Multi-Asset

The fiscal and monetary cavalry pulls out the bazookas

The size of fiscal and monetary stimulus is significant and the speed at which it has been announced has been swift.
April 2020
  • The COVID-19 crisis is unique in its catalyst as well as the speed and size of economic disruption. At the same time, unprecedented levels of uncertainty and economic fallout are being met with unprecedented policy stimulus and liquidity.
  • Given the sharp but temporary nature of this shock, policies have been swift in correcting market failures. The current policy mix across developed economies is well-targeted and significant (over 10% of Gross Domestic Product (GDP)), prioritizing market functioning, small businesses and households.
  • Policy will not save the economy from a deep, short-lived recession, but will help bridge our way to recovery. The bazooka policy response shows that central banks have a big bag of tricks beyond conventional interest-rate tools and can easily go further. These actions have contributed to the market stabilization of late.
  • Bond duration remains attractive with Quantitative Easing (QE) programs absorbing the newly printed money, but 2021 could be year for the great underweight of duration. Fixed income should continue to play a strong diversifying role in balanced solutions.
  • Equities remain exposed to the downside risks of a prolonged economic shutdown, but our base case remains for economy activity to slowly reopen in the coming months. We look to rebuild our equity overweight as we get more clarity on when normal life will resume.

Kites rise highest against the wind – not with it.

– Winston Churchill

We do not know how long it will take to contain the COVID-19 pandemic or how long economic activity will be shut. What we do know is the size of fiscal and monetary stimulus is significant and the speed at which it has been announced has been swift, and both are unprecedented compared to past crises. Central banks have stepped in to provide stimulus and liquidity to keep financial markets functioning and aid the recovery. And a massive fiscal backstop across the world is being implemented. Furthermore, the wide range of policy measures has further room to be ramped up.

The current crisis is unique in that it is both a supply shock (disruption to supply chains) and demand shock (reduction in consumer and investment spending). The catalyst is also unique: government-mandated closure of non-essential businesses in order to flatten the curve of COVID-19 cases. It will come at a heavy cost. For perspective, the Spanish Flu of 1918, when limited preventive measures were put in place, saw an estimated drag of less than 1% on global GDP, but also 50 million deaths (Source: The Wall Street Journal). The cost of the COVID-19 pandemic will be in the form of a double-digit contraction in Q2 GDP and jump in unemployment rates in the US, Canada and Europe, but with far fewer lives lost.

Table 1: Central Bank policy responses

Central bank Rate cuts (bps) Current policy rate QE (total purchases, bn) QE (% GDP) Future policy options

Fed

150

0-0.25%

$700+

3-19%

QE; Yield Curve control

BoC

100

0.25%

C$5/week+

6%

Rate cuts (25-75bps); QE

ECB

0

-0.50%

€ 870

12%

QE

UK

65

0.10%

£200

18%

QE

BoJ

o

-0.10%

¥12180

2%

QE

Source: BMO Global Asset Management, as of 1 April 2020.

Policy goal one: Market functioning and liquidity

Starting with monetary policy, the first and most prioritized goal is to restore financial market functioning in order for borrowing and lending to continue properly. For example, the London interbank offered rate-overnight indexed swap (LIBOR-OIS) spreads (the interest rate that banks charge each other for short-term, unsecured loans and which filters through corporate credit) widened in early March, causing stress in commercial paper (CP) and mortgage-backed securities (MBS), causing  borrowing costs like mortgage rates to rise while central banks were cutting rates.

In response to this lack of liquidity, central banks implemented liquidity and emergency lending facilities in addition to rate cuts and QE purchases to help to compress spreads.

  • Central banks not already at the lower bound (European Central Bank, Bank of Japan, Riksbank) have cut interest rates, with the average policy rate in developed economies now at 0%, compared to 0.5% during the Global Financial Crisis.
  • QE purchases of government bonds and other assets offer additional stimulus, keeping long-term bond yields anchored. The Fed’s buying program is now open-ended and already amounts to one trillion in asset purchases, equivalent to an additional 100bp of rate cuts. The Bank of Canada has also launched QE for the first time ever at a pace of $5bn/week. Although rate cuts and QE are not as effective when businesses and consumers are shuttered, they do enhance liquidity and will help bridge the way to recovery.
  • The remaining facilities are arguably the most important in the near-term. These facilities are not only broader than in 2008, but have been implemented in a matter of weeks as opposed to months. For the Fed, these include regulatory relief (lower bank reserve requirements and capital buffers), increased repo operations, easing of collateral requirements, use of the discount window and swap lines to lower the cost of USD funding. In addition, Global Financial Crisis (GFC)-era facilities have also reopened to ease funding pressures for commercial paper issuers, primary dealers, money market funds along with new ones for investment grade (IG) corporate credit and asset-backed securities (ABS) issuers. The Bank of Canada (BoC) has similar programs intended to provide liquidity and increase banks’ funding capacity, such as MBS and government bond buyback programs and the Bankers’ Acceptance Purchase Facility (Source: Bank of Canada).

 

Policy goal two: Backstop to firms

The second goal is to provide liquidity to small and medium-sized businesses (SMEs) and those businesses directly hit by government-mandated closures—in order words, correcting market failures given the sharp but temporary nature of this shock. SMEs have less cash and less diverse assets to weather crises, and account for about half of economic activity (from about 44% of GDP in the US to 54% in Canada and 60% in Europe). Aside from the healthcare industry, firms directly impacted by the pandemic (air transportation and hospitality industries) need help dealing with the shock.  Policies like credit lines, loan guarantees and forbearance will help cushion their balance sheets and retain their workers.

