- COVID-19's impact on markets has differed widely across countries.
- Debate over what shape an economic recovery could continues.
- A realistic recovery scenario will likely take the shape of a 'kinked V'.
The patterns of COVID-19 infection are differing widely across countries and markets. This in turn affects economic outcomes. In this blog we reflect on these differing outcomes and what they might mean for the pace of global economic recovery. Governments around the world have taken different policy stances and strategies for handling the coronavirus pandemic, depending on their circumstances. In this blog, I do not comment on the political response - but make clear that the containment of the virus should be the upmost priority.
What have we seen so far?
There has been considerable debate as to what the shape of economic recovery might look like. Optimistic scenarios point to a rapid “V” shaped recovery, while more pessimistic viewpoints suggest a “U” or even an “L” shaped recovery. While such scenarios are useful in characterizing some of the key issues facing all economies affected by COVID-19, they are also simplistic – recovery patterns are trending differently across key markets (financial, non-financial and labor).
Variable trends across different markets will not combine in an even manner due to inherent differences in each market, their relative health pre-COVID-19 and the design and prioritization of government policy initiatives designed to help offset the health and economic crises.
The most realistic recovery scenario is shaped like a “kinked V” – an initial sharp decline in market activity, followed by a relatively swift bounce back towards pre-COVID-19 levels (once lockdown measures are eased). However, this bounce back won’t occur in full. Given the scale of the initial decline most markets will experience long term scarring, meaning that after the initial bounce back there will be an elongated period before markets return fully to pre-COVID-19 levels.
After examining a wide range of data across multiple market segments, differences between the presence and timing of the kinked-V can be seen most starkly in financial and labor markets. These are discussed in turn, but the essence is that in some financial markets the kinked-V has already manifested itself, meaning that they have largely returned to where they were before the pandemic. Labor markets, however, lag significantly behind with evidence from previous recessions illustrating that it may take as long as a decade for normality to return – if at all.
Financial markets: a fast paced forward looking reaction
Chart 1 below shows evidence of the kinked-V for US and UK stock market indices. Take the S&P 500 for example, following a sharp decline at the back end of Feb 2020 (around the time of the announcement of the Italian lockdown) the market has rallied significantly over the past few months and is now pretty much back to pre-COVID-19 levels. The FTSE has not recovered as strongly and has a slower more gradual upward trend.
Commentators have called out the loose linkage between stock market fundamentals and the economy. However, this is not clear cut. Stock market indices are forward looking, take a long-term view, are more sensitive to uncertainty than bad news itself, and many corporates are benefiting from government debt funded large-scale market support programmes. Coupled with weak returns in bond markets, and many businesses slashing costs to preserve earnings while revenues are falling, it’s no surprise that there is a relatively rapid bounce back in financial markets.
Labor markets: a slower lagged reaction
The labor market position contrasts strongly. In their current COVID related research, Robert Hall and Marianna Kudlyak have observed that the unemployment rate has typically recovered by 0.85 percentage points per annum following a recession in the US. If this was the case the spike in US employment (14.7% in April 2020 shown in Chart 2 below) would take more than a decade to get back to its pre-COVID-19 level and present something closer to an “L” shaped recovery.
In the more optimistic outcome - the “V-shape”: workers’ expectations regarding a rapid return to work are fulfilled and only a small proportion become long term unemployed. In the pessimistic outcome - the “L-shape”: a high proportion of workers who are temporarily furloughed are not recalled to their pre-COVID-19 job roles. This means they must re-enter the labour market, spend time on job search and possibly even re-skill. This outcome would lead to a much longer recovery timeline.
Perhaps the most likely outcome is somewhere between the two. Initial, tentative signs of a bounce back can be seen in the US unemployment data. In Chart 2, 2020 data for May and June show a rapid reduction in unemployment levels of 13.3% and 11.1% respectively – a +3% shift even with lockdowns still in place in many US states. This is well ahead of the Hall and Kudlyak estimates.
However, a combination of a broad range of factors might limit this bounce back and point to a kinked-V recovery more in line with Hall and Kudlyak. Factors driving the slower paced recovery could be: employer cost-cutting measures leading to job destruction, fundamental changes in working process needed to prevent the spread of COVID-19, the structurally weak state of labor markets and household earnings growth going into the COVID-19 crises, the time-lags and costs associated with re-skilling and a sharp adjustment in how workers and employers use their workforces (e.g. more working from home, streamlined operational processes etc.).
The contrasts between the pace of adjustments in financial and labor markets are stark, but perhaps also unsurprising. While stock market indices seem to be recovering quite quickly, the labor market effects could take a up to a decade to be fully realized. The question then becomes: what scale of feedback loop is there between these two markets? A weaker labor market will put further downward pressure on product and service demand which could in turn lead to hysteresis, weaker equity markets, lower business earnings and reduced overall economic growth.
While the risk of a full downward employment-demand-price spiral (a hysteresis type effect) is relatively low, it could manifest itself in lower incomes for poorer households and widening inequality which was one of the key outcomes of the 2008 crisis. A second-round feedback loop into financial markets should also not be ruled out as this picture becomes clearer. Policy makers should seek to avoid this outcome and invest now in bolstering labor market opportunities for those whose jobs and earnings potential are negatively affected by the COVID-19 crisis.