The financial effects of Covid-19 and why we need strong supply and demand at the same time.

Blog courtesy of FT Adviser.

The Office for Budget Responsibility (OBR) estimates UK GDP could fall by 13 percent in the 2020 calendar year.

During the global financial crisis, the worst year for GDP decline was 5 percent.

Richard Buxton, head of UK equities at Merian Global Investors says the economy has “effectively been put into the deep freeze” and the challenge facing policy makers now is to “unfreeze it.”

The economy is formed of two factors, supply and demand. On a graph, in a healthy economy, the level of supply should slope gently upwards, as should the level of demand. 

The steeper both curves are, the greater the level of economic activity, and the ideal scenario is that the demand curve and apply curve slope gently upwards precisely in unison.

If the demand curve is steepening at a markedly faster pace than the supply curve, that means the demand is increasing at a pace faster than the supply of goods. This causes inflation, and can lead eventually to a recession as prices rise more quickly, causing demand to fall, with the demand curve flattening. 

Companies respond to the fall in demand by reducing supply, which means workers lose their jobs, causing the demand and supply curves to flatten. 

If the supply curve steepens at a much faster pace than the demand curve, then the economy has over supply, and companies faced with unsold inventory will reduce production, cutting jobs, and so also flattening the demand curve.   

Response to financial crisis

The Global Financial Crisis was caused by a sudden flattening of the supply curve, as a crisis in the banking sector led to a reduction in the supply of credit around the world, meaning firms were unable to pay bills, or borrow to expand their operations.

That led to a flattening of the demand curve over a slightly longer period of time. 

The response of policymakers  was to pump money into the banks and the wider financial system in order to steepen the supply curve, and this eventually led to a steepening of the demand curve and the return of growth.

That asset prices rose to a much greater extent than did GDP growth or wage growth in the decade since the financial crisis indicates the supply curve steepened faster than the demand curve. 

The government’s traditional response is to increase its own level of demand in the economy, replacing the reduced demand from the private sector, and so steepening the demand curve.

The pandemic response

With the coronavirus pandemic, it caused a sudden, sharp, flattening of the supply curve as the government ordered many businesses to close.

This had an obvious impact on demand, with that curve also flattening.

In order to steepen the supply curve, the Bank of England immediately cut interest rates and extended its quantitative easing programme. 

The aim is that many more companies will be able to stay in business as a result of the furlough scheme and other measures, than would have been the case, if no action was taken, keeping the supply curve relatively steep.

On the demand side, the government’s furlough scheme means that when the lockdown does end, the demand curve should be steeper than would otherwise be the case.

This is because when the lockdown ends, furloughed  workers will have had at least 80 per cent of their salary to spend, instead of social security payments plus savings.

This idea, that the demand curve will be steeper than is typically the case in a recession while the supply curve can be steepened easily is the rationale behind many investors view that the exit from recession will be rapid.

In the lockdown, spending the 80 per cent of salary they have received may be difficult; creating surplus cash to spend later and leading to a rapid steepening of the demand curve.

Mr Buxton describes this as the “optimistic scenario”, and while not dismissing it entirely, he says it’s not his base case, due to a phenomenon economists call “the paradox of thrift”.

He says: “Having put the economy in the freezer, it’s hard to imagine that it can be unfrozen without some scarring.

“Some companies will not survive this, so unemployment will go up, and that reduces demand. But the data shows that it’s the fear of impending unemployment that has the really negative impact.”

Table below assesses the potential impact of the coronavirus on the economy and public finances

Updated 14 AprilQ2 2020Q3 202020202020-21
Real GDP (percentage change on previous period)-3527-12.8 
Unemployment rate (per cent)108.57.3 
PSNB (£ billion)   273
PSND (Per cent of GDP)   95

Source: OBR

Fear factor

The “paradox of thrift” is a theory popularised by Lord Keynes.

It states that far more people think they will lose their job or suffer some other deterioration in their financial circumstances than actually do.

The pandemic has led to a worst-case recession, and economic figures suggest a wasteland, with the expectation of even worse to come over the second quarter.–Fahad Kamal

This causes them to rein in their spending, which causes the demand curve to flatten by more than it otherwise would have done, and so unemployment will rise by more than otherwise.

This may mean that the furlough scheme fails in its aim to steepen the demand curve.

Phil Smeaton, chief investment officer at Sanlam, says: “There’s some evidence of pent up demand out there. For example, a lot of items that are non-essential but desirable, are out of stock, because the supply chains are disrupted.

“But while people probably will buy many of those items when they can do so, but they won’t buy two, to make up for the one they couldn’t buy earlier. They won’t buy two haircuts for example.”

Ed Smith, head of asset allocation research at Rathbones is another market participant who is sceptical of the chances of a rapid recovery.

He puts the chances of such an outcome at no more than 50 per cent, and even in the best-case scenario, and believes GDP would decline by 5 per cent in the 2020 calendar year.

For Fahad Kamal, chief market strategist at Kleinwort Hambros a potential best case, V-shaped economic scenario is now a “fantasy”.

He adds: “The pandemic has led to a worst-case recession, and economic figures suggest a wasteland, with the expectation of even worse to come over the second quarter.

“However, assuming no second-wave – which remains our base case – a recovery will begin in the third quarter. The situation will only go from dire to bad over the next 18 months, with elevated levels of unemployment, bloated levels of debt and reticent corporate and consumer spending. A full return to January 2020 level of unemployment, jobs and spending will not occur until 2022 at best.”

Meanwhile, Luke Bartholomew, UK economist at Aberdeen Standard Investments, says “there may be a quick upward movement in growth in terms of the data, but we will still be way behind where the economy would otherwise have been, so it won’t feel like growth”.

