Fast-moving events involving the coronavirus and efforts to contain it, as well as the immense unpredictability about the duration of the world’s new hunkered-down reality, require a flexible framework for assessing the effects of the outbreak on the global economy. The Vanguard Investment Strategy Group’s global economics team has considered three potential scenarios, and sees the most optimistic one as the most likely. We expect that the worst of the economic disruptions will have passed by the end of the second quarter, allowing global economies to start to recover in the second half of 2020.
This article presents Vanguard’s view, as of April 6, 2020, based on such a scenario. It looks at global economies in the context of their pre-coronavirus status and how they may be positioned to withstand the pandemic. We offer it with the caveat that our view would become more pessimistic if strict containment measures were required beyond the second quarter.
Several global themes emerged in interviews with members of the global economics team:
- Monetary policy responses have largely helped keep markets functioning.
- Fiscal policy responses are a matter of stabilization—keeping businesses and individuals afloat—rather than stimulus.
- The strength of eventual recovery will depend in large part on the duration of required containment measures, the depth and breadth of unemployment, and the extent to which consumers overcome lingering fear of resuming normal activities.
- It will be crucial to avert a second wave of infection and associated renewed containment efforts that could carry long beyond the second quarter.
- Without knowing more about the progression of the virus and containment efforts, it’s impossible to conjecture whether equity markets have hit bottom.
- The world is in recession, but strong recovery remains possible if stringent lockdown measures can be lifted in the second quarter.
We know that this period is deeply concerning for reasons of both health and welfare, and that a lack of definitive answers is frustrating. We caution investors—now more than ever—that such a period of great uncertainty is not a time to change a well-considered investment plan created with specific goals in mind. It may not seem so in the moment, but this period will pass, and goals will seem relevant again.
This article is informed by interviews with the following Vanguard global economics team members: Jonathan Lemco, Andrew Patterson, Jonathan Petersen, Adam Schickling, and Max Wieland in the United States; Alexis Gray and Shaan Raithatha in London; and Beatrice Yeo in Melbourne, Australia.
China: The original epicenter and a bellwether for recovery
Many people outside China became familiar with the novel coronavirus only when China’s government imposed a lockdown January 23 in Wuhan and other cities in Hubei province. Wuhan, a city of 11 million people, quickly resembled a ghost town, with near-real-time data showing vehicular traffic at a trickle—a clear manifestation of the severity of containment measures weeks before broad January-February economic data became available.
The world, with some parts still only approaching the expected peak of infection, is looking to China for a sense of what may lie ahead, including numbers of infections and deaths and what recovery looks like. Just over two months after those first lockdowns in several Chinese cities, business has resumed in the country, with estimates of activity as high as 90% of pre-coronavirus levels. Although China hasn’t stamped out new infections, the rate appears to have slowed dramatically, with the government reporting that most of the few new cases it has identified have been in people who have traveled outside China.
The United States, Spain, Italy, Germany, and France all have surpassed China in infections, according to the widely cited Johns Hopkins University & Medicine Coronavirus Resource Center.
Flattening the curve of new infections
Sources: Vanguard calculations, based on data as of April 2, 2020, from the Johns Hopkins University & Medicine Coronavirus Resource Center, sourced from Bloomberg.
Among the biggest questions for China’s economy is how long it takes for face-to-face businesses to recover. Although the government can strongly influence manufacturing, electricity generation, commodity production, and state-owned enterprises, it has less sway over the private, small to medium-size enterprises typical of face-to-face businesses.
“The government can only do so much to boost consumer sentiment in such a fear-driven environment,” Mr. Schickling said. “They can encourage non-essential consumption with stimulus, but until people feel safe leaving their house and returning to more populated activities, those sectors of the economy will continue to be hit. So we’re watching China because it will provide insight into how fast people in other parts of the world will resume going to restaurants, movies, and shopping malls.”
China’s economy will still face challenges even after its economic activity resumes, given slowdowns in countries that are less far along in the progression of the virus and containment efforts. Vanguard thus expects China’s growth for 2020 to be the lowest in the four decades since it opened its markets.
Italy: The second epicenter
Even as the world is beginning to look to China to learn about recovery from the virus, it’s looking to Italy and elsewhere in Europe for clues about the effectiveness of containment. A cluster of cases was identified in the northern Lombardy region in late February, and strict containment measures quickly followed. “Broadly speaking, we’re now at a point where most of the large countries in Europe—Italy, France, Spain, as well as the United Kingdom—all have quite strict containment measures in place,” Mr. Raithatha said.
Germany has taken a softer stance, with less stringent containment measures, yet it has fewer confirmed cases and significantly fewer deaths than Italy and Spain. “Germany has also been able to test at a much larger scale than most other countries in Europe,” Mr. Raithatha said. “They’ve been able to test health workers very quickly for current illness and also test to see if they’ve had it already and are able to come back to work.”
Italy and Spain, hit hard in both infections and deaths, have imposed some of the strongest containment measures, according to the Oxford COVID-19 Government Response Tracker. They’re also beginning to see the infection curve flatten, a sign that new cases may have peaked.
