pressure as companies surrender lease or demand cuts in rents. If many people are laid off general demand will be reduced more. These are not good conditions for companies trying to sell new vehicles or homes, though the big sell-off in housebuilders shares may soon offer opportunities for recovery.
Longer term impacts on business
Throughout the West governments and Central Banks will take a more active part in lending to the corporate sector through guarantees and changes of rules. Whilst banks will have plenty of access to cheap credit and will be able to extend more loans with guarantees, there will be a reluctance to see any extra profit being used for dividends or bonuses given the way it is generated. The general shift to more government direction and control of the economy will lead to greater demands for price and earnings controls and more criticism of any profiteering. The commercial banks have a good chance to rebuild their reputations by lending promptly and well, without providing excesses for themselves. Dividends and share buybacks will be reined in, both through the damage done to cashflow and by the general mood.
The trend to execute more business using digital technology will be given a further boost by what is happening. People will buy more online and may not go back fully to the shops after the event. Some of the businesses conferences and seminars now switched to webinars and electronic conferences may not return either. Businesses that flourish from tourism, weddings, sporting and cultural events should bounce back, with people probably keen to resume a more normal life after a period of home isolation. More professional and medical services are being delivered by digital means which may also persist in many cases.
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John Redwood is Chief Global Strategist at Charles Stanley & Co. Limited, which is authorised and regulated by the Financial Conduct Authority.