Watch this 10-minute video for a quick view as global economies start to reopen.
The past week has brought no radical change to our thinking on COVID-19. We have upgraded our growth forecasts, but this eventuality was flagged last week and we remain both below the consensus and concerned about the risk of a double-dip. Here are some of the key negatives and positives:
- The daily number of new COVID-19 infections has resumed growing.
- Emerging market nations are having particular trouble corralling the virus.
- Our concern that there may have to be a second round of quarantining is edging upwards.
- There is further evidence of an economic rebound underway.
- Accordingly, we have upgraded our base-case growth forecasts.
- There has been incremental good news in the science surrounding COVID-19.
- The number of global deaths is falling, and this may be more accurate than the rising infection count.
After going roughly sideways since early April, the number of new daily infections has again begun to rise over the past one to two weeks, with more than 100,000 cases recorded on consecutive days. The cumulative number of infections now exceeds 5.5 million (see next chart).
Spread of COVID-19 globally
Note: As of 05/25/2020. Spike on 02/13/2020 due to methodology change. Source: ECDC, Macrobond, RBC GAM
However, the number of global COVID-19 deaths has continued to decline on a trend basis since mid-April (see next chart). There are now around 4,000 deaths per day, in contrast to a trend rate of about 6,000 in mid-April. This is arguably the more accurate (or, to be more precise, less inaccurate) of the two measures. Thus, the rise in cases may have more to do with enhanced testing than an accelerating number of actual infections.
COVID-19 deaths globally
Note: As of 05/25/2020. Spike on 02/13/2020 due to methodology change. Source: ECDC, Macrobond, RBC GAM
From a geographic standpoint, the main European players continue to look quite good. For example:
- France, Germany, Spain and Switzerland are on declining trajectories and down to no more than a few hundred cases each.
- Italy’s number has ceased to improve, but remains massively better than in late March.
- Even Sweden is on a flat-to-slightly declining trend despite more lax public health measures, though with a higher per capita rate of infection than its Nordic peers.
Elsewhere, the U.K. and U.S. (see chart) remain on slightly declining trajectories, and have enjoyed somewhat more substantial improvement when measured by deaths as opposed to infections. However, the U.S. experience varies substantially by region, as discussed later.
Spread of COVID-19 in the U.S.
Note: As of 05/25/2020. Source: ECDC, Macrobond, RBC GAM
Canada’s infection figures have also generally declined, though there was a tick higher a few days ago (see chart). This may well represent the start of a rising trend, but is more likely a statistical blip, a relic of the May long weekend, or even a more dated consequence of Mother’s Day socializing.
Spread of COVID-19 in Canada
Note: As of 05/25/2020. Source: ECDC, Macrobond, RBC GAM
Emerging market trouble
As developed countries have begun to better control COVID-19, emerging market (EM) nations are unfortunately trending in the opposite direction. Our measure comparing the number of daily infections of the six most affected developed countries versus the six most affected EM countries shows that whereas developed countries once suffered roughly 10 times more infections in early April, they now enjoy fewer new cases as EM has taken the hot potato (see next chart).
COVID-19 hitting emerging market countries now
Note: As of 05/25/2020. DM aggregates case count from France, Germany, Italy, Spain, U.K. and U.S. and represents 50.6% of global cases. EM aggregates case count from Brazil, India, Iran, Peru, Russia, and Turkey and represents 23.1% of global cases.
To the extent most EM countries have limited testing capabilities, the infection numbers are almost certainly underestimated to an even greater extent than in the developed world. For example:
- India is now up to nearly 7,000 cases per day.
- Mexico continues to rise, with nearly 3,500 per day.
- Brazil’s figures have come down recently, but it is nevertheless running at a daunting 15,000 to 20,000 new cases per day – nearly equivalent to the U.S.
- Russia’s official figures have now stabilized at around 9,000 per day, but this remains a significant load.
