Nomura special report
A world after furloughs, face masks and fear
The world remains in the grip of Covid-19, but this will not last forever. At some point in the not too distant future, the fear of this pandemic will most probably dissipate through some combination of effective treatments, vaccines and herd immunity. On one hand, Covid-19 has been an extraordinary economic shock. It has been so abrupt, many economies shrank by an annualized 25-40% in a single quarter. It has even caused the deepest global recession in peacetime since the Great Depression.
On the other hand, the pandemic presents an opportunity for change. Decisions made during a crisis can shape the world for decades to come. This could also be a blessing in disguise in uniting efforts to tackle climate change, with the financial system and corporate social responsibility playing a much more powerful role. Since most of the world is now working from home, the move to digital technologies has also been expedited, serving as a catalyst for more dynamic change.
As we elaborate further into this article, regarding a global new order, we are unfortunately not very optimistic. Covid-19 is expected to further undermine the capacity of the US to lead on international economic policy. Additionally, the outcome of the upcoming US presidential election is unlikely to have a positive impact on US-China relations. Deglobalization could continue through a diversification of production away from China, international immobility of people and countries prioritizing self-sufficiency and national security over efficiency. The medium-term growth path for EM has also become more challenging.
There are four broad issues affecting near-term US-China dynamics, including implications from the upcoming US election: trade and economic integration, tensions over national security/technology, matters surrounding human rights, and Covid-19. The first three are also likely to remain structural challenges for some time. The relationship between technology and national security puts limits on economic integration, with the recent developments around 5G serving as an important reminder that separate spheres of influence across technology will likely continue to develop.
Over the long term, the relationship will likely be defined by how tensions over national security, technology, human rights and trade affect the ability of the US and China to realize at least some potential benefits from a degree of integration and to cooperate to resolve common concerns.
Deglobalization may gain some momentum from the Covid-19 pandemic, but the pace is likely to remain slow. On one hand, globalization has significantly boosted global productivity and narrowed cross-border gaps over the past five decades. On the other, it has also increased the rift between the social classes, especially within developed economies. Deglobalization may alleviate some woes, such as worsening inequality, but it could come at the cost of impairing productivity, raising prices, slowing the growth of emerging markets (EM) and triggering even worse regional conflicts. The impact of Covid-19 is likely to be felt especially by those countries heavily reliant on tourism and migration as a result of the immobility of populations.
Most economists agree that globalization increases economic growth, raises living standards, lifts poor countries out of poverty, and brings about net gains to society, but globalization also unambiguously creates winners and losers.
We now believe a protracted pandemic is likely. Countries may only reopen slowly, amid much stricter constraints on the flow of individuals rather than the flow of goods. If people refrain from travelling abroad, the adverse impact would likely be first seen in countries that are heavily reliant on the tourism industry, and thus likely to suffer from a slower economic recovery and smaller services surpluses than those less reliant on tourism.
Since World War II, the US has played a leading role in shaping the way the global economy functions. It has also helped guide the system of “liberal order” through large structural changes such as the emergence of China as a major power. However, in recent years, the capacity and/or willingness of the US to provide that leadership has been declining. The rapid increase in the integration of the US into the global economy in recent decades coincided with a period of rising economic inequality.
Covid-19 could further undermine the capacity of the US to lead on international economic policy, given its response in containing the virus compared to other countries. Furthermore, the aftermath will likely significantly limit the capacity of the US government to focus on international issues. Currently, no other country seems able to step into the role that the US has played since the end of World War II, thus we potentially face a period without strong global leadership, particularly one that is necessary for global policy reform.
Sizeable fiscal loosening has been deployed globally to support economies during the crisis and, as a result, government debt is set to reach unprecedented peacetime levels. Contingent liabilities from government guarantees and loans may yet be called upon too, adding to sovereign debt. Some countries have sufficiently low debt, such as Germany, the Netherlands and Sweden, while others are commodity-rich, like China and Australia; thus, GDP ratios in these countries are likely to remain below 75%.
There are a number of reasons we are less worried about the rise in government debt as a result of Covid-19 than the global financial crisis, including the likelihood that interest rates will remain lower for longer and that rising debt has been a consequence rather than a cause of the crisis. Still, a combination of government responses is likely to be necessary to address the rise in debt.
