VIEWS & RESEARCH

Macro Insights

Expect long-term economic scarring from Covid-19

22 September 2020

Author: Gavyn Davies, Executive Chairman

As winter approaches in the northern hemisphere, new Covid-19 infections — which are feared to rise in cold weather — continue their inexorable worldwide march. Nevertheless, consensus economic forecasts for gross domestic product growth are being revised generally upwards. This optimism could soon be challenged.

The surprising ability of the American economy to withstand a very large rise in cases in midsummer, and the control of the resurgence without the severe lockdowns of April, have increased confidence that any winter outbreaks of the virus will not damage the global economy. So, too, have relatively low hospitalisation and death rates.

But with a very low chance of an effective vaccine or testing regime being widely available much before next spring, the reopening of schools and businesses may lead to surges in infections that are controllable only through widespread lockdowns. The economic damage from such events will not be negligible and is not yet built into consensus forecasts, so downgrades are likely.

In the longer term, the main risk to advanced economies is economic scarring. According to the OECD Interim Economic Assessment published last week, the effects of greater uncertainty will include higher precautionary savings by households and lower business investment, particularly by companies with high debt.

Structural changes in sectoral output caused or accelerated by the pandemic will trigger bankruptcies and job losses. This process of “creative destruction” is necessary for long-term recovery, but will inevitably mean lower levels of output for a lengthy period compared with the growth path seen pre-pandemic recessions. There is huge uncertainty, acknowledged by policymakers, about the scale of these scarring effects.

Fulcrum economists have published calculations comparing the possible scarring from coronavirus with that observed following the start of the financial crisis in 2007 — the only recent event remotely comparable in severity. We measure the degree of economic scarring as the difference between the level of output three years after the 2020 shock and that of the growth path predicted just ahead of the event.

We have found the expected path for the world economy over the next two years to be very different from that after the previous crisis. The latest consensus economics forecasts show a very sharp V-shaped recovery, far stronger than that of 2009-10. This would take global output in 2022 about 4 per cent higher than that of 2019.

Among individual economies, China will be by far the most successful of the major economies in handling the virus shock, according to these forecasts. Its GDP actually rises by 2 per cent this year, then surges to 15 per cent above pre-Covid levels in 2022.

The advanced economies are expected to be far less successful. Nevertheless, they all exhibit a very strong recovery after the troughs of mid-2020. The US is expected to record a smaller drop in output this year than the EU and UK, with a slower rebound in 2021. Japan is the only major economy that fails to recover all its lost ground by 2022.

Although global output is expected to recover fairly quickly to pre-Covid-19 levels, the previous growth path will not be achieved for many years.

The latest forecasts suggest scarring in 2022 will be 3.0 percentage points of global GDP and 3.3 percentage points for the AEs. These estimates appear to be subject to greater risks on the downside than the upside. The three-year scarring seen after the financial crisis was roughly twice what is expected this time. Then, early forecasts of a very sharp economic rebound proved far too optimistic. Furthermore, the trend growth rate never recovered to pre-crisis levels, so the scarring effect continued to increase year by year for the rest of the decade.

 A repeat of these disappointments is a very credible risk. OECD simulations — which are broadly in line with the consensus — suggest that, on pessimistic assumptions, there could be a further 3 percentage-point drop in global output by the end of next year, with consumer price inflation 1 per cent lower, compared with their central scenario expectation. Global equity prices would be 15 per cent lower; and non-oil commodity prices 10 per cent lower, in the first half of 2021.

Bond yields and policy interest rates, which would normally fall to cushion the decline in risk assets in such circumstances, are already close to rock bottom, so they would not provide much of a safety net as the equity risk premium increases.

Markets have been very optimistic since the global economy reached its trough in the spring. The harder part is now just starting.

 

About the Author

Gavyn Davies

Gavyn Davies is Chairman and co-founder of Fulcrum Asset Management. Prior to Fulcrum, Gavyn was as an Economic Policy Adviser to the British Prime Minister (1976-1979) and a member of H.M.Treasury Independent Forecasting Panel (1992-1997). He was the Head of the Global Economics Department at Goldman Sachs from 1987-2001 and Chairman of the BBC from 2001-2004. Gavyn graduated in Economics from Cambridge followed by two years of research at Oxford and he is also a visiting fellow at Balliol College, Oxford.

Source: This note is based on material which appeared in an article by Gavyn Davies published in the Financial Times on 20 September 2020.

This content is provided for informational purposes and is directed at professional clients as defined in Directive 2011/61/EU (AIFMD) and Directive 2014/65/EU (MiFID II) Annex II Section I or Section II or an investor with an equivalent status as defined by your local jurisdiction.  Fulcrum Asset Management LLP (“Fulcrum”) does not produce independent Investment Research and any content disseminated is not prepared in accordance with legal requirements designed to promote the independence of investment research and as such should be deemed as marketing communications.  This document is also considered to be a minor non-monetary (‘MNMB’) benefit under Directive 2014/65/EU on Markets in Financial Instruments Directive (‘MiFID II’) which transposed into UK domestic law under the Financial Services and Markets Act 2000 (as amended). Fulcrum defines MNMBs as documentation relating to a financial instrument or an investment service which is generic in nature and may be simultaneously made available to any investment firm wishing to receive it or to the general public. The following information may have been disseminated in conferences, seminars and other training events on the benefits and features of a specific financial instrument or an investment service provided by Fulcrum.Any views and opinions expressed are for informational and/or similarly educational purposes only and are a reflection of the author’s best judgment, based upon information available at the time obtained from sources believed to be reliable and providing information in good faith, but no responsibility is accepted for any errors or omissions. Charts and graphs provided herein are for illustrative purposes only. The information contained herein is only as current as of the date indicated, and may be superseded by subsequent market events or for other reasons. Some of the statements may be forward-looking statements or statements of future expectations based on the currently available information. Accordingly, such statements are subject to risks and uncertainties. For example, factors such as the development of macroeconomic conditions, future market conditions, unusual catastrophic loss events, changes in the capital markets and other circumstances may cause the actual events or results to be materially different from those anticipated by such statements. In no case whatsoever will Fulcrum be liable to anyone for any decision made or action taken in conjunction with the information and/or statements in this press release or for any related damages. Reproduction of this material in whole or in part is strictly prohibited without prior written permission of Fulcrum Copyright © Fulcrum Asset Management LLP 2024. All rights reserved.

Share this article

Share on facebook
Share on twitter
Share on linkedin
Share on whatsapp
Share on email
Your privacy

Cookies are data files that are stored on your computer or other smart device by a website’s server. Each cookie is unique to your web browser. It will contain some anonymous information such as a unique identifier, website’s domain name, and some digits and numbers. Cookies are useful as they allow us to recognise a user’s device and its preferences in order to ensure that our website works properly. By continuing to use this website, you consent to the use of our cookies.

 

You can find out the different types of cookies used on our website in our Cookies and Data Privacy Policies.

Necessary cookies