These countries are challenged by weaker health care systems, flimsier social safety nets, less scope for fiscal and monetary stimulus, and a questionable ability to impose quarantines for an extended period of time. That said, it should be noted that most EM countries have been no less aggressive in their quarantining efforts so far, as demonstrated by an Oxford University measure of quarantine stringency. Africa, South America, Eastern Europe and Asia look quite similar to developed regions.
Interesting virus slices
We share a number of interesting COVID-19 findings with a scientific element.
True infection rate
As we have written on extensively in the past, the true number of infections is almost certainly much higher than the official count. A few weeks ago we used a statistical model to estimate that the U.S., U.K. and Canada might actually have three to five times more cases than officially determined. A variety of antibody studies have argued that the true infection rate could well be 10 times the official number.
A more recent study of New York City workers theoretically more exposed to the virus – transit workers, police officers, health care workers and fire/ambulance staff – reaches a slightly less bold conclusion, with 10% to 17% of the group showing antibodies via serological testing. This is around five to seven times the official population-wide ratio. The true multiple would presumably be somewhat lower were less vulnerable occupations included.
Another recent study in Sweden finds that 7.3% of Stockholm residents had COVID-19 antibodies as of late April. This is 22 times the official count. However, it also highlights that the Swedish push for herd immunity remains well short of target – 60% to 70% of the population would need to be infected/immune before the virus would cease to spread.
The bad news in all of this is that the virus is indeed highly transmittable, if symptom-free for many. The good news is that we are incrementally closer to herd immunity (though still very far away!) and that the true fatality rate is indeed much lower than the raw case fatality rate.
Virus spreads easily
In terms of the theoretical ability of the virus to spread, recent research from the National Institutes of Health finds that droplets of water can remain suspended in the air for more than 10 minutes, undermining the assumption that virus-filled droplets must quickly drop to the ground.
Simultaneously, another new study finds that, when expelled, the flu virus can travel beyond 2 metres fairly easily.
Both of these findings could help to explain how the virus has continued to infect new hosts even after aggressive social distancing measures have been implemented. They could also help to explain why countries such as Japan that have largely kept their economies running but have enthusiastically embraced face masks have enjoyed such great success.
Happily, confidence is rising that COVID-19 antibodies do indeed confer a measure of immunity against re-infection. There is no evidence of widespread reinfection. And, from a scientific perspective, the immune response appears to be vigorous even in asymptomatic cases, and virus mutations appear to be minimal. In turn, a vaccine is theoretically possible, as is herd immunity.
A Chinese study finds that the vast, vast majority of COVID-19 transmission occurs indoors rather than outdoors. This is a promising finding as the weather becomes nicer and people begin to spend more time outdoors. It is also useful information for retailers and restaurants seeking to minimize the risk of infection. However, one has to wonder whether the diminished risks outdoors are exaggerated by the fact that China’s outbreak was concentrated in January and February, a time when few people would have spent much time outdoors.
Warmer weather helps
Several weeks ago, we highlighted tentative research arguing that warmer weather should diminish the clout of COVID-19. The scientific evidence has gone back and forth on the subject, though it is at a minimum plausible given that the cold and flu appear to spread much less freely during the summer. New research from a group of scientists spanning six academic institutions concludes that warmer weather does likely help, but not to the point of eradicating the disease altogether. They estimate that the rate of infection could fall by more than 40% in the hottest parts of the U.S. such as Phoenix, with the rate of infection in more moderate climates like New York City down by around 25%.
This is useful, as a lower transmission rate means that a larger fraction of the economy can likely be restarted during the warmer months. This could also help to explain why warmer states such as Georgia are managing to revive their economies without a big spike in cases. Of course, what goes up must come down, and colder weather in the fall and winter should result in a higher infection rate.
The resilience of children
It is widely appreciated that children enjoy a very low fatality rate from COVID-19. It would appear they also enjoy a lower infection rate. Theories as to why this is include:
- Their stronger immune systems may clear COVID-19 before antibodies are even required.
- The disease may have a diminished ability to bind to the receptors in their nasal passageways.