For Chris Ralph, chief global strategist at St James Place, “what is clear is that this recession will be deeper than that experienced in the Global Financial Crisis, as the ‘catastrophic’ jobs report from the US on Friday demonstrated”.

“But if – and it’s a big if – most parts of the global economy can restart quickly without the feared second wave of infections, then the recession is likely to be shorter than that experienced a decade ago,” Mr Ralph adds.

Stagflation 

As the government works to steepen both the supply and the demand curves, there is a risk that only one of those steepens. 

If the supply curve steepens as shops re-open, but the demand curve remains relatively flat because people are afraid, then the supply curve will flatten quickly as shops without customers choose to close, and make staff redundant.

If the more optimistic scenario happens, and the demand curve steepens quickly, there is also the risk that it steepens at a rate that is faster than the supply side of the economy can cope with.

For example, if waves of people have grown weary of their own cooking and visit a restaurant, the demand curve for the hospitality sector would steepen quickly.

But if restaurants can only serve a smaller number of customers as a result of social distancing, then the supply curve will remain flatter than the demand curve. The only way the restaurant can stay in business in that scenario is to put prices up, which is inflationary, and will reduce demand.

The impact on demand from the higher levels of unemployment we are about to witness will keep inflation low, and while companies may face higher costs.–Richard Buxton

More broadly in the economy, if employers have to take measures such as providing hand sanitisers or masks for staff, this would push the cost of bringing goods to market upwards, and that is something which flattens the supply curve.

A scenario where supply side pressures push prices up, but demand is too weak to sustain the higher prices and so falls, but not in a way that causes prices to fall, is called stagflation.

This means that while the demand curve is flat, the supply curve is rising, because the costs of supplying goods and services is higher.

The problem governments are faced with in this scenario is that if they act to increase demand, then this creates more inflation, which eventually becomes a drag on demand, causing it to fall, while the inflation caused on the supply side remains.

If policy makers try to flatten the curve on the supply side as a way to push prices down and boost the demand side of the equation, then the likelihood is some firms would close as they would be unable to absorb the higher costs, and this would lead to unemployment and lower overall demand in the economy. 

Table below provides initial broad-brush estimates of the costs of various policy interventions, although its coverage is not yet complete 

 Updated 30 April£ billion, 2020-21
Direct effect of Government decisions, of which:103.7
Spending99.3
Tax4.4

Source: OBR

Flattening curve

The UK existed in a stagflationary scenario in the 1970s, and the response of policy makers in the 1980s was to focus on flattening the supply curve via driving inflation downwards, and let a demand shock happen, including higher unemployment. 

Mr Buxton doesn’t believe stagflation will happen in the UK.

He says: “The impact on demand from the higher levels of unemployment we are about to witness will keep inflation low, and while companies may face higher costs.

“The prevailing public attitude will mean they are unable to pass those costs onto the end consumer, with the result that corporate profits will be lower.” 

Some elements of the CPI will be hard to assess for a while.–Simon Edelsten

Anthony Rayner, multi asset investor at Premier Miton says significantly higher unemployment means that employers will not need to grant pay rises, and this will prevent supply-side inflation becoming much higher. 

Mr Smeaton says he believes there is a chance that inflation could rise because: “The supply of money has increased, with government spending having gone up, and central banks printing money to pay for it, and that money has to go somewhere.”

But he is positioning portfolios on the basis that inflation will not rise significantly from here, while Mr Bartholomew believes the drop-in demand will be so severe that deflation, rather than inflation, will be the problem.

Simon Edelsten, who runs the Mid Wynd investment trust is anticipating very low bond yields and says the deflationary impact of this crash may take a while to register.

Mr Edelsten adds: “Some elements of the CPI will be hard to assess for a while, such as the price of cars when nobody is buying. 

“There is a risk that inflation takes off sharply in the longer term. This is always a prospect when governments spend large amounts and take the risk that savers will worry their currency is being diluted.  We have therefore invested in a number of gold mines which would benefit  (and already have benefitted) from a rising gold price.” 

Fiscal Drag 

The stimulus programme undertaken by the UK government, most notably the furlough jobs scheme, means government debt will rise.

The implications of the higher borrowing are twofold.

The first is, government resources being deployed today to fight the pandemic are not being used to improve the long-term growth rate of the economy, harming the long-term potential of the economy.

The second problem is that the cash borrowed today has to be repaid, with the future interest payments taking cash out of the economy, as it will have to come from cuts to spending, or higher taxes.

Mr Smith says that with borrowing in the private sector likely to be muted, “it makes sense” for governments to borrow.

There is a risk that inflation takes off sharply in the longer term.–Simon Edelsten

He noted that with central banks buying huge quantities of the debt, the yield on the government debt is unlikely to rise much from here, and if it does, central banks will intervene by buying more of the debt to push the yield down. 

Chris Iggo, chief investment officer for core investments at Axa Investment Management says he believes the debt will be dealt with in the same way it has been dealt with since the global financial crisis, with interest rates kept low.

Mr Iggo says: “A relatively simplistic view is that high debt levels are dealt with either by boosting growth (not easy), generating primary budget surpluses (austerity) to pay down debt (not politically popular after it led to the rise in populism in the last decade), generating inflation (again, not easy) or providing some kind of debt relief.

“I guess over the last decade financial repression has been the response to the inability to generate inflation as it has kept real interest rates down and made financing debt “easier”.  The rapid ratcheting up of quantitative easing suggests that this is the go-to solution under the circumstances as it is operationally the most direct.”

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