The coronavirus recession will be the first ever ordered by government decree, according to PIMCO’s Joachim Fels and Andrew Balls, but the extraordinary levels of fiscal and monetary support should help the global economy bounce back once the spread of the virus is brought under control.
Global economic adviser Fels and Balls – PIMCO’s chief investment officer for global fixed income – said the recovery is likely to be U-shaped, in their opinion, although there remain a number of unknowns about the virus.
“There is no precedent and thus no good playbook for the global recession that is currently unfolding,” said Fels and Balls.
“Recessions are usually caused by the interplay between severe economic and/or financial imbalances building up during the expansion and a typical late-cycle tightening of monetary policy, sometimes aggravated by a sharp increase in the price of oil.
“This time is very different because the underlying cause of the downturn is a truly exogenous shock that originated from outside the economic and financial sphere: a highly contagious new coronavirus that has been spreading fast in a globalised world since the start of the year.”
As the pandemic threatened to overwhelm health systems, governments around the world responded by “aggressively curtailing economic and social activity” to stop its spread.
This, they said, has already led to a sharp drop in aggregate output and demand in many Western economies in the latter part of March – as represented below by composite purchasing managers’ indices (PMI) data – which should continue as measures remain in place.
“Over the past 10 years, all these PMIs were largely range-bound between about 45 and 60, except for a brief dip in Japan’s PMI in 2011,” the pair noted. “Then, in March 2020, all four composite PMIs dropped significantly: the euro area to 31.4, Japan to 35.8, UK to 37.1, and US to 40.5.
“Thus, we are seeing the first-ever recession by government decree – a necessary, temporary, partial shutdown of the economy aimed at preventing an even larger humanitarian crisis.”
While the slowdown has been unexpected and sharp, there have been no major economic imbalances - limiting the number of legacy issues once the virus is brought under control.
“Consumers were less exuberant than in the previous cycle, firms hadn’t overinvested in capacity, housing markets – with a few exceptions – didn’t overheat, and inflation was generally low and stable,” said Fels and Balls.
While the speed and severity of the downturn has surprised many investors, so too has the reaction of policymakers and authorities to the coronavirus.
“Policymakers have been pulling out virtually all the stops in an attempt to keep the recession from turning into a lasting depression with mass bankruptcies and mass long-term unemployment,” said the pair.
Unprecedented monetary and fiscal support has been unveiled by governments and central banks, which in many cases exceeds that announced during the global financial crisis of 2008.
Nevertheless, while a deep recession is "inevitable" given the shutdown of major parts of the global economy, the robust response is likely to prevent a global depression and should help support economic recovery once restrictions are lifted.
As such, Fels and Balls expect that the global economy will transition from “intense near-term pain during the virus-suppression phase to gradual healing over the next six-to-12 months” once the spread of the virus has been brought under control.
PIMCO’s base case scenario remains for a U-shaped rather than a V-shaped recovery because the lifting of restrictions will be gradual and at different speeds for different sectors and regions. In addition, it will take some time to repair the supply chain and clear logistical and transport bottlenecks.
“As a consequence, following the nosedive in economic activity that is currently underway (the downward I in the U), we expect the bottoming process to last a few months after the virus is under control (the L in the U), before output and demand ramp up back closer to more normal levels eventually, helped by fiscal and monetary support (the upward I in the U),” they said.
There are two main downside risks to a U-shaped recovery, the pair warned: first, a prolonged L-shaped trajectory and, second, a recovery interrupted by relapse ("call it a W").
These two risks could emerge should either pandemic curve or should the default curve of highly leveraged cyclical corporates deteriorate.
“A prolonged stagnation would likely result if governments’ current suppression strategy turns out to be insufficient to significantly slow the spread of the virus, so that suppression measures have to be kept in place for longer than the six to eight weeks currently anticipated,” they said.
“With activity depressed for longer in this scenario, many of the more highly leveraged firms in the cyclical parts of the economy would likely default, feeding back negatively into jobs and demand.
“Conversely, even if the virus suppression is successful in the near term and a lifting of containment measures leads to a revival of economic activity, we may experience a second wave of contagion later this year that leads to renewed economic stoppages. A relapse following the recovery would likely be exacerbated by defaults of cyclical companies that survived the first wave.”