- Even coronavirus-based forms of the common cold (which run rampant in children) may provide some measure of cross-immunity to COVID-19.
All of this hints that schools may not be the breeding ground for COVID-19 that is feared, despite the poor hygiene and social distancing habits of many children. An Australian study of several schools found that 18 infected individuals only managed to infect a further 2 students out of the 863 they were in close contact with. Another study estimates that U.S. children have been 7 to 20 times more likely to die from the flu than from COVID-19 so far this year.
When COVID-19 first arrived, the widespread view was that it would be difficult to develop a vaccine in fewer than 12 to 18 months, with even those figures regarded as optimistic given that no prior vaccine had ever been developed in fewer than four years.
Those numbers remain entirely valid estimates, but it is interesting to now hear occasional predictions of an even faster solution. Scientists at Oxford University and a few other labs have talked about developing a vaccine by the fall, even if this is viewed with skepticism by many. But now Bill Gates – whose foundation is the largest funder of vaccines in the world – has indicated that it may be technically possible to develop a cure in as little as 9 months. That would be the best-case scenario rather than a forecast, but we’ll take what we can get.
Our tracking of real-time economic data reveals mostly positive economic news. Online restaurant reservations continue to rise, with Germany nearly half way back to normal! The improvement is more tentative in other countries. Airline travel remains quite low, but is visibly rising.
U.S. businesses now report that they have recovered 36% of their initial decline in revenues (see next chart).
New orders and sales of U.S. businesses hammered by COVID-19
Note: As of 05/17/2020. Estimated as weighted average of % change in new orders or sales for all respondents. Source: Weekly Business Outlook Survey on the COVID-19 Outbreak, Federal Reserve Bank of Philadelphia, RBC GAM
Similarly, hours worked by U.S. hourly workers continues to revive, having now recovered 32% of the initial decline (see next chart).
Percentage change of hours worked by hourly workers in the U.S.
Note: As of 05/21/2020. Impact compares hours worked in a day vs. median for the same day of the week in January, 2020. Source: Homebase, Macrobond, RBC GAM
One counterpoint is that U.S. credit card spending data staged a slight retreat. After unwinding an amazing three-quarters of the initial spending drop, the latest week revealed a moderate retreat. Spending nevertheless remains more than half of the distance back to normal.
Combining Google Mobility, Apple Mobility and Oxford stringency data, our metric argues that the U.S. has now recovered around 40% of its lost mobility. The figure is very similar for Canada, while more tentative in the U.K. Remarkably, Apple Mobility data claims that driving activity has already fully revived in the U.S.
Severity of lockdown varies by country
Note: As of 05/16/2020. Deviation from baseline, normalised to U.S. Source: Google, University of Oxford, Apple, Macrobond, RBC GAM
Household income contradictions
We wrote in our past two weekly notes about how the average household income hasn’t actually gone down very much in the U.S. or Canada as government support supplants labour income. Of course, there is substantial variation among households. Among those who lost their jobs, high-income households are nowhere near retaining their prior level of income, while a significant fraction of low-income households are earning more than they did before.
A new U.S. survey from the Census Bureau paints a somewhat more negative picture. Nearly half of U.S. adults report that their household has lost income in the two months since COVID-19 struck. Of the respondents, 15% say they are not able to pay their mortgage, and 26% say they cannot make rent. It may be that these figures are ultimately found to exaggerate the severity of the situation, much as the true decline in business revenue and hours worked is probably not as extreme as that reported in the aforementioned real-time business survey. In this case, a household with financial investments would be technically correct in reporting diminished income if even a single company in their portfolio had cut their dividend. But the survey is nevertheless worrying.
Jobless claims deterioration (and contradiction)
U.S. weekly jobless claims remain the timeliest way to track economic activity using conventional economic data that has the advantage of a long and well understood history. The initial claims figure continues to ebb, though not with the speed that we would have imagined given the substantial rebound in spending and activity. Another 2.4 million people filed for jobless claims in the latest week, only slightly below the prior week’s figure of 3.0 million. Nearly 40 million such claims have now been made since the arrival of COVID-19.
