Where’s the financial stress?
The speed and severity of the economic downturn has been far greater than the last recession, in 2008–09. The 0.1% contraction in the global economy in 2009 now looks like a pinprick by comparison with the International Monetary Fund’s forecast that world GDP will shrink by almost 5% this year.
- Growth is coming back as the lockdown eases, and some of the economic data are looking V-shaped. Activity will rebound in the coming months fuelled by pent up demand and policy stimulus. But the pandemic has blown a big hole in the economy and it’s likely to be a long haul, probably a couple of years, for GDP to get back to pre-COVID levels.
- Yet in one important respect the outlook today is better than it was in 2009. This time we have an economic crisis, but not a financial one. Financial markets have continued to function and measures of stress in financial markets are running at surprisingly low levels.
- Things didn’t look this way in February and March. As the scale of the pandemic emerged equities and corporate bonds went into freefall. Some markets, notably the US treasury market, looked close to seizing up. In a ‘dash for cash’ investors were selling even the safest assets, including long-term government bonds. At times it felt like the very worst days of the financial crisis.
- Massive policy stimulus, greater even than in 2008–09, helped stem the tide. Central banks deserve credit for the speed and scale of their response to the financial turmoil. Falling interest rates and quantitative easing have, as they’ve done before, boosted asset prices. Equity investors seem to have taken the view that the bad news from a huge shrinkage of the economy will be more than offset by massive monetary stimulus.
- The US S&P 500 equity index has risen by almost 40% from its March low. Today it stands less than 10% below the all-time peak reached in February. Corporate bond spreads, a measure of financial risk for large businesses, are now lower than in 2008–09 or even during the euro crisis of 2012.
- Remarkably, the latest reading for the St. Louis Federal Reserve’s financial stress index, based on 18 markets indicators, is close to normal. Implied volatility in equity markets, another widely watched measure of financial stress, though at elevated levels, is running well below previous peaks.
- The problems of the banking system were at the heart of the last recession. But this time, with much-strengthened balance sheets and vast support from central banks, banks have played a significant role in countering the downturn. Bank lending to corporates has risen sharply, aided by central bank liquidity and guarantees. Regulations introduced in the wake of the financial crisis have strengthened banks’ balance sheets. Few institutions could have prepared for a pandemic. But since 2014 annual stress tests have sought to ensure that UK banks have the ability to manage even severe recessions and market turmoil.
- Yet downturns on this scale cast long shadows. The financial system, and financial markets, are not out of the woods.
- The disconnect between buoyant equity prices and the reality of a much reduced, debt-laden economy is unsettling. Activity is coming back, but corporate insolvencies are likely to rise and profits have further to fall. Some worry that the heady effect of low interest rates has blinded investors to the risks in the assets they own. The gap between equity markets and the real economy could narrow if activity picks up more quickly than expected. But the correction could also be driven by an abrupt fall in equities and other risk assets, fuelling financial stress.
- The banking sector has coped well so far, but rising stress in the corporate sector and higher unemployment would inevitably mean losses on corporate and household loans.
- The latest analysis by the Bank of England’s Financial Policy Committee offers reassurance on this front, suggesting UK banks are well placed to cope with future losses. The Committee’s stress test shows that the banks, with the backing of the government’s lending guarantee schemes, have the capital to withstand severe losses and to carry on lending to business.
- The path of the recovery is full of uncertainties and financial markets have yet to feel the full effects of the downturn. In short, plenty could go wrong. Yet what was starting to look like a financial crisis in March has, so far, been avoided. Given the shock to the global economy that is something of an achievement.
OUR REVIEW OF LAST WEEK’S NEWS
The UK FTSE 100 equity index ended the week down 2.1% at 6,159. Markets around the world were unsettled by a resurgence of infections in the US.
COVID-19
Globally, the spread of the pandemic continued to accelerate with a record number of new daily cases recorded
In the US, the rolling seven-day average of new cases reached 33,070 last Friday, exceeding the previous record of 31,942 cases set on 11 April
This suggests that the US is now experiencing a second wave of the pandemic although it is disputed if the first wave ever really ended
Arizona, Florida, Texas and California have all seen significant increases in confirmed cases over the last week
Some affected states such as Texas and North Carolina are halting or rolling back plans to ease lockdown
The US, Brazil and India account for the majority of new cases
In the UK, the seven-day moving average of new cases fell to 1,073 on 26 June, down from 1,294 on 19 June and a peak of 5,519 on 14 April
Approximately 100,000 people have been advised to self-isolate by the UK’s test-and-trace service after coming into contact with an active case
However, one in four who tested positive for COVID-19 could not be reached to establish their recent contacts
The UK is planning to further relax lockdown restriction from 4 July, including reopening bars and restaurants
UK guidance on social distancing will be modified to permit a minimum of a one metre distance when greater distancing is not possible
The UK government is considering a localised lockdown of Leicester, following a spike in infections in the city
Economic developments
The IMF revised its forecast for global growth and now expects a contraction of 4.9% this year, down from a previous forecast of a 3.0% contraction in April
The WTO estimates that second quarter global trade was 18.5% lower than levels seen last year, the steepest decline on record
Some 1.48m Americans filed a new unemployment claim, a similar number to that seen in the preceding week but well above levels seen last year
Early estimates suggest that activity has stabilised in the US and the euro area as surveys recorded only modest declines in June
In the UK activity in the manufacturing sector showed slight growth in June after sharp declines in April and May
Orders for US durable goods rose 15.8% from April to May although are well below pre-pandemic levels
Some 5,314 cars were produced in the UK in May, up from 197 in April but 95% below levels seen in the same month last year
The number of UK job adverts posted on the website Adzuna increased for a fifth consecutive week but are running at roughly half of 2019 levels
Policy response
US president Donald Trump suspended the issuance of new work visas until the end of the year, ostensibly to prevent the spread of the virus
The US erroneously sent $1.4bn in stimulus checks to deceased individuals
The US Fed will prohibit large banks from buying back their shares and impose caps on dividends due to concerns that defaults may spike
UK prime minister Boris Johnson pledged not to return to the austerity of ten years ago, announcing a “doubling down on levelling up”
The UK Treasury is in talks with six companies over a scheme to support strategically important industries, the FT reports
Business news
Just 18.2% of rent due to commercial landlords was paid on time on the quarterly collection day last week
Shopping centre operator Intu entered administration – a further sign of the difficult conditions in the commercial property sector
Payment processing firm Wirecard collapsed into insolvency following allegations of financial impropriety
Shareholders of German airline Lufthansa voted to accept a €9bn bailout from the German government, who will take a 20% stake
Politics
India is planning to impose new restrictions and tariffs on imports of Chinese goods following the deaths of 20 Indian soldiers in a border conflict with China, Bloomberg reports
The US Senate passed a bill imposing sanctions on Chinese officials who interfere with the autonomy of Hong Kong
North Korea announced that it was suspending “military actions” against South Korea, a move seen as a de-escalation from the aggressive rhetoric of recent weeks
And finally… Kent District Library in Grand Rapids Michigan has asked its patrons to refrain from microwaving books. Users of the library were thought to be doing so in an attempt to disinfect them – cooking the books