Pandemic Update

The global economy continues to operate under the spectre of COVID-19, though the worst of the pandemic seems to have passed in most countries. The pandemic's epicentre has shifted to emerging markets, but second waves continue to appear in the advanced economies. In recent weeks, India has passed Brazil in the total number of cases and is now behind only the U.S. And it looks set to eventually overtake the U.S. at some point.

An alternative way to measure the intensity of COVID-19 that combines health and economic variables is to take a country's global share of cases divided by its global share of GDP (1) (see Chart 1). By this measure, the effect of the virus was firmly centered in Europe (especially Italy) in the first quarter before shifting to Brazil in April-September, with South Africa, Argentina, and India gaining ground. The U.S. intensity score has been relatively high and stable since March. (2)

Chart 1

Second-Quarter Damage Report

The economic damage in the second quarter was unprecedented (outside of China, which took its biggest hit in the first three months of the year). U.S. output fell by an annualized 32%, Europe's dropped nearly 50%, and the output in the emerging markets we cover declined 43% (but ranged from 30% to 70%). We continue to believe the focus should be on output levels relative to year-end 2019 rather than growth rates. These rates will be well outside of the historical distribution of outcomes in the next few quarters and therefore won't be particularly meaningful. Comparing the second quarter with the last quarter of 2019, the level of output dropped 10% in the U.S. and 15% in Europe. China's GDP was 10% lower at its bottom in the first quarter than at the end of 2019.

Chart 2

Activity rebounded strongly in the third quarter, though momentum has begun to fade. Drivers varied across the major economies. The bounce in the U.S. and Europe stemmed from household spending on the back of government transfers and improving incomes as pandemic-related restrictions eased. Retails sales have regained year-end 2019 levels, but investment remains weak. China's story is the opposite: The rebound has been led by infrastructure spending from central government outlays and local government bond issuance with exports providing additional support. Retail sales have been sluggish, in line with the slow service sector recovery, and growth has just recently turned positive. Pre-COVID retail sales growth was trending at about 8%. In emerging markets, the recovery is advancing at different speeds, helped by the rebound in major trading partners and supportive financial conditions.

Employment outcomes have varied as well, at least as reported in unemployment rates, owing to the structure of fiscal support as well as institutional norms. Headline unemployment in the U.S. soared to 14.7% in April from 3.5% before the pandemic and stood at 8.4% in August. In contrast, in Europe (as in most other advanced economies) various employment initiatives have kept the rise in joblessness very modest. July unemployment in the Eurozone was 7.9%, only half a percentage point above the pre-COVID-19 rate, though employment was 3.1% lower.

Some recent trends are more global. Property sales have been buoyant across a wide swath of economies reflecting (near) record-low mortgage interest rates as a result of quantitative easing (QE) and low inflation expectations. Meanwhile, trade levels remain generally depressed (though growth has picked up recently), with the important exception of Asia-Pacific based on China's commodity demand and electronics production, which has been lifted by the shift to working from home.

Fiscal Policy Is The Key To Recovery

Fiscal policy remains key to the shape of the recovery. (3) COVID-19 has resulted in a massive contraction in demand, not only in directly affected sectors but spilling over to most other sectors as well. We believe the role of fiscal policy should be to cushion the blow, keep (or incentivize) workers and firms staying as connected as possible, and create a bridge to the eventual recovery. Governments' fiscal responses have varied widely, mainly as a function of available space (4). This, in turn, is highly correlated with per capita income, so the wealthier economies have been able to provide direct (on the order of 10% of GDP, on average) and off-balance-sheet (guarantees, mostly) support to their economies to combat the pandemic. As a country's per-capita falls, the amount of support falls close to zero for the poorest countries, with the attendant negative effects on both economic and health outcomes.