Of course, initial claims only tell us about the job losses side of the ledger, with no insight into the hiring side. One would expect some re-hiring given that business revenues and hours worked are reported to have rebounded by around a third from their lows. Perplexingly, this appears not to be the case. With the caveat that continuing jobless claims are lagged one week relative to the initial claims figure, the continuing claims number rose from 22.5 million to 25.1 million.
We continue to believe continuing claims should begin to shrink quite soon, perhaps as soon as this week or next. Indeed, the most recent data came closer to improving than the headline number suggests. Despite the overall deterioration, 32 out of 50 states managed to reduce the number of people on unemployment insurance for the week. Alas, this was obscured by a couple of large states that may be suffering from lagged data (Florida and Texas) and a few others that have been more cautious about lifting their quarantine (California, Oregon and Washington).
Purchasing Manager Indices bounce
Once upon a time, purchasing manager indices (PMIs) were the freshest and best means of gauging economic activity. Their role has been somewhat diminished by the many new real-time measures that have recently sprung forth. But PMIs still offer useful insight as a sober confirmation of what less reliable measures are claiming.
On this front, May PMIs have happily risen in the main developed markets, confirming that some sort of economic recovery is transpiring, though the absolute numbers remain no better than the low normally experienced during a recession:
- The Markit Eurozone composite rose from a putrid 13.6 to a still soft 30.5. In theory, 50 represents the delineation point between growth and decline, so the move is a giant leap forward but hardly a ringing endorsement.
- The story was similar in the U.K., where the equivalent PMI rose from 13.8 to 28.9.
- In the U.S., the Markit Composite PMI rose more cautiously, from 27.0 to 36.4, but to a higher absolute level than the others.
One fascinating trend in the corporate space is the extent to which some big retailers are thriving even as others declare bankruptcy. The likes of Walmart, Home Depot, Costco and Target are all growing as people focus their shopping in stores where sufficient social distancing is possible due to large store sizes, it is possible to buy a wide range of goods, and the retailers are not hidden within indoor shopping malls. Several of these stores have now reported revenue rising by 10% or more over the past year – unprecedented growth for such mature businesses. These companies are also in a position to provide significant e-commerce offerings, with Walmart reporting its e-commerce sales up a remarkable 74% over the past year. Conversely, small businesses are not in a position to compete on any of these fronts.
That said, corporate earnings have not generally increased as easily as revenues. Changing how products are sold is costly. Front-line workers are being paid more, store configurations are changing, supply chains have become more complex, and people are buying goods in different ways (online/storefront pickup). McDonald’s restaurants are now expected to sanitize their digital kiosks after every order and their bathrooms every half hour.
Some companies are now beginning to add a COVID-19 surcharge to compensate themselves for these extra costs. To the extent this happens, profit margins might revive, but so too might inflation.
One black box into which we still have little insight is how companies are modifying their capital expenditure plans. One can easily imagine that the high level of uncertainty and diminished economic outlook make now a poor time to pursue big new initiatives. On the other hand, refitting stores, offices and factories will not be cheap, and any on-shoring of supply chains will require significant spending. As workforces have pivoted to work-from-home mode, one has to think that practically every firm is spending near record amounts on new IT equipment. Normally, capital expenditures collapse during recessions. We have assumed a sizeable 20% peak-to-trough drop during this one, but this is actually slightly less steep than the assumed decline in consumer spending. Normally, capital expenditures swing much more wildly than consumer spending.
Canadian CPI data has now been released, yielding the expected outcome. Headline CPI fell from 0.9% to -0.2% YoY in April. This might be as low as it gets in the near term, as oil prices have since staged a partial rebound. Core inflation, meanwhile, has been more sedate in its decline, falling only incrementally to a range of 1.6% to 2.0%. None of this is likely to influence the Bank of Canada one way or the other because central banks are focused on the growth and liquidity implications of COVID-19 rather than the extent of the deflationary aspect.