What is encouraging is that both central banks and governments are focused on backstops for SMEs and vulnerable firms, above and beyond the regulator relief and facilities freeing up capital for banks to lend. Fiscal packages include a mixed of liquidity and stimulus measures for businesses, such as direct loans, loan guarantees, tax deferrals and pay subsidies, all amounting to 10-25% of GDP across G10 countries. For a temporary but sudden stop, bridge financing and loan guarantees could be the most impactful by widening the access to credit while protecting banks. Specific programs include the following:

  • US: The Fed-backed corporate credit and municipal facilities in the US ($454bn proposed) could dramatically support the flow of credit as the equity could be levered up to support over $4 trillion in lending. The Fed has also proposed a Main Street business lending business program while third Federal stimulus bill includes roughly $350bn in SME lending as well as aid and loans for distressed industries like airlines.
  • Canada: A Bank Credit Availability Program will provide $65 billion in credit to businesses and the government is extending wage subsidies and a work-sharing program to keep workers employed (https://www.canada.ca/en/department-finance/economic-response-plan/covid19-businesses.html#business_credit_availability_program).
  • Europe: Loan guarantee schemes appear to be the most significant in Europe, ranging from 8-16% of country GDP.

Table 2: Fiscal stimulus & fiscal liquidity measures

Region Fiscal stimulus % GDP Fiscal liquidity % GDP Total (% GDP)

US

  • $50bn (FEMA Funds)
  • $8bn (1st Bill)
  • $110bn (2nd Bill)
  • $1338bn (3rd Bill)
    • $553bn Households (tax refunds, direct payments, unemployment benefits)
    • $263bn Business Tax Relief
    • $522bn Healthcare/State & Local/Education/Distressed

7

  • $400bn (Tax Filing Delay)
  • $342 (Payroll Tax Deferrals)
  • $50bn (Credit Protection for Fed's CPFF, MMLF, PMCCF, SMCCF, TALF)
  • $350bn SME Lending
  • $500bn Corporate Lending Facility

8

15

Canada

  • C$26bn (Household Transfers)
  • C$71bn (Wage Subsidies)

4

  • C$85bn (Tax deferrals)
  • C$150bn (IMPP)
  • C$65bn (Business Lending)
  • C$15bn (Energy Support)

14

18

Euro Area

  • €8bn (EU Budget)
  • €29bn (EU Structural Funding)
  • €100bn (Regional Stimulus)

1

  • €1080bn (German, French, Spanish Loans, Guarantees)

9

10

UK

  • £18bn (Regular)
  • £12bn (COVID-19)
  • £20bn (Grants)
  • £7bn (Wage Support)

3

  • £330bn (Government Loan Guarantees)

15

18

Source: BMO Global Asset Management, as of 1 April 2020.

Policy goal three: Household stimulus

Finally, policies to shore up households’ balance sheets are needed as unemployment skyrockets and growth craters through Q2. Beyond the social safety net already in place, governments are expanding the scope, such as for protections for workers not covered by current policies. Workers in industries most vulnerable include leisure, hospitality, and transportation, totaling a minimum of 20% of workers. Gig-economy and self-employed workers are also exposed and do not have access to the social safety net. Gig workers may account for as much as a third of jobs in the US and just under a tenth in Canada. As a result, fiscal packages include enhancing unemployment benefits and extending them to gig and self-employed workers, along with direct payments, mortgage and student loan holidays and tax rebates. So far, household stimulus is roughly 2% of GDP in the US and Canada.

Bazooka in place, with room to run

In sum, a combination of fiscal and monetary stimulus and liquidity measures has been announced globally in a matter of weeks, and is well-targeted and significant. The global fiscal stimulus impulse is already 2.5% of global GDP, up for close to 0% at the start of 2020 and eclipsing the stimulus in 2008-09 (1.7%). Developed economies are not alone, with China accounting for roughly a quarter. This also excludes other fiscal measures such as tax deferrals and credit guarantees as well as monetary stimulus. Taken together, these policies already comprise 15-25% of GDP in developed economies.

Policy will not prevent a recession but will significantly dampen the costs by helping to keep households and businesses liquid and solvent. Moreover, the size and scope of the third US fiscal package ($2tn) among others is on par with the immediate economic costs of the virus. And because structural issues (toxic assets, weak bank balance sheets, lack of macroprudential rules) are not the source, the economic downturn is unlikely to last more than 2-3 quarters while the recovery is likely to be swifter. This does depend on when new coronavirus cases subside and social distancing mandates are lifted, which remains uncertain. But the fiscal and monetary backstop has already laid a strong foundation and is ready to increase further.

Implications for asset allocation

Evidence so far suggests that social distancing is a painful but successful step to contain the virus. There is light at the end of the COVID-19 tunnel. Meanwhile, the policy response to counteract the economic damage is already helping markets stabilize and will help ensure a faster path to recovery once normal life resumes.

With central banks going all-in, interest rates should remain low well after COVID-19 is behind us, which makes duration attractive even with 10-year yields below 1%. Fixed-income should continue to play a strong diversifying role in balanced solutions despite the mid-March hiccups. Down the road, taxpayers and investors will have to debate on who foots the bill for this healthcare crisis. Unless central banks permanently let the size of their balance sheet balloon and decide to kick the debt can down the road, 2021 could be the year for the great underweight in bond duration. 

Although equities are still exposed to downside risks if the economic shutdown was to linger late into the year, our base case remains for the economy activity to slowly reopen in the coming months. We look to rebuild our equity overweight as we get more clarity on the timeline of the economic shutdown.

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