“Each day the number of new cases, while growing, is not growing exponentially,” Ms. Gray said. “In countries in Europe that have been in lockdown for several weeks, it’s evident that those measures are starting to pay off and that we’re just starting to turn the corner.”
European response: Stabilization, not stimulus
Italy’s economy was struggling before the coronavirus outbreak, as its GDP contracted in the fourth quarter of 2019. Its manufacturing sector, like Germany’s, took a hit from the global trade uncertainty that Vanguard’s 2020 economic outlook highlighted as weighing on economies globally. The United Kingdom, which infection data suggest may be a week behind Europe in virus transmission, had been looking for a pickup in economic activity in the first quarter, after its official exit from the European Union removed a key source of uncertainty.
The role of fiscal and monetary policy in addressing the challenge, however, is one of stabilization, not stimulus, Mr. Raithatha said: “The response both on the monetary and fiscal side has been very strong and pretty much unprecedented in the scale of asset purchases. The welfare package in terms of providing guarantees on income and loans to companies has also been pretty big.
“The problem is, this is only partly a demand shock,” he said. “It’s probably more akin to a natural disaster than anything else, so there’s a limit to how effective both monetary and fiscal policy can be, at least in the very short term.”
United States: Looking to weather a coming storm
The U.S. Federal Reserve has cut its benchmark interest rate target to near zero, made large-scale asset purchases, and taken other measures to calm bond markets that faced liquidity challenges. Spreads on mortgage-backed securities and corporate bonds have narrowed, reflecting improved sentiment since the Fed action and lowering transaction costs. The federal government has announced more than $2 trillion worth of fiscal measures.
But the United States most likely hasn’t reached the peak of infections and has lagged many other countries in the stringency of containment efforts. Concerns about growing U.S. debt need to be tempered by acceptance that the country faces a health care emergency and that “we need to get to the other side with a recognizable economy,” Mr. Patterson said.
Notes: Each country’s composite measure has been calculated by attributing a score to seven indicators measured on an ordinal scale, rescaled to vary from 0 to 100. Data as of March 31, 2020.
Source: Hale, Thomas, and Samuel Webster, 2020, Oxford COVID-19 Government Response Tracker.
U.S. GDP could contract at a significantly greater degree in the second quarter than it did at the worst point of the global financial crisis, Mr. Patterson said, with the extent and timing of recovery dependent on when containment efforts can be rolled back. Even then, it will take time for activity to return to normal as consumers come to terms with their fears.
“Containment measures to date are putting nearly three-quarters of activity in arts, entertainment, and hospitality out of commission,” Mr. Patterson said. “It will be crucial to that sector for people to come back quickly.”
Yet absent a vaccine or a discovery that an existing medicine can combat the virus, the strict containment efforts are necessary. Fiscal policy providing small-business loans and expanded unemployment insurance is essential, Mr. Patterson said: “Money needs to get to small businesses and unemployed individuals as soon as possible so they can weather the storm.”
Japan: A new challenge for a struggling economy
With its tourism from China, population density, and elderly population, Japan might have seemed susceptible to the worst of COVID-19. Individual rights afforded by Japan’s Constitution limit the severity of government action; the government can’t legally constrain people from going outside by imposing punishments, and a wider array of businesses continue to operate than in the euro area or the United States. So the modest case numbers, fewer than 4,000, are an encouraging albeit surprising development. A spike in recent days, however, suggests that Japan may not yet have seen the worst of the outbreak. (On Tuesday, April 7, Japan declared a month-long state of emergency in its largest population centers.)
Japan’s economy, meanwhile, was struggling even before the outbreak. GDP fell at an annualized rate of 7.6% in the fourth quarter of 2019, with imposition of a value-added tax straining an economy already late in the business cycle and with monetary policy stretched seemingly to its limits. Although Vanguard had foreseen recession in 2020 as a risk for Japan, it wasn’t our base case. Now we see an economic contraction for the year as inevitable.
An economy that, according to the World Bank, derives nearly 7% of its GDP from travel and tourism, much of it from China and South Korea, saw tourism decline 80% in the first quarter. Consumption has faltered, hurting the retail sector in a country where brick-and-mortar sales still predominate. Slowing global demand for automobiles, machinery, and other durable goods is likely to hit Japan’s manufacturing sector.
Postponement of the Tokyo Olympics until 2021, however, isn’t a significant blow to Japan as the bulk of economic activity from such an event is front-loaded as a country engages in related infrastructure projects.
Emerging markets: Hard times are likely
Emerging markets may have it harder than any others, Mr. Lemco said. The worst of the pandemic may be yet to come in Asia’s emerging markets, which have densely populated cities and fewer resources than developed markets to protect inhabitants. Without the pandemic, we would have foreseen 2020 GDP growth of 5% to 5.5% for India and Indonesia and 4% to 4.5% for Malaysia, Thailand, and the Philippines. Although that potential may be gone, Mr. Lemco said, Asia’s emerging markets are likely to fare better than other regions.