Later this week, Canada’s first-quarter GDP print will be released. The consensus looks for a 10% annualized decline. This is double the recorded decline in the U.S. for the same period – consistent with our view that Canada is suffering a more severe economic shock than the U.S. Of course, the first quarter only captures a sliver of the COVID-19 effect.
Our updated economic scenarios
Our growth forecasts for 2020 are enjoying a moderate upgrade. We now assume a peak-to-trough decline in GDP of 18% in the U.S., versus our prior assumption of a 22.5% decline. As discussed last week, it simply appears that the real-time economic data exaggerated the extent of the hit now that more conventional economic data is starting to fill in the blanks. The following table and chart show how the new peak-to-trough estimate was arrived at from expenditure-based and industry-based perspectives.
U.S. expenditure-based GDP stylized math
As of May 2020.
Medium-depth scenario: U.S. peak-to-trough GDP decline by sector
Note: As of 05/21/2020. Bars show the assumed peak-to-trough % deviation from normal output for each sector due to COVID-19 in the medium-depth scenario. Source: Haver Analytics, RBC GAM
A further positive is that the economic rebound has come about both sooner and more enthusiastically than we had expected. We suspect the real-time data exaggerates the extent of the rebound, but some amount of recovery has already been underway for a month – ahead of the June schedule we had previously assumed. Combining these two thoughts and incorporating the latest news about additional fiscal and monetary stimulus, we arrive at a 7.1% decline in U.S. 2020 GDP as our new base-case scenario – an improvement from the prior -10.6% figure.
This still leaves us somewhat below the consensus view, but to a less extreme extent. Of course, there remains little precision in this exercise. We retain our nine-scenario approach, but with a twist (see next table). Whereas previously the 3x3 matrix consisted of three depth possibilities and three trough duration possibilities, the second axis has now changed. We already know when economies began to rebound – late April to early May – and so the second axis is now focused on the extent to which the subsequent recovery happens quickly or slowly.
COVID-19 scenarios: 2020 U.S. real GDP forecast (annual average % change)
Note: As at 05/21/2020. Assumes rapid decline into trough versus much lengthier recovery period.
The full suite of nine scenarios leaves the possibility of an economic decline as mild as -2.8% if the economic decline proves even shallower than we have assumed and the recovery is unusually zippy, or as severe as -18.7% if the peak-to-trough decline is worse than we have assumed and the recovery proves quite gradual (perhaps because a second round of quarantining proves necessary). While the resulting range of possible outcomes is undeniably wide, let the record show that it is around half as wide as the prior set of forecasts. This represents progress: as time passes and evidence accumulates, we are able not just to refine our base-case forecast, but also the range of scenarios surrounding it.
Our international growth forecasts have been similarly updated and upgraded. Using the same methodology we used to construct them initially – a wide-ranging scorecard system combined with sector, mobility and stimulus data – the process and result are now depicted in the following table.
COVID-19 impact on GDP
Note: As of 05/23/2020. Scorecard estimates based on factors including transmission rate, testing, containment, health care system, education, demographics, globalization, labour market flexibility, public debt and government policy response. Peak-to-trough decline in GDP combines assessment via scorecard, sector-based and mobility-based methodology. 2020 and 2021 GDP growth forecast based on medium depth and duration assumptions. Source: CIA, Google COVID-19 Community Mobility Report, kita.org, Knoema, Our World in Data, national governments and central bank websites. Bruegel, ING, UBS, Haver Analytics, Macrobond, RBC GAM
Canada’s growth forecast has been upgraded from -12% to -8.8%, while the Eurozone is now set to shrink “just” 10.6% rather than 15%.
We do not assign formal probabilities for each of the nine growth scenarios presented earlier. However, it is fair to acknowledge that, at the same time that the base-case scenario has improved, the risk of a bear-case outcome has also arguably increased. As such, the weighted growth outlook is arguably not that different than it was beforehand.
These opposing developments are for one and the same reason: quarantining has ended more vigorously than expected. This increases short-run economic activity, but also raises the risk that governments must step on the brakes again at some point in the future.