In the near term, the sharp drop in oil prices (notwithstanding its partial rebound) should dominate any upside inflation pressures emanating from the prices of some food and high-demand items. Indeed, headline inflation has already fallen below 1% across the G7, and is below zero in Canada, Italy, Spain, Portugal, Greece, Ireland, Sweden and Switzerland. However, the jury is out on the longer-term inflationary effect of the virus. Some argue that an eventual rebound in supply after lockdown measures are lifted, combined with sharp rises in unemployment and falls in wages will be disinflationary – possibly even deflationary. Others say that the negative shock to supply will raise inflation when demand returns.
The disinflationary theme should continue to play out, largely the result of commodity price moves, but also as shuttered businesses fight for cautious consumers as lockdowns are lifted. A year hence, inflation should be forced up by energy base effects. Further ahead, there is greater uncertainty, however. It is our view that negative output gaps will prove persistent, and that through a (possibly weak) Phillips curve relationship, central banks (CB) will generally struggle to impart enough stimulus to bring inflation up to target.
Unconventional Monetary Policy (UMP) needs a new name, for it has become decidedly conventional. The distinction between CBs and governments has blurred, until further notice, and perhaps permanently. We judge the risk of CBs losing autonomy and undermining the value of national currencies to be low, at least for developed markets (DM). However, in many EM countries, CBs have moved from combating UMP spillover effects to joining the party and trying it out for themselves.
UMP has brought stability to markets and economies in crises. It has helped to cut off the tail risk of negative wealth and confidence effects spilling back onto the real economy and kept rates low. However, this has not been without risks: build-up of government and corporate debt is potentially contributing to moral hazard and asset bubbles in other markets, creating zombie companies and impacting productivity, while negative interest rate policy has compressed bank margins and profitability, and worsened wealth inequality and intergenerational equity issues.
Moral hazard occurs when excessive risk-taking is encouraged by agents who are either fully or partly insulated against the consequences of their actions, usually by taxpayers or the central bank. While broad-based economic rescue plans such as those seen in response to Covid-19 will inevitably generate some moral hazard, the key differences between this crisis and the GFC should limit such bad incentives.
Private entities now know that they can rely on being bailed out when natural disaster strikes. That, in turn, could feed a process of greater risk-taking, deteriorating credit quality and ultimately greater credit risk differentiation by investors in the long run. These are potentially important long-run costs of moral hazard, but the fact that high debt was not the root cause of this crisis is an important feature that should limit the extent of these repercussions. Acting quickly and aggressively at the expense of moral hazard concerns was, in our view, the right thing to do in response to what has been a unique global demand and supply shock.
We expect the pandemic to result in less global trade and lead to smaller global current account imbalances. The significant increase in public sector borrowing driven by the large scale of fiscal stimuli in response to Covid-19, in this context, should be offset by increased net savings in household and corporate sectors, although we would still advise caution for some EM countries (and possibly the US) that may be vulnerable when restoring deteriorated government fiscal balances. A narrower global imbalance, with net savings of private entities offsetting expanding government deficits, should lead to a lower natural rate of interest than before the pandemic.
Through our analysis, it is likely that global imbalances will be narrower and that net savings of private entities in major economies will expand, implying that we will have a lower natural rate than before Covid-19. If this is the case, it would once again become difficult for CBs, as it would further narrow the gap against the effective lower bound of policy rates and thus reduce the room to maneuver in monetary policy.
Economic recessions often exacerbate income inequality, as low-income earners are more likely to lose their jobs or experience wage cuts. However, the ongoing pandemic recession, along with structural changes induced by Covid-19, is expected to have a larger-than-usual negative impact on income distribution.
The lack in ability to work remotely, the essentiality of their work and the need for interpersonal contact are all factors leading to their vulnerability in the aftermath of the Covid-19 shock. Considering the high level of interpersonal contact and essentiality their work entails, the magnitude of job losses is more significant in industries such as leisure and hospitality.
The pandemic also widens the divide between advanced and developed economies with weaker healthcare systems that may struggle to copy with local outbreaks, necessitating the implementation of severe lockdown measures and social restrictions for longer periods which, in turn, could lead to widespread and more permanent job losses.
