Flattening the recession curve

The global economic outlook has centered around the depth of the initial economic contraction following the coronavirus lockdowns, the pace of re-openings and the collateral damage along the way. Financial markets have been seduced by extensive asset purchases, while governments are pouring money into their ailing economies. Will it be enough? Read the Global and Financial Markets Overview from the Nordea Economic Outlook, The Road to Recovery.

This article is the Global and Financial Markets Overview from May 2020 issue of the Nordea Economic Outlook, The Road to Recovery. Read the full report here.

Nordea Economic Outlook cover May 2020

Key takeaways

Since the January edition of this publication, we have made two interim global outlook updates as the coronavirus pandemic evolved and more and more countries went into lockdown. Starting from a pre-coronavirus forecast for the world economy of just below +3% for 2020, we adjusted downwards in March to -1%, again in April to -2% and now we expect -3%.

With many countries starting to ease restrictions, the lowest activity levels are now behind us. Focus has shifted to the pace of re-openings and will later turn to the proportion of the jobs lost that are recovered when the economies have fully re-opened. The latter will largely determine the degree of economic policy accommodation needed on the other side of the re-openings.

Meanwhile, we see a number of risks, apart from the virus, with the potential to affect this economic outlook: China’s recovery has been slow even after the re-opening; the US-China trade war is threatening to escalate; the US presidential election is drawing closer; post-Brexit trade negotiation deadlines are looming and EU politics is just a mess.

Financial markets are calmed by the big central banks’ promise to do whatever it takes, which is keeping yields low for the foreseeable future. Oil prices are also likely to remain low, while we believe a storm is brewing for the USD.

US numbers are staggering

In the US, the negative consequences of the Great Lockdown will be most pronounced in the second quarter, when we expect a decline in GDP of 31% quarter on quarter in annualized terms.

On the demand side, private consumption – the main growth driver in recent years – will take the biggest hit, though business investment and exports will also decline significantly and likely stay depressed for longer than private consumption.

Employment dropped by 20.5 million in April, and the unemployment rate rose to 14.7% – the highest since the Great Depression. Unfortunately, unemployment numbers will get worse during the second quarter.

Hopes of a decent recovery in the second half of the year hinge on fast re-hiring, supported by the fact that 78% of the layoffs in April were considered temporary. Moreover, Congress’s Paycheck Protection Program (PPP) incentivises businesses to keep employees on the payroll and re-hire those laid off.

Hence, we expect a relatively rapid decline in the unemployment rate when the lockdowns end, although unemployment at the end of 2020 will remain above pre-coronavirus levels due to bankruptcies and lingering uncertainty. In GDP terms, we expect a 5% contraction in 2020, with risks tilted to the downside.

Listen to the podcast, “Risks about in the US and UK outlook,” with Analyst Morten Lund.

Euro-area asymmetry

The Euro-area economy contracts faster than the US economy, by 9% in 2020, and recovers only partially the year after, with a growth rate of around 6%. In the current quarter, we expect economic activity to be about 18% lower than before the lockdowns. This unprecedented decline is a direct result of the drastic measures put in place to contain the spread of the virus, bringing parts of the Euro-area economy to a standstill for more than a month.

While all Euro-area countries have been hit by the virus, the economic damage and subsequent rebound will be asymmetrical. The first obvious reason is the different timing and extent of the virus’s spread. Italy was hit early and hard, putting it in a weaker position than Germany, which has managed to maintain a higher level of activity throughout the pandemic.

Differences in the structure of economies play a large role in determining how quickly they will be able to recover once the virus is under control. Unlike previous crises, the service sector is the hardest-hit in this crisis. As a result, countries such as Italy and Spain that depend more heavily on services, especially tourism, will struggle more to recover, as many restrictions on the sector are likely to remain. Germany, on the other hand is less dependent on services, and

manufacturing will most likely be able to recover more quickly. These differences are reflected in our GDP forecasts.

Unfortunately, the countries that are set to suffer most from the pandemic are also the countries with the least fiscal firepower. Governments have launched comparable support packages targeting households and businesses. But the differing sizes and expected effectiveness of the support will contribute to further divergence of economies, unless a powerful common response can be coordinated at the EU level. Worries about debt sustainability in countries like Italy may restrain the government now and in the coming years, although fiscal easing is even more necessary there than elsewhere in the Euro area.