Countries in Central and Eastern Europe would follow in their ability to protect themselves. Latin America presents a mixed bag, Mr. Lemco said, with Chile and Peru ahead of others in their readiness, while Africa may be least able to protect itself. “So many of the investable emerging markets want to do the right thing to protect their citizens and shore up their economies,” Mr. Lemco said, but “there are limits to their financial ability to do that.” The International Monetary Fund on April 3 pledged to make $1 trillion in emergency financing available to emerging markets.
For many emerging markets, the biggest economic challenges will come from reduced commodities prices, as many of these countries are commodities exporters, and from reductions to their role in global supply chains as trade slows amid containment efforts.
Mexico: Weakness alongside oil, U.S.
Vanguard’s expectation for modest growth in Mexico in 2020 has given way to one of modest contraction. The economy in Mexico—which in 2019 surpassed China and Canada to become the United States’ leading trading partner, according to the U.S. Census Bureau—typically takes its cue from what happens in the United States, Mr. Lemco said.
Mexico, whose deficits and debt-to-GDP ratios had already been widening of late, is likely to be hurt by virus-related shutdowns of manufacturers, including those in the auto and auto parts sector. Just as important, remittances from Mexican migrants in the United States are likely to dwindle given U.S. containment efforts.
The credit-rating agency Standard & Poor’s downgraded Mexico’s sovereign debt rating in late March to two notches above junk, while the ratings agency Fitch in early April downgraded the debt of the state-owned oil company Pemex, saying low oil prices would require more government support of the company. Mexico has become a net importer of petroleum, so it won’t be hurt by lower oil prices to the same degree as other emerging markets, but neither is it likely to benefit much amid interruptions to manufacturing.
Canada: A $4 barrel of oil
A barrel of Western Canada Select oil was quoted in late March at just more than $4 in the futures markets. That’s not a typo—or a good sign for Canada’s oil industry or economy.
The heavy, lower-quality oil typically trades at a discount to the West Texas Intermediate light sweet crude whose price is routinely quoted as one of two global oil market benchmarks. A steep drop in demand, because of the coronavirus and downward pressure on the benchmarks as Russia and Saudi Arabia talk of flooding the oil market, means “a barrel of oil was selling for less than a good cup of coffee,” Mr. Petersen said.
Prices have since firmed somewhat but not enough to quell concerns. With break-even prices in the high $20s and as much as the low $40s for some producers, Mr. Petersen said, the viability of some producers in an industry that accounts for about 7% of Canada’s GDP and about 500,000 jobs could be threatened if low prices persist.
“The global oil industry is going through some very severe dislocations right now,” Mr. Petersen said. “It’s not clear how much production will actually come back online, so there’s a high risk that a portion of Canada’s oil production could be permanently shut down or impaired, because it’s higher cost and lower quality than a lot of other North American crude from Alaska or the shale patch.”
Vanguard’s annual economic outlook for Canada anticipated GDP growth of about 1.6% in 2020, with a resilient labor market and robust wage growth supportive of inflation near the upper bound of the Bank of Canada’s 1% to 3% target. Now we foresee flat growth at best for Canada, with inflation at the lower end of the range and the Canadian dollar weakening given oil’s challenges.
Australia: Decisive early action
Australia wasted little time closing the door on COVID-19, imposing lockdowns state by state and eventually across the commonwealth, even as confirmed cases stood at only about 1,000. Three weeks after Australia in mid-March first reported 200 new cases in a week, its death toll stood at just 40, a paltry figure compared with many other countries even after adjusting for population. Early indications suggest Australia may have already begun to reduce the incidence of new infections.
The strong early measures could put Australia in a better position for economic recovery than developed-market peers, but complacency could raise the risk of a second wave of infections as the country enters winter. “China’s recent increase in asymptomatic and imported cases is a good example of how this is not a negligible risk,” Ms. Yeo said, “and lifting social distancing measures prematurely could potentially give way to a W-shaped recovery, where growth double-dips on the back of a renewed outbreak.”
Australia’s economy was vulnerable even before COVID-19, with summer bushfires most likely shaving 0.2% to 0.3% from GDP. The coronavirus outbreak threatens to drag Australia to two consecutive quarters of economic contraction for the first time in nearly 30 years.
Policymakers have responded with fiscal stimulus of about 10% of GDP, much of it targeted at businesses to pay workers and prevent a surge in layoffs. Unemployment, stubbornly above 5% for most of 2019, was a challenge before the outbreak. Part-time employees make up about 20% of the workforce in high-risk sectors such as tourism, air travel, and real estate, Ms. Yeo said, so underemployment bears watching too. “Given that we expect this to be a temporary shock, we hope most employers, with the help of the government’s wage subsidy scheme, will choose to reduce hours instead of completely laying off workers,” she said.
The Reserve Bank of Australia has reduced its key cash rate to a record low 0.25% and is unlikely to go lower because of considerations about banks’ profitability, Ms. Yeo said. RBA asset purchases announced in mid-March successfully anchored the yield on 3-year government bonds at 0.25%, helping to calm markets.