May 7, 2020

Fathom’s Recession Watch 07.05.2020

by Fathom Consulting.

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Headlines

  • European Commission spring report makes the case for a sharp recovery underpinned by demand and a limited rise in unemployment
  • Bank of England also firmly in the V-shaped recovery camp; minutes strike a dovish tone with two MPC members favouring an increase in QE purchases
  • German factory orders drop 16% YoY
  • The US ADP employment report plummets by 20M
  • European services PMI fail to rebound in April
  • A V-shaped recovery increasingly consensus among both economists and investors. In markets, investors seem to believe that downside risks may have been minimised through central bank liquidity injections

The European Commission has released its spring economic forecasts. The main headlines include a significant drop in GDP driven primarily by falling consumption. Relative to other forecasts from international organisations and consensus, the European Commission is both slightly more bearish in 2020 and slightly more optimistic in 2021, while emphasising a very high uncertainty and that downside risks outweigh the upside. Relative to our expectations, we would argue for a slower recovery in growth both globally and in the Eurozone, as laid out in previous editions of this newsletter, closer to scenario iii put forward by the EC (section 3 of the report).

Among more specific areas of disagreement, we find the projected 2.1 percentage point increase in unemployment  to 9.6% (and subsequent drop to 8.6% in 2021) amid one of the largest drops in economic activity somewhat wide of the mark even assuming a generous degree of effectiveness in the policies put in place to fight this pandemic. According to the Commission, the cost of these policies accounts for the bulk of the significant deterioration in public finances (budget balance expected to drop to -8.5% from -0.6%). However, a 5pp improvement in the Eurozone budget deficit as early as 2021 seems somewhat optimistic, as the experience from 2008 leads us to believe that ‘temporary’ measures during periods of crisis tend to become permanent.

The BoE this morning announced its policy decision (no change) along with a series of new reports: the Minutes; the Monetary Policy Report and an Interim FSR. The Bank also provided ‘an illustrative scenario’ for the UK economy which is consistent with a V-shaped recovery while also acknowledging the prevalence of downside risks and various conditions that could lead to a more sluggish recovery.

On the monetary policy front, there was no change, with rates held at 0.1% and the increase in the stock of QE held at £200 billion. However, the decisions had a clear dovish tilt as two members (Haskell and Saunders) wanted to announce a further increase in the stock of QE of £100 billion, taking the total COVID-19 response to £300 billion. At current rates, they will have bought the extra £200 billion by the beginning of July.

Shorter-term data in Europe continue to surprise on the downside, with German factory orders contracting 16% YoY in March, an ominous sign for German exports and an economy extremely reliant on trade.

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Moreover, the hoped for rebound in the Spanish, French and Italian April service PMIs failed to materialise, with all three measures hovering around the single digit territory.

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Across the pond, the ADP job report showed a drop in employment of over 20M as an advance taster for April’s employment report due Friday (we expect a 25M decline).

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Looking forward, conditions in Europe and more broadly are set to improve as restrictions on mobility have clearly started to ease.

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The worst may be behind us in terms of the absolute size of the shock, although some important questions remain about the cumulative damage that world economies will suffer from this pandemic. Consensus among economists seems firmly in the camp of a swift return to something very close to normal within the next twelve months. A couple of recent studies also suggest that similar expectations might be currently priced into markets.

In ‘Inside the Mind of a Stock Market Crash’ the authors use survey data to show how revisions to investors’ short-term expectations of market returns and economic fundamentals appear broadly uncorrelated to revisions about the longer-term outlook for markets and the economy. Another paper shows how sentiment measures derived from the StockTwits website have seen a broad rebound back to the pre-market correction levels of February.  What the papers do not address is whether any of these sentiment indicators are contrarian or leading signals of market prices. Given the swift rebound in markets, I suspect the answer might be closer to the former than the latter.

One theory that we are eager to test over the coming weeks is whether there is a difference in the performance of assets with a greater sensitivity to changes in market liquidity than economic fundamentals. The idea being that assets highly sensitive to market liquidity may have seen a sharper rebound as they benefit more directly from central bank largesse relative to assets which are more closely linked to macro fundamentals and remain more uncertain.

For example, we showed in the past how equity market returns have been increasingly correlated with the ebbs and flows in our Fathom Liquidity measure (FLiq).

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Conversely, something like the copper-to-gold ratio, which is much more closely related to fundamental economic trends (e.g. a measure of IP derived from our leading indicator – FLI) than liquidity, has shown no clear signs of a rebound.

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Overall, preliminary evidence would suggest that the sharp market rebound from the March lows has been driven primarily by central banks’ swift actions in averting a liquidity crunch. If true, there remains a question about whether central bank actions will be enough to completely discount an economic reality that is still at best uncertain, or whether economic fundamentals will eventually reassert themselves in equity markets. The jury is still very much out, but the pace and the overall shape of the recovery will be the key factors to watch.

Interesting reading

Fathom forecast scenarios

Economic forecasting is difficult even at the best of times. It is particularly difficult today. At Fathom, we think in terms of scenarios and seek, wherever possible, to downplay point forecasts. A severe contraction in global economic activity through the first half of this year is inevitable – we are facing what French economist Pierre-Olivier Gourinchas has referred to as a ‘sudden stop’, something the global economy has never experienced before. But how long will it last? In our Global Economic and Markets Outlook for 2020 Q1, we set out three scenarios. The first was a V-shaped recovery, in which the number of cases peaks within months and begins to decline, allowing activity by the end of this year to return to normal levels. The second was a U-shaped recovery, where the virus continues to spread, depressing activity until a vaccine is found, but the economic and financial market infrastructure remains in place to deliver a strong rebound when that occurs. The third was an L-shaped recovery. Since we finalised our forecast on 17 March, a number of major economies have placed more severe restrictions on movement, and imposed a temporary shutdown on more industries than we had thought likely. This more aggressive action has caused us not only to anticipate an even sharper contraction in economic activity in the first few months of this year, but to increase the weight we attach to a V-shaped recovery. At the same time, we have also increased the weight we attach to our more severe risk scenario, making the outlook somewhat bimodal. In the event that COVID-19 returns with equal or greater vigour once restrictions that are holding back economic activity are lifted, then a

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