Coronavirus: Short-term pain but strong rebound likely

• ▪ Attention has understandably focused on limiting the damage from the short-term effects of the coronavirus outbreak. But it's likely that, once disruption and uncertainty fade, the rebound in activity will be strong. It's important for firms to position themselves for such a recovery.
• ▪ Historical evidence supports this view. In the past 200 years, short recessions have typically been followed by robust recovery. Long-term impacts from natural disasters have generally only been evident for specific hazards. Except for AIDS, longer-term pandemic effects also appear to have been contained.
• ▪ Surveys during the 2003 SARS and 2009 influenza outbreaks highlight one explanation for time-limited impacts. Public fears increased alongside rising infection rates, but they dissipated promptly as outbreaks came under control.
• ▪ Our modelling is consistent with these stylised facts. In our coronavirus pandemic scenario, global growth grinds to a halt in Q2 2020 but then rebounds to a rapid pace within a year. With much of the initial output loss recovered in a relatively short period of time, long-term impacts are limited.
• ▪ But there are risks to this view. The period of disruption could be longer than anticipated, depending on the potential spread and seasonality of COVID-19 and policy actions to mitigate the fallout. Opinion polls also highlight the potential risk of larger, more persistent effects for some countries.
• ▪ Moreover, coronavirus-related weakness and associated financial distress could expose other key vulnerabilities - for example related to deteriorating corporate sector balance sheets and fragile trade relations. These would be expected to have persistent effects on global activity over the coming years

     

Coronavirus fallout threatens financial stability

• ▪ The coronavirus is set to sharply cut global growth and also risks sparking substantial levels of financial distress among both businesses and households, potentially cascading into the banking sector. The challenges this poses for policymakers is formidable.
• ▪ Financial vulnerabilities were evident in the corporate sector in many economies even before the virus struck, with rising debt, declining credit quality and worsening liquidity positions. Consumer-facing sectors especially at risk from the impact of the virus tend to have weaker financial positions.
• ▪ There are also household fragilities. A large fraction of households - often 40%–50% - have limited liquid assets to tide them over if they cannot work. Access to sickness and unemployment benefits varies widely across economies.
• ▪ High levels of bad loans in some banking systems, most notably in Italy, could be exacerbated by the virus impact, threatening financial stability. High dollar debts in many economies outside the US are another risk factor.
• ▪ As well as containing the virus, policymakers need to consider imaginative approaches to prevent financial distress worsening the economic downturn, potentially including a need to rapidly backstop banks, firms, and households.

     

Brexit — velvet divorce or messy breakup?

• We use a ‘scenario tree’ approach to look at the possible outcomes of the negotiations around the UK's exit from the EU. Given how little common ground there is between the two sides, we find that a relatively loose relationship is the most likely outcome, with the UK set to leave the EU in early‐ 2019.
• The negotiating positions of the UK and EU are diametrically opposed. The UK wants to end the free movement of labour, cease making contributions to the EU budget and regain ‘sovereignty’ from Brussels, while retaining as much access to the single market as possible. But the EU's starting position is that single market access is dependent upon agreeing to the four freedoms and that this is non‐negotiable.
• So far all signs are that the UK will prioritise the ability to control immigration over single market access. Thus remaining a member of the EEA is very unlikely to be viable over the longer‐term – our scenario tree analysis gives it a probability of just 6% – although it may be adopted as an interim step. Remaining part of the customs union is also unlikely (18%) as it will preclude the UK from making FTA with third countries.
• If the EU takes a mercantilist approach, it will have little incentive to come to an agreement with the UK over single market access for services, given the UK's large trade surplus with the EU for these activities, implying that UK firms may face growing non‐tariff barriers after the UK has left the EU. The UK's large deficit on goods trade with the EU gives a better chance of agreeing a FTA for goods, though with any FTA requiring agreement from all 27 EU members, the UK would have to be prepared for lengthy negotiations and make extensive concessions. Therefore, we think that a reversion to WTO rules (37%) is slightly more likely than agreeing a FTA (36%).

