Trying to think beyond the trough
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Trying to think beyond the trough

Key points

  • The wave-like form of the covid-19 epidemic means that the beginning of a normalisation in China coincides with an acceleration of the propagation of the virus in other key economic regions. Re-starting production in China deals with one leg of the disruption to global supply but this is not enough. We took our forecasts markedly down.
  • We look at the appropriate policy-mix with the 2009 precedent in mind. The short term response needs to differ – this crisis did not originate in the financial system. The medium term response – to avoid permanent scars - needs to learn from the mistakes of 2010-2013: policy support will be needed for long. Another reason to think the “low rates for long” regime will stay.

Chinese normalisation may come too late

The first macro data on China reflecting the state of the economy since the start of the epidemic is trickling in and the collapse in the official composite Purchasing Management Index in February, to an unprecedented 28.9, confirmed the depth of the contraction there. Note that just like everywhere else, the index would have been even lower were it not for the lengthening in delivery time, normally signalling overheating but here merely reflecting supply disruptions. Although the print is spectacular, we don’t think it brings much in terms of new information. We already knew that China was going through a “lost Q1”. The issue is whether – following the new strategy of the Chinese leadership – we are seeing proper progress on activity normalisation now.

Two weeks ago, the French embassy in Beijing conducted an interesting survey among the French companies operating in China. A small majority – 51% - of the respondents expected a return to normal (defined as a level of orders above 80% of the usual level) by the end of March, but still leaving 40% forecasting a normalisation by Q2 only (nearly 10% declared having no visibility on this). Interestingly, the return to normal was seen as happening faster for manufacturing businesses than for services, which would bode well for global value chains even if it would point to a protracted slowdown in aggregate Chinese demand.

We still need to rely on indirect indicators to gauge the very latest developments in China. Pollution maps are quite interesting, but for our part we like to focus on shipping activity. The number of ships arriving and leaving the port of Shanghai averaged c.700/day in the first half of February. It has increased to c.1,000/day in the second half and we find a positive trend for Shenzhen as well. So it seems some gradual normalisation is taking place.

However, even if we assume that once domestic travel restrictions are lifted the epidemic does not rebound in China, the “wave-like” form of the covid-19 epidemic means that the beginning of the normalisation in the first country to be hit is coinciding with an acceleration of the propagation of the virus in other key economic regions, with the number of cases forcing severe disruptions on South Korea, Japan and Italy, and with autonomous centres of contagion also starting to appear in the rest of Western Europe and in the US.

We took our forecasts down

The global impact of the epidemic thus no longer stems primarily from second-round effects on exporters to China. Domestic economic activity outside China is being hit. Moreover, beyond the epidemic, “old” headwinds (weak corporate capex globally) and “old” risks (US elections, Brexit, Persian Gulf) have not disappeared and may have become even more acute because of the health scare.

Indeed, we note that Donald Trump decided last week to take a more visible personal role on fighting the epidemic, which may turn out to be the wrong decision electorally if the level of preparedness of the US administration comes out short. It is still early days but given the lead in the polls taken by Bernie Sanders for the democratic primaries, having to raise the probability of a democratic candidate with a radical platform defeating the incumbent could fuel the already crippling wait-and-see attitude of corporate America on investment decisions.

Finally, worse-than-expected hard data at the end of 2019 in Europe and Japan means the carry-over into 2020 is worse than projected. Consequently, last week we decided to revise our forecast for 2020 from 3.2% to 2.6% for world GDP. This would be the weakest pace since 2009 even if this is still very far from the absolute decline in global GDP which was observed then (-1.7%).

The distribution of the shock across the various still follows the current level of (i) exposure to global trade and specific sectors at risk such as tourism and (ii) the magnitude of the current epidemic at the national level (see Exhibit 1). Note however that even in the case of the US where the forecast change looks small, the actual revision to the scenario is significant since before the emergence of the epidemic we probably would have revised our forecast up for this country given the resilience in consumer demand.

Considering an even worse scenario

Despite this significant downward revision to our baseline we believe the balance of risks is still tilted to the downside. In a note released two weeks ago we sketched out an illustrative macroeconomic scenario in case of pandemic (

We summarize it here: assuming an infection rate close to swine flu, and a mortality rate that remains around the current WHO estimates for covid-19 (but affecting prime-age workers less), we could see a direct supply-side loss for global GDP of around 1.75%. But the main effect of the pandemic would stem from a demand shock, reflecting behavioral changes in spending habits – e.g. avoiding crowds, thus impacting a lot of recreational activities. Retail sales fell back by 15% at the height of the SARS virus in key Asian economies in 2003. Demand would also be affected by falling investment, against a background of falling consumer spending, rising uncertainty and potentially rising finance costs.

A simple summation suggests an order of magnitude impact that could be around 4-5% of global GDP, to subtract from a global trend growth of around 3%. A contraction of this order of magnitude would constitute the second outright contraction in world GDP since the IMF kept records from 1945 – a contraction similar to the wake of the financial crisis in 2009.