Despite extensive support packages aimed at preventing widespread layoffs, the labour market is set to deteriorate rapidly. About a fifth of the workforce has applied for short-time working schemes across Germany, France, Italy and Spain. This shields workers from losing jobs like they did initially in the US and may accommodate a faster rebound. Yet we may still see a dramatic rise in unemployment, with a delay. This will push down wage growth and dampen inflation over the whole forecast horizon.

For more, listen to the podcast, “Euro area outlook: An asymmetrical recovery,” with Chief Analyst Jan von Gerich and Analyst Inge Klaver.

Charts showing US and Euro area economic contraction

EU politics still a mess

EU politics haven’t brightened, and political disagreements between EU countries are wide. Italy feels it was left alone in the early stages of the crisis, when it was asking other EU countries for help. Partly as a result, the support for the EU has suffered in Italy.

More importantly, the collapse in activity and the cost of repairing the damage to the economy will push government debt levels much higher. Already this year, Italian gross debt relative to GDP will exceed the Greek levels at the time of its first bailout in 2010. The ECB alone may not be able to keep the Euro area together, especially as the limits of its mandate are increasingly being questioned in Germany.

Several measures to alleviate the acute phase of the corona crisis have already been agreed on at the EU level, but the discussions on the so-called recovery fund are only starting. The currency area will probably be able to come out of this crisis in one piece only with the help of more risk-sharing between the countries and further steps towards a tighter union. How that can be done without causing serious disapproval among sceptical voters remains to be seen.

Risks Bremain

The UK economy will likely take one of the hardest hits. Besides draconian lockdown measures, much of its vulnerability is linked to the years of Brexit uncertainty – a factor, that did not vanish when the UK officially left the EU. Negotiations on the future relationship remain a major obstacle, and the deadline for extending the transition period expires at the end of June. Time is an issue. Trade deals normally take years, and the two parties realistically only have until October to make a deal (assuming no extension).

China’s slow recovery

Another risk to the recovery story comes from China, where the post-lockdown recovery has been far slower than expected. The challenge is no longer production bottlenecks but insufficient demand. Fear of second wave infections as well as expectations of income loss keep consumers at home with their wallets closed. External demand offers no comfort either. A record-high number of people are expected to be out of jobs. Given China’s lacklustre social security system, this creates a vicious circle and further suppresses consumption. Thus, we expect growth by a mere 1% this year, with significant downside risks.

For more, listen to the podcast, “China’s slow road to recovery,” with Chief Asia Analyst Amy Yuan Zhuang.

Charts showing China's slow recovery and diverging debt levels in the Euro Area

The US-China trade war risk is back

Moreover, the pandemic casts a shadow over the phase one trade deal between the US and China. The relationship has cooled, with both sides criticizing each other on how the pandemic has been handled. Trump will likely maintain a tough stance on China ahead of the election in response to Americans’ increasingly negative views on China. The trade deal could also be jeopardised by China struggling to meet the agreed sharp increase in imports from the US this year.

US election in remembrance of 2016

Trump vs Biden will dominate the media picture as the November presidential election approaches. Remembering the surprise on election day in 2016, financial markets will be on high alert this time. Conventional election wisdom suggests that Biden is a clear favourite, given that the economy is in a recession, Trump’s approval rating is low and Biden is leading the polls. Thus, although surveys indicate that Americans themselves believe Trump will win – perhaps due to the 2016 surprise – we also have a Biden win as our main scenario.

Fed going all-in

The Fed has responded swiftly to the virus shock, implementing the 2008 playbook – with add-ons – in weeks rather than months.

Besides slashing rates to zero and introducing open-ended QE, the Fed has introduced a long list of liquidity and credit facilities. These aims to support the flow of credit to households and businesses.

Looking ahead, we do not see any rate changes in our forecast horizon. The bar is thus high for any future rate hikes, given the large negative output gap and the low inflation. Any rate cut is also unlikely, as the Fed has clearly refused that option on several occasions. Instead, focus will be on the Fed’s balance sheet.