     

Brexit and FDI

• The potential for a departure from the EU to undermine the UK's attractiveness as a location for Foreign Direct Investment (FDI) is often cited as one of the key risks were the UK to leave the EU. In weighing up the threat to FDI posed by ‘Brexit’ we assess the net gain from inward investment and the role played by EU membership in attracting FDI.
• In theory, FDI benefits the economy via lower interest rates, higher wages for workers and ‘spillover’ benefits boosting economy‐wide productivity. But the evidence for these benefits is ambiguous. And FDI has potential drawbacks. These include an adverse effect on the tradeable sector, reflected in a wider current account deficit, the potential to ‘crowd out’ investment by domestic firms and the fiscal cost of subsidies paid to inward investors.
• That almost half of FDI in the UK comes from other EU countries suggests that EU membership is not the only driver of foreign investment in the UK. Other factors include the UK's business friendly environment, as reflected in global competitiveness surveys, and a relatively deregulated labour market. Of perhaps most importance is the lure provided by the UK's large domestic economy. 80% of FDI in the UK is in sectors where sales to the EU account for less than 10% of total demand.
• However, FDI in manufacturing does look vulnerable to Brexit, given the importance of the EU market. Granted, manufacturing accounts for a modest share of UK FDI. But to the extent that FDI boosts productivity, a loss of inward investment in this sector is likely to come at a disproportionate cost.
• Our modelling suggests that in a worst case Brexit scenario, the stock of FDI could ultimately be 7% lower relative to the UK remaining in the EU, potentially knocking around ½% off the level of GDP.

     

The economic cost of coronavirus lockdowns

• ▪ Widespread lockdowns and social distancing in economies affected by the coronavirus outbreak are set to cause a massive negative short-term impact on consumer spending and GDP.
• ▪ A large chunk of consumer spending is discretionary and so is very sensitive to being postponed or lost completely due to quarantines and social distancing.
• ▪ The early evidence from China supports the idea that up-front effects will be large, with retail sales down 20% y/y in January–February and industrial output over 13% lower, thanks to widespread factory closures.
• ▪ We estimate that a three-week lockdown affecting 50%–90% of a population would cut consumption in the three–month period featuring such a lockdown by 5%–8%, a six-week lockdown by 9%–16%, and a 12-week lockdown would slash it by 18%–32%.
• ▪ Full-year effects depend on how quickly postponed consumption revives as outbreaks come under control. But even quick recoveries imply big full-year losses: An initial 18% slump in consumption would still imply a full-year loss of 9%, even if spending recovered to pre-pandemic levels in four quarters. If recovery took eight quarters, the full-year loss would be an enormous 14%.

     

After the pandemic: Medium-term growth uncertainties

• ▪ The coronavirus is having a very large short-term negative impact on world growth. But the medium-term growth outlook is more uncertain. Much depends on the policy response - a strong and well-designed response could contain the medium-term output losses, but large and enduring damage is a risk.
• ▪ Growth patterns after significant GDP declines vary. Historical evidence points to large upfront effects from pandemics and natural disasters, but the medium-term outcomes are mixed, with policy responses a crucial determinant. Longer recessions and financial crises tend to lead to weaker medium-term growth.
• ▪ The coronavirus may trigger annual GDP declines among the worst seen in the last 100 years. Economies can bounce back sharply after such declines, but our analysis suggests output losses also endure in a significant number of cases.
• ▪ The US interwar experience shows the danger of allowing financial distress to snowball and exacerbate GDP declines. The weakness of medium-term growth after the global financial crisis confirms the long-term impact of such distress.
• ▪ A key risk for the medium term is that firms and/or households react to the coronavirus recession and disruption by raising savings, accelerating a shift toward ‘Japanification’ of major economies.
• ▪ Our baseline forecasts envisage moderate medium-term output losses due to coronavirus, in part reflecting rapid and large-scale policy interventions. But uncertainty around this forecast is significant and considerable variation is possible across economies.

     

Will Brexit speed a seismic shift in UK trade patterns?