As a point of reference, we note that a 2008 paper by the London School of Hygiene and Tropical Medicine estimated a 6-7% GDP shock to EU countries, suggesting a similar order-of-magnitude estimate (

Discussing the policy response

Increasingly we see a temptation in sell-side research to look at 2008/2009 for guidance on the right policy response but as much as we think we should draw lessons from the inappropriate macro-management of the global economy in the aftermath of the 2009 global recession, the immediate policy response at the onset of the crisis, although successful, provides little insight in how we should deal with our current predicament.

Indeed, in 2008 the root of the crisis was firmly within the financial system. Even if it sometimes took time to coordinate action across markets and initial mistakes were made (tomes of alternative economic history are written on “what would have happened if Lehman Brothers had not been allowed to fail”), the generic recipe was obvious: central banks had to flood credit institutions with liquidity, and when this proved insufficient, purchasing assets which had become illiquid (by the Fed) as well as recapitalising banks with public sector funds became the blueprint.  Action was not swift enough to prevent a spill-over from the financial system to the real economy, but then traditional policy action proved quite adequate: interest rate cuts combined with a fiscal push quickly brought the economy back to growth by the end of 2009.

This time the financial system bears no responsibility: the decline in asset prices is merely a reaction to an exogenous shock. Obviously, if down the road the market slide were to trigger a systemic risk for the financial system then the recipes of 2008/2009 would have to be used, but as “weapon of first intention” they would not be appropriate in the current configuration.

Still, as we discussed in Macrocast last week the market is already pricing some aggressive response from the central banks and expectations for a coordinated response were rising. On Friday a written statement by the chairman of the Federal Reserve signalled a willingness to act fast.

There is a rationale for this: the US equity market is already correcting very fast, before actual domestic disruption has appeared in the US. Given the higher-than-average sensitivity of the US real economy to equity prices (wealth effects tend to be large there), cutting policy rates, even if it cannot directly lift economic activity faced with a supply-side shock would still help support asset prices and thus help keep on source of spill-over to the real economy in check.

In our baseline the Fed would cut twice by 25 bps in April and June, but we see a significant risk they move in March already.

We argued last week that with policy rates already very low we don’t think cutting further would be very helpful in the Euro area, given the possibility it would trigger even more pressure on banks’ profitability and also given the weak sensitivity of consumption to wealth effects in Europe. This may be an impediment to a coordinated policy action which a lot of investors would like to see from major central banks. At the very least this should come with more generous conditions for the next batch of TLTROs.

Maybe more than monetary policy “proper” we think financial regulators in the Euro area should offer some preventive forbearance to credit institutions. We think a rise in corporate default as a result of severe supply disruptions could be a consequence of an extension of the current epidemic towards proper pandemic levels. The Italian government is already taking steps to suspend corporate tax payments from businesses located in the worst-hit areas (the overall new fiscal push in Italy amounts to a puny 0.2% of GDP though), and banks such as Unicredit and Intesa have offered “payment holidays” to some of their affected borrowers. But at some point, if the situation sours further, we would need to see some pre-emptive statements on a temporary relaxation of the key regulatory metrics. In the same vein we think that the ECB should increase its purchases of corporate bonds to avoid a tightening in financial conditions at the worst possible moment.

Beyond the short term

All this pertains to some short term mitigation of the crisis, avoiding collateral damage rather than directly counteracting the downturn itself. What will actually trigger a rebound will purely and simply be the end of the epidemic, which may well wait until the drier and warmer weather settles in. Still, policy-makers will have to make sure this does not leave lasting scars on economic growth. This is why we think they should reflect on the policy mistakes which, after the rebound of late 2009, kept the developed economies on a mediocre growth pace.

We have used Exhibit 2 before. After providing massive fiscal support at the peak of the 2008/2009 crisis, both the US and the Euro area countries tried to restore their budgetary positions too quickly. In Europe, the absence of direct monetary support in the form of quantitative easing forced the peripheral member states into crash adjustments.

The situation is different today. Many peripheral countries have cleaned up their balance sheet and globally the banking sector has been forced into building significant buffers. But our point here is that the current shock will probably result in some permanent losses. Some investments will be missed. Some hiring will not happen. Potential growth – already quite weakened after years of poor productivity gain and under-investment, is likely to take another hit. This calls for a measure of fiscal support which will probably have to be maintained beyond the end of the epidemic, even in fiscally fragile countries such as Italy. In Germany the finance minister mentioned again the possibility to use the country’s fiscal buffer “if needed” (and we definitely think there is a need).

The political equation also needs to be considered. After years of sub-par growth and fiscal austerity – even if the latter has been softened in the more recent years – public opinion in many European countries is “tired” and tempted by populist solutions. Income inequality rose by a lot in the countries which went through the harshest adjustments. Even in the most prosperous member states populism is gain traction (see AfD in Germany). Another macro shock could trigger even more pressure on political stability. One possibility is that the epidemic ends up being seen as the epitome of “bad globalisation” in large swathes of public opinion in the West, originating in China and allowed to develop through “open borders”. Exogenous issues - such as Turkey’s decision last week to let Syrian refugees move to the EU borders – may exacerbate these feelings.

Given how limited fiscal space is today – not just in most Euro area countries but also in the UK and the US – monetary policy will be again requested to “keep things running”. This new crisis is another reason to believe “low rates for long” will remain a fixture for longer than what had been hoped in 2018, before the trade war made a first dent in the belief in – at last – a steady pace of expansion for the world economy.

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