Financial markets have rallied since April, with investors growing more confident that economies will turn around quickly from the fallout caused by the pandemic. Their optimism has increased in recent weeks as various countries have started to ease lock-down restrictions and tentative signs of stabilisation have emerged. Daily activity trackers from the likes of Google and Apple show most developed countries edging towards normality, halving the declines suffered during their March and April lows. China is back to January levels, though the country’s unique policy circumstances (regarding lock-down and stimulus) mean it might not be a template for elsewhere.
Huge job losses will inevitably have an impact on consumption, which is at present being mitigated by massive fiscal stimulus. Indeed, fiscal deficits are off the charts: in the US, the deficit is expected to reach US $4 trillion this year (20% of GDP), without even taking into account the various spending programmes winding their way through Congress. 90% per cent of that increase is being financed by the US Federal Reserve, which has become the ATM of the US Treasury.
This should push the US “shadow” rate (which takes into account the impact of its unconventional easing) below the previous trough of -4.7% in real terms by the year end, down from the current -3.3% (yes, there is a negative sign at the beginning of those numbers!).
While benchmark interest rates are unlikely to fall below zero, we expect the Fed to adopt a Japan-style yield control curve policy if inflation undershoots its target significantly in the coming months (spoiler alert: it will).
The Eurozone had initially been more conservative in its approach, but a new EUR 750 billion rescue programme (a mix of grants and loans), to be funded through a commonly issued bond, is a big first step towards fiscal integration of the single currency region. Even if the plan is watered down, the Franco-German programme could change the EU’s medium and long-term economic prospects.
While emerging market economies are likely to suffer less of a drop in growth than their developed counterparts, world growth could be down circa 4% this year (a peak-to-trough drop of 8%), which would be double the fall seen post-Global Financial Crisis.
The rebound in risky asset prices owes plenty to the very aggressive easing implemented by global central banks, with the Fed clearly the pace setter. The injection of liquidity from the Fed in recent months has elevated its balance sheet by more than US $3 trillion, and we should expect the balance sheet to near US $10 trillion by the end of the year (or 50% of GDP).
Where the Fed has moved the needle for risk appetite is through its backstopping of credit markets. Stemming a credit crunch in the very important area of capital markets (the Fed’s actions have triggered an avalanche of debt sales from companies since March) certainly helps the equity market, particularly the weakest links. This has the potential to wake up the “animal spirits” of investors that are desperately looking for places to park their assets.
Crucially, not only do we have the biggest money printing experiment ever, but also bank balance sheets are robust enough to transmit this through to credit creation (unlike during the 2008-09 crisis).
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