Real and financial lenses to assess the economic consequences of COVID-19

Catherine L. Mann

Citi

A dramatic pivot in prospects and markets marks the impact of the novel coronavirus on countries and the global economy, from January’s prospects for an upturn in global growth and record highs in US equity markets to February’s downgrades of global growth and market corrections.

• The appearance of the novel coronavirus (COVID-19) dashed prospects for an upturn in global growth.

Incoming data at the end of 2019 were favourable: Citi’s Economic Data Change indicators were rising toward outright expansion; leading indicators of sentiment were turning up; and Citi’s Financial Conditions Index was easing further, as central banks generally were taking advantage of the Federal Reserve’s policy rate cuts in 2019 to ease as well. In emerging markets, fiscal policy was also generally supportive. Even though hard data were somewhat mixed, it did look like the downgrades of 2018/2019 were over and that the global economy was poised for an upturn. Concerns in the data included trade prospects, which were continuing to weaken as measured by the container throughput index and export orders. There were also concerns that the accommodative financial conditions were showing up in market valuations but were not being passed through to faster GDP growth.

Then the virus hit. The human toll is already dramatic, with disruption to personal and business routines via quarantine, work closures, and mobility limitations - first in China, and then spreading worldwide.

• The real economic impact of the virus requires evaluation through multiple data lenses: (1) manufacturing supply chains; (2) tourism, transportation, and services relationships; and (3) energy and commodity demand and prices.

These linkages and factors have different weights for different countries, so the evolution of growth during 2020 and 2021 will be affected by the intensity of an economy’s production, consumption, and trade across these three data lenses, because each will have a different ‘shape’ to its shock and recovery.

Manufacturing will show a ‘V’ or ‘U’ shape. Manufacturing spillovers from factory closures loom large in the near term, but production will rebound to restock inventories once quarantines end and factories reopen. However, the duration of closures, as well as spillovers through supply chains and through virus cases and closures worldwide, will generate a set of Vs that should take on a U-shape in the global data. Importantly, the loss to global growth momentum will drag on both in individual country data and global rebound economic data, particularly trade and industrial production.

Services, on the other hand, will experience an ‘L’ shape. The shock to tourism, transportation services, and domestic activities generally will not be recovered, and the projected slowing of global growth will further weigh on the L-shape evolution of demand for these non-storable tradeable services. Domestic services also will bear the brunt of the outbreak, depending in part on the responses of authorities, business, and consumers.

Energy and commodity prices are showing the pivot already, and there will be winners and losers. The third real-side data lens is the evolution of energy prices and commodity prices, which can either exacerbate or offset the other shocks, depending on an economy’s structure of production, consumption, and trade. As an example of the change in expectations elicited by the coronavirus shock, Citi’s energy price base case changed from a near-term 10% increase in energy prices in the January projection to a 15% decline in the February exercise. Falling energy and commodity prices undermine investment and GDP growth in exporting countries, but are potentially positive for importers, business users, and consumers.

• Financial markets initially ‘looked through’ the corona virus shock.

After an initial selloff at the end of January, markets - even in China - rebounded, with US markets reaching a new high. There could be several reasons for this. First, there was limited data to evaluate the impact of the various shocks and little evidence of virus transmission to other economies. Relatedly, the market may have believed that a quick rebound in China would lift other economies and that, on balance, the near-term lower energy prices would be positive for the global economy. The third reason is that markets apparently assumed that monetary policy will react to cushion the global economy, as has been the case in recent years.

But then the markets sold off dramatically. An apparent reassessment of the data spillovers, the transmission of the virus, the shock to uncertainty and the hit to sentiment precipitated a generalised market sell-off. Various research, including Citi’s own Financial Conditions Index and the financial conditions indexes created for the US Monetary Policy Forum 2020 research paper (Cecchetti et al. 2020), shows that the most important factors underpinning changes in financial conditions are equity valuations and volatility. An important question is how long the level of financial conditions will remain as accommodative as it is now.

• The rise in uncertainty and its effect on sentiment and financial conditions are key.

The COVID-19 outbreak has increased uncertainty and negatively affected sentiment through (1) how authorities are responding (via mandate or recommendation); (2) how consumers are responding to the fear of infection (and the authorities’ suasion) by staying home, telecommuting, and so on; (3) how business sentiment is responding to the virus, as well as to both weaker trade and domestic data. Historically, a rise in uncertainty and a hit to sentiment have been associated with weaker real activity data with a lag of two to four months. The financial markets have taken note.

For both uncertainty and financial conditions, the current levels matter for how changes affect the global economy. Investigation using threshold VARs shows that a rise in uncertainty (due in this case to the outbreak and transmission of the virus) has a greater impact on economic activity in a environment of high uncertainty than when uncertainty is low; the current environment was one of high uncertainty even before the coronavirus hit, because of trade policy uncertainty. A tightening of financial conditions has much less of an effect on economic activity so long as the level of financial conditions is in accommodative territory.

The financial conditions threshold VAR has implications for monetary policy. If financial conditions remain accommodative through the market turbulence, in part because conditions were quite accommodative before the virus hit, then monetary policy easing has relatively little traction to support economic performance through the standard channels of consumer wealth or business cost of capital, because these are not the constraints on consumer or business behaviour. Rather, uncertainty and sentiment are the constraints. But if the hit to confidence is large enough and markets correct sufficiently, financial conditions could enter into tight territory, which opens the door for central bank policy.

• The interlinkage between economic conditions, financial conditions and uncertainty/sentiment increases the challenges facing policy authorities.

For central banks, so long as the level of financial conditions remains accommodative, central bank easing will not be an effective response to support the real economy. If the rise in uncertainty, the hit to sentiment, as well as the data are sufficiently great so as to yield an overall tight level of financial conditions, a monetary policy response would be warranted to avoid a market overshoot beyond that consistent with the expected path of the real economy. But, this is a challenging confidence game. Fiscal authorities also face challenges. Although many do have room to manoeuvre, particularly those that have enjoyed very low sovereign rates for the last decade, the types of fiscal response to the outbreak (crisis healthcare, crisis support for business and consumers) are not structural supply-side choices, which heretofore had been our recommended use of fiscal space.

References

Cecchetti, S G, M Feroli, A K Kashyap, C L Mann and K L Schoenholtz (2020), “Monetary Policy in the Next Recession?”, US Monetary Policy Forum 2020.

About the author

Catherine L. Mann is the Global Chief Economist at Citibank, where she is responsible for thought leadership, research guidance of a global team of economists, and cross­fertilization of research across macroeconomics, fixed- income, and equities. Prior to this position, she was Chief Economist at the OECD, where she also was Director of the Economics Department and was Finance Deputy to the G20 (2014-2017). Prior to the OECD, she held the Barbara ‘54 and Richard M. Rosenberg Professor of Global Finance at the International Business School, Brandeis University, where she also directed the Rosenberg Institute of Global Finance (2006-2014). She spent 20-plus years in Washington, DC (1984-2006) where her positions included Senior Fellow at the Peter G. Peterson Institute for International Economics; Economist, Senior Economist, and Assistant Director in the International Finance Division at the Federal Reserve Board of Governors; Senior International Economist on the President’s Council of Economic Advisers; and Adviser to the Chief Economist at the World Bank.

Dr. Mann received her PhD in Economics from the Massachusetts Institute of Technology and her undergraduate degree is from Harvard University. Her written work includes more than 85 scholarly articles and seven books primarily on the topics of US external imbalances, trade, international capital flows and the dollar; and information technology and services trade in global markets.

9