Although these asset purchases will continue throughout at least 2020, they will be (and are) tapered in response to decreasing market disruptions. Still, overall asset purchases for 2020 will be unprecedented, totalling close to the same amount as the three former QE programs altogether. On top of this comes lending facilities and credit purchases, which could result in the balance sheet being almost tripled by the end of 2020, according to our estimates.

ECB unlimited

While the ECB got off to a slightly bumpy start when President Christine Lagarde stated, “We are not here to close spreads,” leading Italian bond yields to rise, it soon proved that the promise to do whatever it takes remains in place.

The temporary Pandemic Emergency Purchase Program (PEPP), with an envelope of EUR 750bn, is one of several new inventions designed to keep bond yields low, thereby allowing governments to support their economies without considering the financial market repercussions. Moreover, this program allows for flexibility with regard to maturities, issuer limits, capital key and credit quality. We expect the PEPP envelope to be doubled during the year.

Liquidity operations have also been expanded and could be expanded further going forward. Banks can now access ECB liquidity more cheaply, for longer maturities, with fewer requirements on their use of the money and against weaker collateral.

Questions regarding the purchase programmes have been raised by the German Constitutional Court, but we doubt that will stop the ECB in the short term.

Bond yields mostly under control

The volatility in long bond yields, especially in the US but also in Germany, has receded. While bond issuance needs have exploded, which should put upward pressure on bond yields, central banks are buying bonds in unprecedented magnitudes and are determined to keep also long yields low. This is especially the case in the US, where the Fed is buying Treasury securities without limits.

The downside looks limited as well. While the market is pricing in a clear risk that the ECB will cut rates again and has toyed with the idea that the Fed could reconsider its negative stance on cutting rates below zero as well, neither central bank is keen to lower rates further. If short rates have indeed found a bottom, that should limit the downside for long yields as well. Further, especially the Fed would prefer the yield curve to slope upwards, so it is not eager to push longer yields much lower compared to current levels.

In the Euro area, ECB interventions do not guarantee stable bond spreads. It is questionable whether the ECB would even want to take away all volatility and push spreads sharply lower, as such actions would take away pressure from the governments to implement more Euro-area/EU-level measures to tackle the corona crisis. The ECB has been calling for more common measures from the governments and does not want to be left alone holding all the risks. Spreads could still easily widen from current levels, driven by higher Italian bond yields.

FX – USD still strong, but for how long?

The USD remains fairly strong on all measures as the corona crisis re-ignited the need for already semi-scarce USD liquidity around the globe. The Fed has taken a whole string of actions to ensure that everyone in need of USDs has gotten them, which has worked to calm markets. Once we are out of the corona mess globally, we reckon that the USD could be weakened materially against most other major currencies.

There are two major sources of USD liquidity for international market participants. First, the Federal Reserve, which has done everything possible to provide USDs to the market, and second, global trade, which is mostly conducted in USDs. Global trade remains very subdued, which is why USDs don’t float around the global system at the usual pace. A rebound in global trade is the missing link before the USD can weaken materially against, for example, EUR and Scandinavian currencies. We see such a rebound towards the end of the year and into 2021.

Meanwhile, we struggle to get really upbeat on the EUR’s behalf as the ongoing political turmoil in the Euro area remains a drag on the EUR potential. Ultimately, we expect the ECB to be allowed to continue its material bond purchases, but until the case between the ECB and German Constitutional Court is resolved, it is unlikely that markets will buy EUR in size.

Oil is the new low for long

The oil market reflects the dire straits the global economy is in. An unprecedented decline in oil demand has kept the oil price near its lowest levels since 2004 for more than two months already. Oil exporters’ drastic production cuts can do little to bring the market back in balance. A return of the oil prices to a sustainable upward path requires a more vigorous reopening of the global economy and a subsequent recovery in demand. The futures curve currently suggests only a return of Brent price to USD 40/bbl by the end of 2021. Our expectations of a rather slow return to normality after the current shock don’t give us a reason to be more optimistic than that about the future oil price trajectory.


Chief Analyst Anders Svendsen

Chief Economist for Finland Tuuli Koivu

Analyst Morten Lund

Analyst Inge Klaver

Chief Analyst Jan von Gerich

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