Drilling down to the microeconomic level, fiscal policy should ensure that viable firms have the resources needed to survive the COVID-19 shock, which will result in better labor market outcomes. (5) This means augmenting the cushions available in normal times--cash reserves plus access to bank lines or the bond market--with loans or grants. The spike in firm losses due to the shutdowns in the most affected sectors very likely exceeded these normal cushions (see "layer cake" chart below). The implication is that, absent additional support, these firms will exit the market, and their workers will become unemployed (like firm D in Chart 3). This would be costly because capital would lie idle and depreciate, new firms would need to be started up during the recovery, and the labor market would need to resort to match job-seeking workers with new firms. Moreover, depending on the industry, supply chains could be disrupted. The policy challenge is to provide enough financing to get the most vulnerable (viable) firms through the worst of the crisis while keeping their workers on the payroll, thus saving the costs associated with a sharp reduction in firm count and employment.

Chart 3

Monetary policy will continue to play an important but supporting role. When the magnitude of the crisis became clear, major central banks quickly took policy rates to zero (for those not already there). They also stepped up QE to further ease monetary conditions. In addition, central banks intervened in the money market, muni markets, and swap markets as well as selectively in credit markets to ensure orderly conditions, two-sided trading, liquidity, and price discovery.

Macro prudential policy is important as well, widening the market cake layer--at least temporarily--through loan forbearance and loan reclassification by banks to take into account government support. (6) Current monetary and macro-prudential policy stances are therefore helpful and will need to continue through the COVID-19 period. But the role of creating public demand to offset the sharp drop in private demand falls squarely on fiscal policy.

Our Revised Forecasts

Our global GDP forecast for this year hasn't moved markedly since our previous quarterly report, though there have been important compositional changes. The outlook for the advanced economies has improved generally, and we have raised our forecasts for the U.S. and Eurozone on the back of a stronger-than-expected rebound in the third quarter. We have also raised our forecast for China, although the rebound there took place in the second quarter. These improvements have been offset by a much lower forecast for India as well as lower growth prospects for the U.K. and Japan.

A note on our coronavirus assumption. 

S&P Global Ratings acknowledges a high degree of uncertainty about the evolution of the coronavirus pandemic. The current consensus among health experts is that COVID-19 will remain a threat until a vaccine or effective treatment becomes widely available, which could be around mid-2021. We are using this assumption in assessing the economic and credit implications associated with the pandemic (see our research here: www.spglobal.com/ratings). As the situation evolves, we will update our assumptions and estimates accordingly.

U.S.  Despite difficulties in getting the pandemic decisively under control, the world's biggest economy surprised modestly on the upside this past quarter. This reflected resilient consumer spending (partly due to government transfers) and a stronger-than-expected labor market. Investment and capital spending continue to lag. We now foresee sequential annualized growth of more than 30% in July-September, though that will only partly offset the massive losses to output in the first half of the year (estimated at more than 10% peak-to-trough). (7) While the unemployment rate fell to 8.4% in August, only half the jobs lost earlier in the year have been recovered so far. And fully recovering the other half won't likely happen until 2023.

Fiscal transfers remain key to cushioning the COVID-19 pain and supporting the recovery, but agreement on the next package by federal lawmakers remains elusive. The Federal Reserve will likely keep its policy rate near zero for even longer than envisaged, reflecting its move to an average inflation target in August. (8) We now forecast full-year GDP to contract 4% (better than the 5% contraction in our previous forecast) and then grow at 3.9% in 2021 (5.2% previously) and about 2.5% for 2022-2023. As this sluggish recovery unfolds, the main macroeconomic risks are a lack of sustained and appropriate fiscal stimulus and a renewal of trade tensions with China (see "The U.S. Economy Reboots, With Obstacles Ahead," Sept. 24, 2020).

Europe.  The Eurozone economy has also recovered faster than expected from the first wave of COVID-19, for reasons similar to those in the U.S. Once lockdowns were lifted, consumers were eager to spend. Retail sales are now above pre-pandemic levels, though investment has rebounded more slowly. Unlike in the U.S., unemployment has risen much less (by only 60 basis points from February, to 7.9%) owing to widespread short-term work initiatives and a drop in participation; job losses have been only one quarter of those in the U.S. However, following a mechanical bounce in output after the first wave, economic momentum has dropped off.