This caveat is most applicable to the U.S., which has been among the most enthusiastic to re-open relative to its virus count. But it is not a trivial concern elsewhere, including within Canada -- particularly in Ontario and Quebec, where the virus figures are mixed and yet the restart proceeds.
The following table gives some sense for the relative vulnerability of different countries. Those countries that are furthest to the right are suffering the greatest number of COVID cases on a per capita basis, while those closest to the top are imposing the least extreme lockdown. Consequently, the countries in the top-right quadrant are arguably at the greatest risk of a second wave of infections. The U.S. and Sweden feature centrally.
Countries with lenient lockdowns and high new cases at more risk of 2nd wave
Note: As of 05/16/2020. Y-axis: deviation from baseline, normalised to U.S. Error bars represent peak lockdown severity. Source: Google, University of Oxford, Apple, ECDC, UN, Macrobond, RBC GAM
Similarly, countries with a sizeable virus count per capita and that have lightened their quarantine significantly (depicted by the length of the black line below each country’s circle) are also seemingly vulnerable. Canada finds itself in this position.
While countries like South Korea and Japan have lockdowns that are no more severe than the U.S. and have eased their measures significantly, their virus counts are so low that they have more room to maneuver (and they have also earned the benefit of the doubt as they have enjoyed more success with only limited social distancing measures).
Canadian housing thoughts
In the short run, it seems likely that housing markets should be somewhat diminished. After all, risk appetite is down, unemployment has increased massively and immigration has been temporarily slowed. On the other hand, borrowing costs remain very low.
From a geographic standpoint, Canada would appear to be more vulnerable than the U.S. due to its higher household debt load and poor affordability in the largest markets.
In Canada, CMHC has now forecast a 9% to 18% decline in home prices over the coming year. This is certainly within the realm of possibility, though we are inclined to take the “over,” with the view that a 0% to 10% decline in home prices is more likely. The Teranet/National Bank house price index argues that home prices actually rose in both March and April – arguably the two worst months of COVID-19. CREA’s composite home price index also claims that home prices rose in March, though concedes they may have fallen by 0.6% in April (though they remain 6.4% higher than a year ago). The mortgage data from Canadian banks shows a normal increase in lending in March, though no further data is available.
Of course, the pain of lost incomes, failed small businesses, unpaid mortgage and unpaid rent from a landlord’s perspective will mount with time, despite bank and government measures designed to minimize financial distress. This is presumably why CMHC has Canada’s household debt-to-income ratio rising from 176% to well over 200% by 2021. We expect the debt ratio to rise by less than this, particularly given that the natural instinct for households is to save more during economic crises. But, as always, the real story of vulnerability lies in the more granular data that captures individual suffering rather that national averages. The fraction of vulnerable borrowers was already unusually high before this episode.
Over the long run, however, we do not believe the housing market will be significantly perturbed. To be sure, preferences may shift – away from high-density vertical living and toward more suburban options, at least for a time – but immigration (the true driver of the housing market) is likely to revive, unemployment should begin to decline shortly, risk appetite is already beginning to improve and interest rates are likely to remain quite low.
Key stimulus points
The amount of monetary and fiscal stimulus delivered by the world’s governments remains remarkable in any number of ways. The effort greatly exceeds that put forth during the global financial crisis, it was delivered more promptly and has arguably been better targeted. See the following table for our latest estimates by country.
Global COVID-19 stimulus packages
Note: As of 05/08/2020. RBA has implemented yield curve control in place of asset purchase. Asset purchase estimated for BoC, BoJ and Federal Reserve which have open-ended QE, based on an assumption of a duration of one year. Monetary stimulus carried out by ECB shown for Euro Area member countries. Fiscal stimulus only includes spending, tax cuts and non-repayable portion of loans and does not include relief measures such as tax and fee deferral, repayable loans, loan guarantees, and equity investment, etc. Source: National central banks, national government websites, Bruegel, IMF, ING, UBS, RBC GAM
This week, we wish to highlight four specific matters.