• The UK's trade pattern has shifted significantly away from the EU since the 1990s. Our analysis suggests that this shift will continue in the decades to come, with the EU share in UK goods exports potentially slipping to around 35% by 2035. Shifts in relative prices from moves in tariff and especially non‐tariff barriers could lower the share further.
• Over 60% of UK goods exports went to the EU in the late 1990s but this has fallen to around 45%. Slow EU growth is partly to blame, with UK exports to the EU barely expanding since 2007. But our analysis also shows that a 1% rise in EU GDP leads to only around half the rise in UK exports to the EU that a 1% rise in GDP in the rest of the world induces in UK exports to non‐EU countries.
• Based on our findings and OE forecasts of long‐term growth in the EU and the world, the EU share of UK goods exports could fall to 37% by 2035 and around 30% by 2050 – back to its 1960 level. The share of services exports to the EU has held up better but is lower than for goods, at around 40%.
• Weakening growth of UK exports to the EU has taken place despite the development of the EU single market since the early 1990s. Indeed, based on our projections UK goods exports to the single market could drop below 5% of UK GDP by 2050. These projections make no allowance for Brexit effects, but the declining importance of exports to the EU single market could colour prospective Brexit negotiations.
• Simple income‐based projections of potential country shares in future UK exports suggest a further swing towards emerging countries (EM) in the decades ahead, especially China and India. Exports to EM could approach 40% of the total by 2035. A shift in the pattern of trade preferences and restrictions faced by the UK post‐Brexit could spark even larger shifts in the structure of UK exports.

     

The global monetary boom - no cause for panic

• ▀ Global monetary growth has been its fastest for decades over recent months, but we continue to believe inflation risks are lower than many think. A modest inflation overshoot in the coming years is possible but would not be very damaging.
• ▀ While headline money growth figures still look strong, heavy precautionary borrowing by firms in March-April is already starting to unwind in the US and UK. About 80% of the rise in borrowing by large UK firms has been repaid.
• ▀ In addition, tightened lending standards at banks are likely to weigh on future corporate borrowing and money growth. A net 70% of US banks tightened corporate credit standards in the latest Fed survey. Rising loan defaults risk exacerbating this.
• ▀ Heavy government borrowing and accompanying central bank QE have been key drivers of monetary growth and are likely to remain so, notwithstanding a slowdown in the pace of central bank bond purchases. This is the main risk factor those who fear inflation cite.
• ▀ But if credit to the private sector starts to shrink, deficit financing of this sort may be essential to prevent long-term weakness in money, credit, and economic growth. Japan's experience in the 1990s and 2000s is relevant here.
• ▀ Inflation also has room to overshoot current targets, if necessary, given the substantial undershoots of the last decade. This consideration in part explains the recent shift in Federal Reserve thinking towards targeting an average inflation rate over time

     

Brexit – Customs borders will impose costs and delays

• ? The UK's decision to leave the EU customs union is likely to see physical customs borders being introduced, including in Ireland. This will impose administrative costs and delays, with our modelling suggesting that introducing customs checks would reduce the level of UK GDP in 2030 by between 0.7–1.3%. But there are opportunities for the two sides to limit the damage through cooperation and the UK could also mitigate the costs by agreeing free‐trade agreements (FTA) with third countries.
• ? The UK can take as ‘light‐touch’ an approach to customs checks on imports from the EU as it desires. But it is likely that the EU will introduce customs checks on goods imported from the UK, even if the two sides agree an FTA, to ensure regulatory compliance and that ‘rules of origin’ have been satisfied – this will be particularly important if the UK agrees FTA with countries the EU does not have deals with.
• ? Introducing customs borders would pose some logistical problems, particularly in the Dover Strait where existing infrastructure is limited and there are space constraints. A potential fivefold increase in customs declarations will also pose challenges on the IT front. If the UK and EU are unable to agree transitional arrangements, then the additional infrastructure would need to be up and running in a very short period of time. This risks a period of substantial disruption.
• ? Traders will have to complete additional paperwork – such as export licences and import declarations – but much of this can be dealt with electronically, which should help to limit costs and delays. In addition, if the two sides were to share information then this could help to limit the extent to which risk‐based inspections caused delays.
• ? The Government is effectively calculating that the benefits from agreeing FTA with other countries will outweigh the costs of customs controls on the UK‐EU border. This judgement looks doubtful and, at best, would take many years to bear fruit.