The Eurozone is entering a tricky transition period, moving gradually away from government support toward implementing the EU's recovery plan. Liquidity and household behavior will be crucial in this period. We now forecast that GDP will fall 7.4% this year (down 7.8% previously), grow 6.1% next year (5.5% previously), and expand by 2.5% in 2022-2023. We are also lowering slightly our expectations for unemployment, which we forecast will peak at 9.1% in 2021. We don't expect the European Central Bank to begin to remove monetary policy accommodation via raising rates or shrinking its balance sheet anytime soon (see "The Eurozone Is Healing From COVID-19," Sept. 24, 2020).

China.  China's recovery is underway, and while it will be the only major economy to record positive growth this year, the rebound is largely government-led and not yet self-sustaining. Infrastructure spending has picked up noticeably, as have property and technology. Consumption remains subdued, as households seem reluctant to spend after a sizable income shock in the first half of 2020 and lingering weakness in hiring, mainly due to a sluggish service sector. Specifically, retail sales growth recently turned positive for the first time since the pandemic struck, but remain well below the 8% pre-COVID-19 growth trend. This uneven Chinese recovery has contributed to a strong but narrow trade recovery in the rest of the region, as shipments to the Middle Kingdom from the rest of Asia have regained pre-pandemic levels.

We have revised our 2020 GDP growth forecast higher, largely on the back of a surprisingly high second-quarter report, to 2.1% from 1.2%. But we have dialed-back our 2021 forecast by 50 bps to 6.9%, reflecting tighter financial conditions and a substantial fiscal tightening that will partially offset an eventual recovery in private demand. China's apparent move toward greater self-reliance has measurable implications for productivity and thus GDP growth, and if confirmed, would move us closer to our downside scenario for the medium term (see "Asia-Pacific's Recovery: The Hard Work Begins," Sept. 24, 2020, and "China Credit Spotlight: The Great Game and An Inescapable Slowdown," Aug. 29, 2019).

Emerging markets.  Developments in emerging markets reflect the combination of the impact of the virus and the policy response. Overall, the economic impact of COVID-19 so far has been strongly negative. India has yet to contain the pandemic, which--together with limited stimulus--has led us to lower our forecast for fiscal 2021 (ending in March) by a full 4 percentage points to negative 9%. Moreover, we estimate a lasting output loss of about 13% and a likely decline in post-COVID-19 potential growth. Brazil surprised on the upside in the second quarter, and we have revised our forecast higher on the back of robust fiscal support and buoyant commodity exports to China, reflecting the rebound there. However, we have revised most of the rest of Latin America lower. (9)

In other major EMs, a shallower decline in activity in Russia and a faster pace of the recovery in Turkey have led us to forecast a smaller 2020 GDP decline in both economies. In Turkey's case, this reflects a strong credit impulse though balance-of-payment pressures are rising, prompting the central bank to tighten monetary policy. (10) In Indonesia, we have shaved our 2020 forecast but, notwithstanding limited success in containing COVID, the economy is reopening swiftly (see "Emerging Markets: A Tenuous And Varied Recovery Path," Sept. 29, 2020).

The Focus Of Risks Moves To Enduring Until A Vaccine

As economies begin to recover from the depths of the COVID-19 crisis, the risks to our baseline remain on the downside. Many of these relate to the specific pre-vaccine period we are in, when trade-offs need to managed and social and economic protections need to be maintained.

Managing the interplay between the virus and economic activity is front and center. Everyone wants to reopen as quickly and as widely as possible to get back to normal--whatever that will mean in the post-COVID-19 world. The temptation of policymakers to reopen too soon is very real. The risk is the potential for second waves of infections and possible reversals in restrictions and their negative effects on activity as well as health outcomes. While the second waves so far are less lethal than the first waves (11), reflecting improvements in dealing with cases and managing the spread of the virus, reversals in openings are still a real threat. The consequence would be lost or deferred output, weaker employment, and higher fiscal deficits--both lower revenue and higher expenditures.

Maintaining the connectivity between firms, especially those under COVID-19-related stress, and their workers will be key in the coming quarters. Some countries are doing this more effectively than others. In general, Europe and Asia are doing better than the U.S. (12). As argued above, while direct fiscal transfers to firms and workers and various macro-prudential actions aren't without cost (including after the crisis has passed), allowing viable firms to close for largely non-economic reasons and workers to lose their links to the market will impede the recovery.