- Pivoting toward recovery? 0l>
- Negative rates in North America?
- Yield-curve control?
- Mutualization of European debt?
There is a great deal of talk from governments about pivoting toward stimulus that focuses on restarting the economy as opposed to simply helping it weather COVID-19. Initially, policymakers had to work at break-neck speed, pushing broad stimulus out the door as fast as they could. Now, they are beginning to see where the worst damage is occurring and can focus on individual sectors. But, to our eye, this is still work that helps to deal with the initial COVID-19 damage as opposed to representing a strategy of reviving the economy. It is no less worthy, but isn’t actually much of a pivot.
Much of the actual pivot toward the recovery will happen automatically. Government support will naturally shrink as people return to their jobs and cease to be eligible for special programs. Maybe the main new thing governments will have to grapple with is how to encourage people to return to their jobs given that it may be just as lucrative for some to remain at home.
Despite attention by the press on this subject, we remain confident that negative interest rates as a form of monetary stimulus will not be coming to North America. U.S. Fed Chair Powell has been explicit on this subject, and the Bank of Canada has previously uttered similar comments. The Bank of England has admittedly appeared to waver as its chief economist indicated it is researching unorthodox policies such as negative rates, but even here a pivot seems ultimately unlikely. In our view, any economic benefit is outweighed by the distortions introduced.
To be sure, interest rates are likely to remain very low and one might even argue they have already been negative for quite some time when measured on an inflation-adjusted and tax-adjusted basis. But outright negative nominal yields seem both unlikely and undesirable, not so much because North America and the U.K. are special and somehow defying the Japanification tendencies visible elsewhere, but because their central banks philosophically oppose it.
The main issue with the economy is hardly that interest rates are too high. This is why the focus of policymakers has lately been on ensuring sufficient liquidity in government and corporate debt markets, rather than trying to achieve an ever-lower level of interest rates.
However, to the extent liquidity concerns fade, it seems quite easy to imagine central banks shifting toward a yield-curve control approach that threatens markets with intervention should yields dare to rise above a certain threshold. This technique was used to great effect in the U.S. in the years during and after World War II, and more recently by Japan. Neither ultimately had to buy many bonds as the market was convinced of the credibility of the threat.
The Eurozone has long been criticized for being a monetary union (a single currency and single central bank) without a fiscal union. As such, whenever European financial crises or recessions come along, a disproportionate share of the burden falls to the European Central Bank. This arguably reached its breaking point over the past month, when a German court challenged the right of the ECB to engage in large-scale quantitative easing. This is not the first time German courts have tried to limit the powers of the ECB, and there is a good chance that the ECB eventually manages to undermine or reverse the ruling. But the situation is not ideal.
Remarkably, and apparently in direct response to the recent court ruling, German Chancellor Merkel surprised almost everyone by recently signing on to a proposal put forward by France to create a 500 billion euro “recovery fund” to help affected Eurozone nations. This is a big deal on several fronts. The money would be delivered as a grant rather than a loan, making the transfers permanent – in contrast to previous such efforts. And the Eurozone would raise the money via what amounts to debt mutualization: the issuance of Eurobonds that would benefit from the greater economic clout and debt rating of the region’s more successful countries while delivering assistance to poorer and more adversely affected countries.
The plan is not yet across the finish line as it ultimately needs to be approved right across the bloc, but it has taken a big step forward with Germany’s support, and could well represent a fundamental change in how the Eurozone views itself, how it functions, and even whether it survives.
Financial market to and fro
In thinking about the outlook for risk assets, the range of possible outcomes is unusually wide. The following table highlights the key talking points from both a pessimistic and an optimistic perspective.
As of May 2020. Source: RBC GAM
It is impossible to say which arguments will ultimately prove the most relevant in the short term, though as a firm we have tended toward the more optimistic side over the past month because the arguments of greatest long-term relevance (such as the more attractive relative valuation of stocks versus bonds) appear to favour that stance.
-With contributions from Vivien Lee and Graeme Saunders