     

Will the Bank of England turn dovish?

• ? Short of a sharp slowdown in the economy and/or inflation expectations, or a no‐deal Brexit, we think that the Bank of England is unlikely to follow recent moves by the Fed and ECB in signalling cuts to interest rates.
• ? Admittedly, the BoE's guidance on rate rises has gone awry before. And the UK has some commonalities with the US and eurozone, including declining core inflation and continued job creation without inflationary consequences.
• ? But growth projections paint the UK in a relatively favourable light, while stable inflation expectations and a relaxation of fiscal austerity offer two more reasons for the BoE to plough its own, more hawkish, furrow.

     

An investment‐led expansion is no pipe dream

• Contrary to some perceptions, the UK's economic recovery has not been a disproportionately consumer‐led one. In fact, business investment has punched well above its weight in supporting growth. And the conditions look good for this outsized contribution to continue.
• Consequently, we think that the threat of ‘secular stagnation’, reflecting a lack of appetite to spend on the part of firms, is one that the UK should avoid. Moreover, strong investment growth should have desirable by‐products in the form of more accommodative monetary and fiscal policy.

     

Deciphering the UK's business investment performance

• ? Absent June 2016's Brexit vote, growth in business investment would have been much faster and the UK would be sharing in a global “investment boom”. Or so the Bank of England claims. But the reality is more complicated. What is striking is just how subdued investment growth has been across countries.
• ? Survey evidence presented by the Bank suggests that recent business investment growth has been less than a third of what might have been achieved absent Brexit. The UK has also been highlighted as an investment laggard among major economies.
• ? Headline investment growth has certainly been relatively weak since 2016. Uncertainty around future UK‐EU trading arrangements may have resulted in some investment being deferred or cancelled. And the Brexit‐related fall in sterling will have pushed up the cost of imported capital equipment, cutting demand.
• ? But a collapse in investment in the North Sea sector has had a significant effect on headline investment growth. On an excluding‐extraction basis, UK business investment rose at the same pace as the US (ex‐extraction) and faster than Japan in 2016 and 2017, while average annual growth rises from 1.0% to 2.4%.
• ? What is striking about the recent performance of business investment in the UK and other G7 members is how subdued growth has been across economies. Despite a favourable environment, no major advanced economy has seen investment rise at the type of rates that the Bank predicts the UK, but for Brexit, should be now enjoying.
• ? Sectoral shifts, the rise of intangible investment and the consequences of technooptimism offer some reasons as to why measured investment may have become less sensitive to economic upswings. These same factors suggest that 1990s‐style growth in private investment is unlikely in the UK (or elsewhere) even once Brexit uncertainty has cleared. Indeed, our own medium‐term forecasts see business investment growth across major economies continuing to run at a relatively subdued pace.

     

Secular stagnation – are we stuck in Summers' long winter?

• We estimate that the UK has a relatively large output gap of around 2¾% of potential output. With the legacy of the financial crisis fading, the UK should see healthy growth in potential output of around 2.1% a year from 2015–24. Usually this would drive a period of strong economic growth, but we expect GDP growth to average a relatively underwhelming 2.4% a year over this period, largely due to the drag from aggressive fiscal consolidation.
• There is significant disagreement amongst economists about the size of the output gap. Estimation of the output gap has been problematic since the financial crisis because of the depth of the recession and relatively slow pace of the subsequent recovery, while sizeable revisions to the national accounts data have been an added complication. Our estimate of the output gap is towards the top of the range of independent forecasters surveyed by HM Treasury, but it is consistent with the literature on the impact of financial crises on potential output.
• We expect potential output growth of 2.1% a year from 2015–24, a faster pace than that seen since the financial crisis, but some way short of the experience of the pre‐crisis decade. The shortfall relative to the pre‐crisis period is largely due to a smaller contribution from growth in labour supply, which reflects the impact of an ageing population. However, labour is set to make a much stronger contribution to potential output growth in the UK than in most other major European countries over the next decade.
• The combination of a large output gap and healthy growth in potential output will provide the conditions for firm growth and low inflation over the medium term, with GDP growth expected to average 2.4% a year from 2015 to 2024. Growth could be stronger were it not for the sizeable drag from fiscal consolidation over the next four years and the dampening effect that this will have on activity. This will ensure that the output gap closes very slowly. The government's fiscal plans are heavily influenced by the OBR's view that there is limited scope for stronger growth to drive an improvement in the public finances. But if our view turns out to be correct, it will become apparent that the government has pursued a more austere path than is strictly necessary in order to comply with its fiscal rules.