Another risk, one that we saw after the global financial crisis, is premature austerity--whether intentional or as an outcome of political dysfunction. With debt-to-GDP levels continuing to rise due to higher debt (the numerator) and lower GDP (the denominator), pressure to slow spending to put the public finances on a sustainable path will rise. Our view is that as long as the COVID-19 crisis is with us, and with the prospects of a vaccine improving, governments should resist these pressures for now. Indeed, several European countries, led by Germany, have extended their short-term work initiatives well into next year. Moreover, the relaxation of EU budget rules will not be reversed soon. As private demand recovers, public demand can be withdrawn and the fiscal sustainability plans should begin in earnest.

Finally, the virus timeline represents a modest upside risk to our forecasts. Our reading of expert medical opinion is that a vaccine could be available and distributed around mid-2021, which we currently incorporate into our baseline. Multiple clinical trials are underway, and the medical consensus is that we could have one or more vaccines approved by the end of 2020. Those vaccines would then need to be distributed and administered, both of which are potential complications. In terms of the economic impact, a vaccine would greatly diminish the restrictions on activity and eliminate a key source of uncertainty hanging over consumption and investment.

It's Not Over, And It's Mostly Fiscal

Global growth looks set to rebound sharply following the record contractions in the second quarter of 2020. Indeed, there will likely be record positive growth rates in many economies in the third quarter of the year. While the rebound is certainly welcome, we don't believe it's a reason to celebrate. Economic activity remains well below the levels recorded at the end of 2019. And it will take several more quarters (in some cases, years) before regaining pre-COVID levels of activity. Even then, the path of output is likely to be lower than before the crisis.

The current juncture of rebounding activity while waiting for a vaccine presents a host of challenges. Simple patience is not enough. Economic pain remains widespread as certain sectors continue to run well below capacity, putting strain on business survival and, by extension, employment and credit outcomes. Policy becomes important at such a juncture, with fiscal policy needing to be the big—but not the only—game in town. Targeted interventions to keep the affected firms afloat and their workers employed will pay dividends by ensuring a more rapid and equitable recovery. A failure or inability to do so will make the COVID-19 damage larger and the recovery less robust.

Notes

(1) Students of trade theory will recognize that this definition is close to the concept of revealed comparative advantage, although the idea here is obviously quite different.

(2) China's measure peaked in January at around five, reflecting that it had almost 100% of the global cases and a global share of GDP about 20% (on a PPP basis); this number fell quickly as China contained the virus, and it spread to Europe.

(3) For an excellent macro exposition of the COVID-19 crisis and the policy implications, see a recent post by Olivier Blanchard: https://t.co/oGRqW2cn7y?amp=1.

(4) The IMF has a comprehensive global fiscal COVID-19 monitor: https://www.imf.org/en/Topics/imf-and-covid19/Policy-Responses-to-COVID-19.

(5) This paragraph draws from my recent post featuring a "layer cake" model: https://www.linkedin.com/pulse/covid-19-macro-stress-fiscal-policy-firm-survival-layer-gruenwald.

(6) See this concise write up by Brookings: https://www.brookings.edu/blog/up-front/2020/04/06/what-macroprudential-policies-are-countries-using-to-

help-their-economies-through-the-covid-19-crisis/.

(7) This would correspond to a 10-sigma event on the right tail of the distribution, following the 17-sigma left-tail event in Q2. For more on this, see my recent blog: https://www.linkedin.com/pulse/us-eurozone-q2-gdp-data-were-black-swan-territory-paul-gruenwald.

(8) See https://www.federalreserve.gov/monetarypolicy/files/FOMC_LongerRunGoals.pdf.

(9) The contrast between fiscal support to households so far this year in Brazil and Mexico is enlightening. The former has spent 12% of GDP and the latter just 1% of GDP. Consumption fell 40% in Brazil and 60% in Mexico.

(10) The credit impulse is defined as the change in the credit-to-GDP ratio.

(11) For example, in Europe the fatality rate fell from 15% during the first wave to 0.2% in the more recent wave reflecting testing and quarantining.

(12) For a persuasive comparison on the U.S. versus French approach, see Blanchard (op cit).

Related Research

• Global Credit Conditions: A K-Shaped Recovery, Oct. 6, 2020