Multi-Asset

Macro outlook in times of the coronavirus: This is not a 2008 song

For investors, stomach-churning market drops and increasing recession fear in recent weeks due to COVID-19 are reviving memories of the 2008 financial crisis.
March 2020
  • While the full economic impact of COVID-19 is highly uncertain, a Q2/Q3 recession seems inevitable in light of the extreme social-distancing efforts to slow the spreading of the virus. Bond and equity markets already reflect substantial pain in future economic growth and earnings.  
  • The velocity of equity selloff has fueled fear that we are about to experience another 2008-like crisis. This note highlights keys reasons why we don’t think this is the case.
  • Beyond the obvious that the COVID-19-induced slowdown is a unique recessionary trigger, the backdrop is fundamentally different, most notably the resilience of the global banking sector.
  • The North American housing market, a key pillar of consumer wealth and confidence, should see a sharp drop in transactions as social distancing keeps potential buyers on the sidelines, but we expect prices to remain resilient.

For investors, stomach-churning market drops and increasing recession fear in recent weeks due to COVID-19 are reviving memories of the 2008 financial crisis. While a technical recession, defined by two consecutive quarters of negative real GDP growth, seems likely in Canada and the U.S. in Q2 and Q3, our base-case is that this will be a brief. Overall, we expect a less severe economic cycle than during the 2007-09 period when the global financial system was on the verge of collapsing. While the full extent of the drag is highly uncertain, several factors are important to consider when comparing with previous cycles and assessing the medium-term outlook.

Unlike 2008, there is no sign of systemic risk on the radar. Central banks and governments are intervening to stabilize markets, and the private banking sector remains well capitalized. It feels more like a ‪9/11 type of transitory shock than a 2008-type deep and persistent collapse, although social distancing will undoubtedly cause a sharp decline in economic activity.

Before outlining why we believe things are fundamentally different than in 2008, we must first outline the basis of our base-case scenario for the next 12 to 18 months, focusing on Canada and the U.S.:

  • Deep but transitory negative demand and supply disruptions, peak drag by end of Q2 with some spillovers into Q3, followed by steady resumption
  • Bulk of negative impact due to social distancing to slow the virus spread
  • Corporate credit to remain under stress, notably because discretionary spending is falling sharply, and the energy sector endures the oil-price war
  • Large temporary job losses, but relatively few permanent losses outside of energy as normal life resumes
  • Broad fiscal aid, with key measures to prevent a credit crunch in most impacted sectors and SMEs
  • Targeted measures to SMEs to help them cope with financial hardship
  • Whatever-it-takes monetary and fiscal policy actions as financial-stability backstop

Housing fueled by low interest rates and strong labour market, not subprime

The U.S. housing market ran on nitro heading into 2007, thanks to lax lending standards that led to the sub-prime debacle. By contrast, because Canada didn’t really have a subprime segment in 2008 and its housing market came out of the Great Recession largely unscathed.

Going into 2020, the backdrop was greatly healthier in the U.S. Meanwhile, Canadians have accumulated a substantial load of personal debt relative to their income, and household balance sheets don’t look as healthy as in 2007. However, because the bulk of the debt load is linked to real estate, we are not too concerned about the short-term resilience of households assuming economic activity resumes in a few months. Arrears on personal and mortgage loans will likely increase, but personal defaults usually lag by about a year.

Our main concern with elevated Canadian household debt has always been to cause persistently slower growth because of debt deleveraging, which has caused retail sales to stagnate since the BoC began hiking rates in the summer of 2017.

For U.S. households, the current situation is quite different. After experiencing a severe credit rationing following the GFC, household balance sheets gradually recovered. Although we expect job losses and the unemployment rate to surge in the next couple months, we expect this to be a transitory adjustment for most workers and businesses until normal life resumes.

In the current context of social distancing and uncertainty, we expect real-estate transactions to catch a severe cold, but a 1- to 3-month sharp decline in real-estate transactions is unlikely to trigger a cascading selloff and price correction. The 2002-03 SARS episode in Hong Kong and the 2001 U.S. recession are good examples where a recession caused real-estate transactions to fall sharply without impacting prices. We believe the Canadian and U.S. housing markets will experience the same kind of mild price patterns in coming weeks.

Dealers are no longer gamblers

A key lesson from the GFC was to impose strict regulations on the international banking sector in order to enhance the regulatory framework and improve the sector’s ability to deal with financial stress, improve risk management, and strengthen the banks’ transparency. Capital ratio and leverage requirements are much stricter—and safer. The Basel III accord also incorporates counter-cyclical measures where banks have to set aside additional capital during credit expansion, while capital requirements can be loosened during credit contractions. The Volker-rule has also drastically limited the ability of investment banks for proprietary trading and utilizing bank’s balance sheet for risk taking. With all this, it’s quite clear the financial system is much stronger than it was heading into the crisis in 2007, where banks were at the epicenter.

Fiscal stabilizers will kick in early

Even prior to announcing measures to help against COVID-19, the fiscal policy mix of provincial and federal governments contains several axes that act as cyclical stabilizers against slower economic growth. The recent additional measures will help address near-term funding needs of businesses. Get ready to see public deficits widen by a large amount as revenues fall and expenditures spike, but this will help cushion the COVID-19 drag.

Recessionary trigger matters, but the world always recovers

While each recession has its own trigger, every modern recession was triggered by some form of policy mistake that usually saw too loose policies leading to excessive debt levels. As we fall into a technical recession in coming weeks, we can’t blame the Fed for over tightening, quite the opposite. How lasting the damages will largely depend on how long fear and social distancing persist. The fundamental supportive consideration is that the coronavirus can and will be contained. Whatever the economic hardship caused in the process, it should be temporary. Markets and economies should recover.

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