     

Canada‐style trade deal most likely Brexit scenario

• ? All options for the Brexit endgame remain on the table. A free‐trade agreement (FTA) along the lines of the EU's deal with Canada looks like the most likely outcome. The two sides will also need to reach agreements on customs and regulations, with the latter involving the UK compromising on maintaining a high degree of regulatory alignment, to provide a permanent fudge on the Irish border issue. But there is still a sizeable risk of a “no deal” outcome .
• ? We expect a transitional deal to be agreed relatively quickly. The UK has suggested it would prefer a bespoke arrangement, but the EU is unlikely to offer such an option. We expect the UK to remain bound by EU rules during the transition, with the transitional period ending on 31 December 2020.
• ? If the two sides continue to pursue the preferred option of a FTA, it is unlikely to be completed by the end of the transition period. We expect the EU to reject the UK's request for a comprehensive agreement including services and insist on a Canada‐style deal. The Irish border issue means that customs and regulatory agreements would need to accompany such a deal. We place a 40% chance on this outcome.
• ? The question of regulatory alignment and the time required to negotiate a detailed FTA could spin the talks off in one of two opposing directions. If the prime minister is unable to get her party to agree to maintain a high degree of regulatory alignment, the talks could break down. If this occurs, we think it's very unlikely that the UK would honour the phase‐one agreement to maintain regulatory alignment, and we see a 30% chance that the UK walks away from the talks, resulting in a “cliff‐edge” Brexit in 2019.
• ? If the UK accepts the need to maintain regulatory alignment with the EU, it could conclude that joining the EEA and participating in the single market are better than lengthy FTA negotiations, resulting in an inferior deal. But the need to respect the four freedoms means this remains a relatively low probability outcome (20%). Wth Parliament seemingly committed to Brexit, remaining in the EU looks unlikely (10%).

     

How likely is a UK recession after Brexit?

• In the wake of the UK Brexit vote, forecasters have rushed to downgrade their growth forecasts for the UK, with some now expecting a recession. Using the Oxford Economics' Global Economic Model, we examine how likely a recession is by looking at the shocks the UK economy faces and the policy responses. We conclude that while a sharp slowdown is likely – in line with our own new forecasts – a recession is unlikely.
• Many UK forecasters are now predicting a recession in 2017, even though ‘stand‐alone’ recessions in industrial countries are rare. Our forecast is less downbeat. The UK faces a series of negative shocks including to consumers and business confidence, but growth will be supported by the weaker sterling and likely policy responses.
• Using the Oxford Economics' Global Economic Model, we show that to shift our baseline forecast of growth of 1.1% next year to zero would require a very severe negative confidence shock. Our new baseline already assumes a shock equivalent to one‐third of that seen in the global financial crisis (GFC). All else being equal, the shock would have to be around two‐thirds of that in the GFC to cut GDP growth to zero in 2017.
• Our new baseline also does not incorporate all the possible policy levers the UK can employ. We currently assume the Bank Rate drops to zero, but if a ‘rescue package’ of £75 billion of QE and a fiscal stimulus equal to 1% of GDP was also added, then the shock to confidence needed to get zero GDP growth would have to be similar to that seen in the GFC. We do not consider this likely given the scale of financial stress and credit restriction that occurred globally at the time of the GFC.

