Gauging post-lockdown economic outcomes as the US economy contracts 4.8%

The model

I have a bit of a problem. I am not sure how to put today’s post together. What I plan to dissect is the economic outlook as we escape coronavirus lockdowns. But, economies are so complex and the outlook is so uncertain that it’s hard to represent what’s likely to happen on a macro level. So let me do this; I’m going to highlight several data sources I am looking at to construct a mental model of how to think about this. And then I am going to give you ranges of outcomes using those inputs.

• For and against: Can we avoid a second Great Depression? – Jeremy Warner, Ambrose Evans-Pritchard

• Fitch cuts Italy’s credit rating to one notch above junk – FT

• Coronavirus crisis lays bare the risks of financial leverage, again – Martin Wolf

• The Seven Countries Most Vulnerable To A Debt Crisis – Steve Keen

• What Kind of Restart Will We Have? – Jim Bianco
• Belgische economie krimpt 3,9 procent in eerste kwartaal – De Tijd
• Trotz rascher Lockerung bleibt der Ansturm auf die Geschäfte in Österreich aus – NZZ
• Commerces : ceux qui seront ouverts, ceux qui resteront fermés après le 11 mai – Le Figaro

• Starbucks shares fall after coffee chain warns US cafe closures to deal hefty blow to earnings – CNBC

• Coronavirus: Germany’s rate of COVID-19 infections grows after lockdown eased – Sky News
• Coronavirus: US COVID-19 cases exceed one million after doubling in 18 days – Sky News

These aren’t the only data sources I am using, of course. But, they each represent a different thread in my thinking about outcomes. Because of the data sources, this post is going to focus mostly on the eurozone and the US.

Macro debate on a depression

At the macro level, the Warner-AEP debate in the first source frames the issue well. Here’s the reasonable best case that Jeremy Warner frames:

A 25pc slump would be catastrophic if it were persistent; but the fall over one or two years is likely to be much less. That’s what investors are banking on. As a rule of thumb, companies are expected to repay their capital every 20 to 30 years. If a couple of those years are lost, it extends the payback and justifies some sort of correction in the share price, but assuming firms survive, logically the adjustment to valuations should be little more than 10pc.

On the other side is the downside risk, framed by Ambrose Evans-Pritchard. The logic is as much about the economics as the policy response within the eurozone:

Morgan Stanley’s Jacob Nell and Joao Almeida estimate that eurozone GDP will contract by 11pc this year even under its central base case, rising to 12-13pc for Greece, Spain, and Portugal, and a 15pc for Italy. That is three times the shock from the global financial crisis. Not even the awful year of 1931 in the Great Depression matched this.

Their ‘bear case’ is a contraction of 20pc with no recovery worth the name in 2021. They suggest that this could happen if Europe leaves the most vulnerable Club Med states to fend for themselves – as it is doing by proffering loans instead of authentic fiscal stimulus. But it could equally happen because politicians declare victory too soon and allow Covid-19 to outwit them.

Under this bear scenario, Italy contracts by 22.7pc this year, Spain by 22.6pc, Portugal by 21pc, and even Belgium by 18.2p. Furthermore, the South would face steep deflation as you can see from the chart. The effect of this would be to raise real interest rates violently and render the exploding debt burden yet more explosive. It would be a massacre.

Such an outcome would reorder the strategic structure of Europe in ways that are impossible to foresee. It would probably cause a global financial ‘event’ of some kind and the biggest sovereign debt restructuring ever seen.

I do not think these risks can be dismissed out of hand. Clearly Mr Market disagrees.

Given that Fitch has just cut Italy to the lowest investment grade credit rating, one notch above high yield, we can start thinking of Italy in this crisis as similar to Greece in the European sovereign debt crisis. And so Ambrose’s run-through of policy outcomes makes sense. We should be very worried about the sovereign debt issues in the eurozone given the lack of a corresponding fiscal authority to the European Central Bank and given the German-bloc’s resistance to coronabonds or any debt mutualisation scenarios.

Financial fragility and credit growth

In terms of outlining potential outcomes, financial sector structure and fragilities have to be addressed. The way I am looking at this is similar to the framing Steve Keen made in 2016 about the seven economies must vulnerable to a debt crisis. Public sector spending can fill part of the hole in private expenditures, but it can’t replace the private debt growth upon which our economic growth relies. As Steve put it:

…private sector expenditure in an economy can be measured as the sum of GDP plus the change in credit, and crises occur when (a) the ratio of private debt to GDP is large; (b) growing quickly compared to GDP. When the growth of credit falls—as it eventually must, as growing debt servicing exhausts the funds available to finance it, new borrowers baulk at entry costs to house purchases, and numerous euphoric and Ponzi-based debt-financed schemes fail—then the change in credit falls, and can go negative, thus reducing demand rather than adding to it.

So, if you think about the Warner vs AEP debate in this context, you have to ask how fragile is the financial sector. After a big downturn, we should expect households and businesses to hunker down to build liquidity buffers after the initial demand shock. And that will cause the effects of the downturn to linger. But when they are ready to take on debt will the credit be available? That depends on the fragility of the financial sector.

The American banks have been recapitalized relatively well. At this point, I am not concerned about their ability to weather the storm and provide fresh lending once this depression ends.

European banks are another story. Beleaguered Deutsche Bank was forced to issue a special statement just before midnight on Sunday to halt worries about its capital structure. They released earnings today that were poor. And the outlook for 2020 was equally bleak. We have to be concerned about the ability of European banks to withstand the credit writedowns coming due as companies hit the wall and declare bankruptcy. And I write that fully cognizant of the fact that this site is called Credit Writedowns. And it’s named Credit Writedowns for exactly these reasons; the financial sector’s ability to withstand a recession’s writedowns are what make the difference between recession and depression. That was the takeaway from the Great Financial Crisis.

