China as a leading indicator for global recovery: On multiple occasions you referred to China as a leading indicator of what a recovery post-lockdown will look like for nations currently in full lockdown. How linked is China’s recovery to the global recovery? For example, China’s manufacturing production increasing ahead of global demand could result in a global oversupply of Chinese goods, which would in turn once again put pressure on China’s economy.
Chinese exports have become a less significant driver of economic activity in recent years but are still the equivalent of about 43% of economic output (imports represent a similar quantum, around 40%). In terms of export destinations, other Asian countries import more than half of Chinese exports, so Asian economic health is most significant as a source of demand for Chinese exports and is thus far faring slightly better in terms of economic disruption than the major western economies. That said, Europe is the destination for 20% of Chinese exports, while 14% of China’s exports go to the US, so any meaningful drop off in demand for Chinese goods in those economies will have a material impact on China.
Another example of co-dependence is reduced air travel: Chinese airports are showing less travel as they have been confined largely to local travel because many international destinations are now closed. Is China therefore not equally dependent on global consumption returning to normal?
During 2019 about 89% of air travel in China was for domestic purposes, so while international travel is likely to be more impacted than domestic travel, the overall number of travellers falling by around 80% indicates a very significant drop in domestic air travel as well. In addition, around 70% of outbound international travel from China was to Hong Kong and Macau, which are largely controlled by China. So, while Chinese international tourism can have a big impact on many countries that are reliant on tourism, as a portion of Chinese air travel, long distance international flights are a very small proportion of this.
A global recession following COVID-19: The IMF says that the world will “very likely” experience the worst recession since the 1930s because of the pandemic. What is your opinion on this statement? Given that the nature of this recession is largely demand-led, when demand picks up as lockdowns are halted or reduced, do we not expect to emerge from this recession with limited long-term impacts? Or is there a fundamental shift, as a result of COVID-19, that is going to take the global economy longer to recover?
The first-order impact of the current economic shock is certainly demand driven and, to the extent that demand can be temporarily substituted by fiscal spending and then restored quickly once movement restrictions are lifted, the longer-term impacts will most certainly be muted. However, what is more concerning for global economic growth in the longer term is the second- and third-order impacts of the demand shock primarily resulting from the following:
- A drop in confidence and the resultant impact which that will have on delaying longer-term investment decisions (private investment e.g. big capital projects such as companies spending on R&D, commercial and residential construction, the purchases of IT equipment and machinery etc.). This tends to have the biggest impact on economic growth during recessions in developed economies and, although private investment is typically only around 20% of economic activity, it tends to fall precipitously when confidence drops. Discretionary spending, which also constitutes c. 20% of economic activity in developed economies, also tends to fall when confidence drops, but often not as precipitously. Governments have rushed to apply stimulus in an attempt to keep economic momentum going and to maintain confidence in order to try and avoid a collapse in capital spending decisions. The success and timeous implementation of these fiscal spending programmes will be as important as the pace at which economic activity resumes. Confidence may also be a factor in the resumption of some segments of the services economy even after governments lift restrictions (e.g. how confident will people be about getting back on planes, attending sporting events and concerts, going to movies etc. once they’re allowed to resume those activities?).
- A drop in employment, and currently jobs are being shed at an alarming rate. Governments are responding in a way that attempts to minimise job losses (since employment usually doesn’t bounce back as quickly as economic activity, employers usually need to be confident that they’re operating at excess capacity before making hiring decisions. Similar to capital expenditure, employment decisions tend to require confidence in the longer-term outlook). In this respect, a lot of the fiscal response has been targeted at smaller businesses which are typically the largest employers (in the US 50% of people are employed by companies with < 20 employees) and usually don’t have the balance sheet strength to see them through extended shocks. So, the ability of fiscal stimulus to restrict job losses and the pace at which economic activity can return are critical in determining whether the second order impact of job losses becomes a larger drag on global economic growth.
US market reaction to COVID-19: US markets appear to be ignoring the slew of bad news that keeps emerging – despite US unemployment increasing at the rate it has and to the heights it has. Unrealistic statements from US President Donald Trump regarding a reopening of the US economy appear to be enough to keep US markets afloat. Do you think current valuations are reasonable or is there further pain to come?
US markets (and most global markets) have a massive tailwind in the form of unprecedented monetary policy support flooding these markets with liquidity. For some context on the extent of the size and pace of current quantitative easing (QE) stimulus, the US Federal Reserve (Fed) and the European Central Bank (ECB) had a combined balance sheet of about $1.7trn going into the global financial crisis (GFC) in 2008, which they expanded by about $1.9trn in the six months including 4Q08 and 1Q09. They then proceeded to add another $6trn over the course of the next 9 years. Since the beginning of February this year, they’ve added another $2.5trn – 30% more in 6 weeks than they added in six months over the GFC – and they plan to add another $3.6trn in the foreseeable future. As we saw in the taper tantrum in 2013 and the Fed balance sheet reduction in 4Q18, when that stimulus gets removed, markets don’t like it, but that’s not something we’re going to need to worry about for the foreseeable future.
In addition, markets are expecting a tidal wave of fiscal stimulus (equivalent to at least 5% of global GDP) to plug the economic hole created by COVID-19. The additional prospect of government actively discussing the re-opening of economies (we won’t know how unrealistic this is until they try) and equity markets being forward looking is enough to keep markets well supported for now. We fully expect markets to be volatile for the foreseeable future as economies re-open and we get to see the potentially uneven nature of the recovery, with the biggest potential cloud being a second round of infections and movement restrictions. However, for now, markets are well supported by stimulus and the realistic prospects of some normalisation of economic activity in the foreseeable future.