Worldwide central bank policy responses to the coronavirus crisis will combat recession and deflation but will have significant repercussions after “the lost economic year” of 2020, according to strategists at Saxo Bank. 
Recent weeks have seen central banks around the world announce dramatic loosening of monetary policy in an attempt to ease the economic impact of the coronavirus pandemic, with interest rates taken to historic lows and massive quantitative easing programmes rebooted.
In Saxo Bank’s second-quarter outlook, chief economist and chief investment officer Steen Jakobsen said the virus outbreak set three major macro impulses in motion: a global demand shock, a supply shock, and an oil war forcing prices to multi-year lows.
“The triple hit to the global economy almost guarantees 2020 will be a lost economic year, with policymakers needing to pull out all the stops to address a real, global recession” Jakobsen warned.
The economic effects are already starting to be revealed in the data. In the UK, claims for the universal credit benefit welfare jumped by 1 million in the past two weeks, up from 100,000 usually expected in the same period.
In the US close to 10 million Americans filed for unemployment and non-farm payrolls fell by 701,000, according to figures that capture just a fraction of the layoffs that occurred in March.
Central banks stepped in
The fact that coronavirus has caused large parts of the economy to shut down makes a global recession inevitable but central banks stepped in with looser policy.
“Central banks try to move in quickly with ‘support’ in the form of rate cuts and liquidity provision,” Jakobsen said.
“We have full confidence that when we leave 2020 the policy measures taken will prompt strong inflationary forces that even point to the risk of stagflation.”
But the CIO noted that whilst the central bank support will be good for the cost of financing liabilities, it does not help equity or credit prices on the asset side.
“Here, the ‘crowded theatre with a small exit’ metaphor applies, with everyone selling to deleverage across the board,” Jakobsen added.
As markets continue to sell off, Steen anticipates more volatility and a cleaning out of valuation models for private equity and other high-risk assets that are “predicated on low interest rates, central bank intervention and the somewhat naïve assumption of multiples that can go up forever”.
He drew an analogy to the global economy as a “financialized super tanker” fueled by credit and low interest rates, previously heading towards the “port of deflation”, but now changing course, heading to the “port of high inflation”.
Politicians taking reins from obsolete central banks
With the central bank policy tool box empty, Jakobsen believes the world is on the verge of full Modern Monetary Theory (MMT), where “politicians take the reins from obsolete central banks and expand spending without constraint from debt issuance (true money printing)”.
“The UK budget was an early indication of this and was drawn up even before the coronavirus impacts began to crystallise” he claimed.
Jakobsen highlighted that after World War 2, the Marshall Plan saw the US issue “infinite credit” to a war-torn Europe in order to create demand and help the destroyed continent rebuild. “Governments will create money far beyond any on- or off-balance sheet constraint,” he argued.
As a result, the chief investment officer at the said the Danish investment bank’s portfolio allocation will focus on being long inflation and long volatility.
How currencies will fare
Saxo Bank head of FX strategy John Hardy said: “The trigger of this credit crunch is of course the coronavirus outbreak, but the severity of the fallout is a product of a financialised global system made so incredibly fragile by leverage and the QE medicine used to alleviate the last crisis.”
“This time around, due to the severity of the issue, policymakers have no qualms about throwing orthodoxy out the window and printing infinite amounts of cash to drop on the economy.
“The most interesting theme in progress will be the scramble to find alternatives to the US dollar,” he added, referring to the fact that most emerging markets economies owe debt in US dollars.
“This crisis is proving even more clearly than the last one that the fiat-USD-as-global-reserve currency system is dysfunctional beyond all attempts to salvage it” he said.
“Complicating the search for an alternative is the fact that in a deglobalising world, Bretton Woods-style arrangements will prove very hard to come by”.
Hardy said Saxo Bank is convinced that the policy medicine of MMT will eventually be engaged on sufficient scale to avoid deflationary outcomes and, that if correct and if inflation stages a sharp recovery, even if it starts to “run hot”, a key metric of relative currency strength would be the real interest rate — how much the CPI exceeds the policy rate at various points on the sovereign bond curve.
“Those countries overheating the printing press and running ugly, negative real rates will eventually find their currencies weakening rather than benefitting from the initial push of fiscal stimulus,” he added.
Demographics could structurally depress equity valuations
Christopher Dembik, head of macro analysis at Saxo Bank, said the economy has been in this state before, referring to the secular bull market of the 1950s and early 1960s.
During most of that period, the Federal Reserve followed a ‘lean against the wind’ monetary policy that ultimately lead to the Great Inflation, where too-loose monetary policy had a dramatic effect on the economy and inflation.
“In 2020, the global economy is facing a much more difficult challenge that may lead to similar consequences if not controlled: stagflation,” he said.
“The huge fiscal stimulus that is coming is likely to increase inflationary pressures in months to come. We are moving from ‘bailout the banks’ in 2008 to ‘bailout SMEs and anything else’ in 2020.”
Dembik said that contrary to common thinking, Saxo believes the coronavirus is not a temporary market shock, claiming that Covid-19, along with demographics, will precipitate the end of the secular bull market.
He believes the baby boomer generation, a population of about 76 million people in the US, could structurally depress equity valuations in the coming years, as they transition out of the workforce and draw down on retirement funds.
“Demographics will disrupt not only the stock market — they’ll disrupt the financial sector as a whole” he argued.
“Retirement of the baby boomers happens at the worst time ever for the stock market, especially when other structural factors are already affecting the macroeconomic outlook,” he concluded.