     

BoE financing of the government deficit is no longer taboo

• ▪ The BoE has hinted that it could directly finance the government's soaring deficit. While there is no urgency to do so at present, BoE purchases could calm potential disruption in the gilt market and be a strong economic support.
• ▪ Direct money financing by the UK central bank would be a radical approach, but not unprecedented. However, it's necessary to go back to 1914 to find the last episode when the BoE took on the role of funding public borrowing.
• ▪ Once normality returns, money financing could result in a rise in prices. But a time-limited expedient shouldn't result in persistent inflation. And policymakers could seek to unwind the BoE's money creation.

     

Are central banks really breaking the (policy) rules?

• ? Looking at the strength of the global economy, it's no surprise that simple policy rules suggest that interest rates in some advanced economies are much too low and/or that several rate hikes would be needed in 2018 to avoid falling further behind the curve. Nonetheless, we expect central banks to respond cautiously and we see a slower pace of tightening than the consensus view .
• ? Policy rules, such as the Taylor Rule, have long been considered a useful guide to the potential path for policy rates. But while it suggests that current US, Eurozone and Australian central bank rates are broadly appropriate, it signals that UK, Canadian, and Swedish rates should be substantially higher. Based on our economic forecasts, Taylor Rules suggest that the central banks in the US, Eurozone, Canada and Australia will all need to raise intertest rates by around 100bps by end‐2018.
• ? However, there are several reasons not to draw strong conclusions from such point estimates. First, the Taylor Rule requires estimates of two unobservable variables – the output gap and the natural rate of interest – which cannot be estimated precisely.
• ? Second, using models that were designed to predict US policy responses in the 1990s to forecast central banks' behaviour today is likely to be misleading. Meanwhile, inferring central banks' reaction functions from recent policy rate moves to assess the future policy path is fraught with difficulties. Not only have interest rates been broadly unchanged for the bulk of the post‐financial crisis period, but policymakers have provided other forms of policy support.
• ? Third, outside the US at least, Taylor Rules have historically pointed to persistently different policy rates from those observed, yet inflation has been well anchored.
• ? The upshot of all this is that we expect central banks in the advanced economies to err on the side of caution and anticipate interest rates rising less quickly than the consensus amongst economists.

     

Brexit fears mask underlying pressures on investment

• ? Brexit uncertainty is seen as a likely culprit behind weakness in UK business investment. But structural shifts in the economy alongside issues relating to how investment is measured suggest that even without the uncertainty factor, a significant revival in measured investment spending may not materialise.
• ? Movements in relative prices continue to favour expansion by relatively labour‐intensive rather than capital‐intensive sectors. Relatedly, a shift towards investment‐light services activity is persisting, while recent changes in the make‐up of employment are reducing the extent of likely automation.
• ? Moreover, the ongoing pace of technological change and corresponding fears of rapid obsolescence could deter investment. And an increasingly fuzzy division between investment and consumer spending suggests that official data may be increasingly understating investment's true level.

     

Brexit deal and demographics drag on long-term outlook

• ▀ We have revised down our long-term forecast for GDP growth based largely on our expectation that the UK is headed for a much looser relationship with the EU. This will result in damage to trade and lower FDI inflows.
• ▀ We now expect potential output growth to slow to 1.4% a year from 2020–2030 down from 1.6% a year from 2010–2020. In the two decades after 2030 we expect the drag from Brexit-related effects to fade, but weaker contributions in labour supply and human capital will cut output growth to 1.2% a year.
• ▀ Demographics have been a key contributor to potential output growth over the past 30 years. But an ageing population and a more restrictive immigration regime are likely to mean the workforce grows far more slowly in the future.
• ▀ Our long-term growth forecast is weaker than the OBR's and implies that future governments will face a combination of disappointing growth in tax revenues and increasing demands for government spending from an ageing population.

     

Meagre house price growth may kill off a UK obsession

• ? Short of an unlikely jump in interest rates or a no‐deal Brexit proving more damaging than we expect, we think that positive but sluggish growth will continue to characterise UK house prices for the foreseeable future.
• ? Mooted reforms to stamp duty could prompt some upward price pressure, although stretched affordability and the end of ‘Help to Buy’ will work in the opposite direction.
• ? Meanwhile, compared to the dominant role interest rates play in driving house prices, fulfilling the government's housebuilding goals ‐ even if these very ambitious target could be met ‐ would make only a modest difference.