In the US, because of the reliance on capital markets to facilitate credit growth, it’s not just the banks that matter, increasingly it’s asset managers too. That’s why I included the Martin Wolf piece in my sources. Highly levered investors were the source of  volatility that forced the Federal Reserve to provide blanket liquidity in March.

As levered investors tried to remain solvent as markets tumbled, liquidity in credit markets dried up, precipitating a financial crisis and risking large business’ access to capital markets. Initially, we also saw a transfer of credit risk from markets to the banks as companies drew on their bank lines of credit once capital market liquidity dried up. But, once the Fed stepped in, the crisis subsided and capital market access was mostly restored except for the most rickety companies in the high yield and leveraged loan markets.

That’s where we are now. But, if the fall in output and incomes continues longer and we get a spate of defaults, we will see financial fragility increase and a depression with a small d turn into a Great Depression.

What do the data look like?

So, where do we go from here? That’s the big question. And it’s the question Jim Bianco is asking in the source post linked above. He actually told me he was inspired by my April 27 Real Vision Daily Briefing, where I took an optimistic view of Europe’s near-term outlook.

Jim’s analysis pertains only to the US. As I was writing this, figures came out showing the U.S. economy shrank 4.8% q-o-q in Q1. That’s an annualized number. And it only pertains to a partial lockdown in half of March.

But I am also thinking about Europe. And so, it was interesting to see numbers from Belgium for Q1 come out showing a drop of 3.9% of GDP in Q1 2020. These aren’t the q-o-q annualized numbers the US releases. This is an actual drop of 3.9% in Q1, where only a brief portion included the lockdown. The figures were better than expected, as Belgian daily De Morgen says Belgian bank economists were expecting a drop in the 5% region.

Q2 will be a lot worse though. Belgium’s lockdown is slated to ease in phases starting 4 May for many companies and 11 May for stores. But, we know that even in this initial phase GDP will be well below pre-lockdown levels.  ING economist Philippe Ledent said:

“In the second quarter, there will be a lockdown throughout April and part of May. We expect the economy to shrink by about 6 percent in the second quarter. “

According to my source article from Belgian daily De Tijd, a few weeks ago, the National Bank of Belgium and the Federal Planning Bureau predicted economic activity would fall by as much as 15 percent in the second quarter. By comparison, Q4 2008 when Lehman’s collapse was the worst quarter for Belgium in the GFC and the contraction was only 2.2%.

What kind of restart will we have?

Austria is one of the economies that has come out of lockdown earliest. Since the Tuesday a week earlier, stores under 400 square meters in size are open.  The key takeaway from Austria’s experience is this section from Swiss daily NZZ which I have translated:

Anyone who thought that business life would start up again at the push of a button will be disappointed. This has also been confirmed by the managing director of the Austrian trade association, Rainer Will. “We expect retailers’ sales to be 50% lower than before Corona,” said Will.

50% lower. That’s after the lockdown.

And what’s more, Sky News is reporting that, in Germany, where they are also trying to make a comeback, the R0 has been ticking up, putting the return to normalcy at risk. They say:

Hailed as among Europe’s most successful in tackling the pandemic, the country began relaxing restrictions on 20 April to allow small businesses to open as the reproduction rate of the virus fell.

Based on the average number of people each infected person transmits coronavirus to, the rate – known as ‘R’ – had fallen to 0.7.

It has since increased to 0.96, only just below the figure of one officials say it must not exceed in order to keep the pandemic manageable.

And while officials believe it is too early to say whether the lifting of restrictions caused the increase, the country’s overall number of COVID-19 cases grew by 1,018 on Monday and 1,144 on Tuesday.

These two data points speak to the risks of relaxing lockdowns and to thoughts about an economic rebirth.

Like Belgium, France, another laggard in re-opening in Europe, is looking at 11 May as the date to relax its lockdown. And anything that involves strangers in close proximity to one another will still be banned. That means no restaurants, cafes or bars, no cinemas, theaters or museums, and certainly no spectator sports.

In the US, Starbucks expects to have 90% of its US locations re-opened by early June.

So that gives you a timeline and a baseline.

• 6-15% contraction in GDP in Q2 for Belgium
• Re-opening in stages, depending on the country and the type of business between mid-April and early June
• As much as a 50% drop in sales relative to pre-Pandemic levels during the initial period of re-opening
• A risk of R0 rising, causing more restrictions or consumer fears

My view

The best case scenario is that R0s do not rise above 1 and that re-opening can proceed in a step-wise manner. In the most prepared economies like New Zealand or Denmark, maybe we get to 70-80% levels by the end of the quarter with deficit spending bringing us up to the 80-90% level.

Harder hit economies like Belgium and France won’t see any meaningful uptick in demand until late in the Q2. Hence the thinking that GDP contracts 15% in Belgium in Q2. For the US, the Starbucks account tells you re-opening will be even later. And to the degree it is earlier, the risk is for R0s to rise, creating a large second wave of infections.

My base case here for the likes of Denmark is 65-75% levels by June, with deficit spending getting you to maybe the 75-80% level. For Belgium, France, Spain or Italy, those numbers would be much lower. For the US, they would also be lower.

Worst case scenarios are mostly about Q3 and beyond in terms of the ability to ramp up spending and output, in terms of individuals and companies avoiding bankruptcy, and in terms of the balance sheets of the financial sector withstanding credit writedowns.

I think that Jeremy Warner and Ambrose Evans-Pritchard have done a good job framing the range of those longer-term outcomes. For now, we are just in a wait and see mode. Let’s see how much consumers in well-placed countries like Germany are willing to spend and how well controlled the viral contagion remains as their economy opens up.