COVID-19: A V-shape or a U-shape? Policymakers can decide

| 31 Mar 2020

In this commentary, Seema Shah, Chief Strategist, Principal Global Investors, takes a closer look at government and fiscal stimulus in response to COVID-19.

With COVID-19 requiring the slowing of economic activity in order to slow its spread, a sharp contraction in growth is all but guaranteed. Some forecasters are expecting it to be the deepest growth shock in a century. Yet, assuming the spread of coronavirus is contained within the next few months, the duration of this economic shock can still be manipulated—policymakers have the power to make this recession one of the briefest.

Central banks have been typically active, announcing policy rate cuts, new rounds of asset purchases, and dusting off crisis-era monetary tools. Yet, with interest rates already so low and quarantine measures limiting any potential increase in demand, central bank actions have been less economic stimulus and more liquidity provision. As a result, the onus has had to fall on fiscal policy to alleviate the economic hardships and prevent this episode from becoming a long and enduring depression.

As with antivirus efforts, time is of the essence. The faster governments put in place measures to combat recession, the more successful it is likely to be. Governments have, for the most part, recognised the urgent need for fiscal stimulus. It may feel like months, but the first worrying wave of infections hit Italy just five weeks ago and fiscal spending plans are already being announced on almost a daily basis. By contrast, during the Global Financial Crisis (GFC), the U.S. introduced a fiscal stimulus package some four months after the crisis started.

Governments also seem to appreciate that, with a shock of this size, they should throw caution to the wind and spend massively. Japan, already struggling under the weight of its 240% of GDP debt load, appears set to introduce fiscal spending worth 5.5% of GDP. The United States has agreed a $2 trillion stimulus deal, worth around 9% of GDP, dwarfing the $800 billion fiscal package passed in 2008. Even Germany, the staunchest of fiscal hawks, has introduced meaningful spending plans.

Protect productive capacity

A sizeable and timely fiscal package is important, but it also needs to be targeted at areas where stimulus will harvest the economy’s productive potential, thereby enabling a rapid recovery to get underway once containment measures are eventually lifted. This could be the route to a V-shaped recovery.

Keeping businesses alive through this crisis and making sure workers continue to receive their paychecks is the number one essential. In one of the most innovative packages so far, the UK government has pledged to pay 80% of the salary of workers who are furloughed rather than fired, up to a maximum of £2,500 ($2,900) per month. The duration of this emergency measure will be a minimum of three months, and it can be backdated to March 1. For a temporary period, the UK government is, for all intents and purposes, essentially nationalising a large part of private sector employment and becoming the payer of last resort.

By directly supporting businesses through the duration of the coronavirus shock in this manner, not only is the UK government relieving employers of one their largest fixed costs, thereby reducing the chances of bankruptcy, but they also mitigate the potential damage to the labour market and therefore encourage productive capacity to remain. Once social distancing comes to an end, companies will be ready to meet any bounce back in demand, shortening the duration of the economic downturn.

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Other governments have taken slightly different approaches. While these are certainly helpful, they do less to protect productive capacity, raising the chances of a U-shaped recovery. For example, supporting small and medium sized businesses via cheap credit will stop many from going bankrupt and having to let go of employees. But some businesses will understandably be reluctant to take on additional debt, at any cost, during this tough economic time. One innovative aspect of the U.S. fiscal package is that loans to small businesses will become grants if they use the money to pay employees.

Direct cash handouts are being provided to individuals in Hong Kong and Singapore, and the U.S. fiscal package will provide $1200 to each adult whose annual income falls below $75,000 (or $150,000 per couple). The importance of this measure is evident when you consider that, according to Federal Reserve data, around 40% of U.S. households would struggle to put together $400 for an emergency expense.

Yet, it also implies that a cash gift of this size will likely be saved for groceries, medicine, or bills—it will not help boost consumer spending meaningfully. It also doesn’t aid businesses, nor prevent workers from being laid-off. Productive capacity isn’t protected and the multiplier effect is minimal.

Of course, no fiscal plan is a magical solution. No matter what governments do, there will certainly be a deep economic shock. But a timely, sizeable and correctly targeted fiscal package could be the difference between a V-shaped recovery or a U-shaped recovery.

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At the same time, a successful fiscal stimulus package, coupled with aggressive central bank action, still doesn’t necessarily imply that risk markets have reached their trough. While policymaker action is absolutely crucial, the key requirement for the market rout to stop is investors need to believe the virus is behind us. Daily infection rates need to peak.

On this factor there are perhaps some hopeful signs from Italy where confirmed coronavirus cases and deaths tentatively appear to be plateauing, suggesting that many other parts of the world should see infection rates peak within the next few weeks.  My fingers and toes are crossed.

Seema Shah is the Chief Strategist at Principal Global Investors. 

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