The process of production diversification away from China started long before 2018, partly reflecting rising labor costs in China. This process has accelerated since US-China trade tensions began, and the pandemic will further speed up this process, as nations and multinational corporations (MNC) place security and resilience ahead of efficiency, adopting a China plus one strategy for risk mitigation.
The early push factors that kicked in well before US-China trade frictions were largely organic, as China’s rapid growth led to rising wage costs and increasing concerns over environmental costs. It would be erroneous to assume that these push factors will have an imminent and large impact, as most of China’s long list of strengths remain intact: the world’s largest and most cost-effective labor force in the manufacturing and mining sector, rapid progress in education, and one of the best infrastructure systems, including internet and telecommunications.
As supply chains are diversified away from China, the world economy will have to contend with shorter supply chains, more concentrated value addition, longer inventory cycles, lower productivity and potentially higher costs over the medium term. Developing countries will receive much lower FDI inflows and there will be less scope for knowledge/technology spillover effects, both for China and other countries.
Covid-19 has hit EMs harder than DMs because they have weak public health infrastructure, larger informal sectors and less policy space. Thus, a key question is whether the hit to EM growth will be only a short-term blip or whether their longer-run growth paths will be fundamentally altered. It seems medium-term growth in EMs will be an uphill battle for the following reasons: less fiscal support to growth, more permanent damage via unemployment and corporate bankruptcies, the likelihood of exiting 2020 with higher poverty rates, lower productivity, a rising debt burden and higher risk premiums.
However, the pandemic shock may also trigger structural reforms in areas that have historically been harder to push politically. Additionally, in a world of low DM interest rates and ample liquidity due to global central bank easing, investors will be on the lookout for economies that offer higher risk-adjusted returns. EMs, which offer a relative growth advantage, could benefit from such easy DM policies, by tapping low cost funds for high-return investment projects.
The Covid-19 outbreak initially raised concerns about a global food price surge. There were many red flags including panic buying of food, shortages of fruit and vegetable laborers, shutdowns at worker-infected meat processing plants and the challenge of reconfiguring supply chains away from restaurants and hotels and towards grocery stores and home deliveries. Yet the opposite happened: the FAO global food price index has fallen, not risen. A key reason is weaker global demand, as people stopped eating out.
A closer look at the longer-run impact of Covid-19 on food security paints a gloomy picture of why the current environment could represent the calm before the storm of a global food crisis in coming years; this is due to reasons such as a hit to income in the agricultural sector, as declining food sales and prices continue on weakened food demand. Additionally, the global health crisis and the lack of policy cooperation are compelling governments to better safeguard economic sovereignty, which includes advocating more secure access to food. As economies recover from Covid-19 in coming years, the exceptionally strong USD and low oil prices are likely to partly reverse, reducing the downward pressure on food prices.
One of the few silver linings to come from Covid-19 is an estimated 4-7% drop in carbon emissions this year, as economies shut down. However, this also happened after the GFC only for emissions to bounce back even more strongly in 2010. Some might argue that the health crisis has reduced the priority to tackle climate change, and it could be difficult to resurrect concerted action in view of the low ebb of global cooperation and low oil prices reviving demand for fossil fuels as economies recover. By contrast, we believe the economic reset will act as a blessing in disguise; the global crisis is uniting a clarion call for action against climate change.
Covid-19 has changed the world. We expect expedited digitization to change how consumers and businesses interact, fuel the rise of e-health, substantially change where and how we live and work and increase the dominance of IT giants. This pandemic has been a shared global experience; it has helped broaden support for corporate social responsibility and shifted government behavior and policy preferences, including towards increased self-sufficiency in key areas to reduce global supply chain risks, with a willingness to trade off absolute cost minimization for resilience.
Covid-19 has been a massive shock, causing unprecedented declines in activity in some sectors. Almost all businesses have had to adapt. In the short run, Covid-19 will likely lower productivity. Firms will fail, and workers will have to find new jobs. It will raise costs. Critical infrastructure – such as public transportation and office buildings – will have less capacity, given the need to maintain social distancing. Complex supply chains have been disrupted. However, this will not last forever. At some point, the threat of the virus will dissipate through vaccines, effective treatments and herd immunity. Once the short-term disruptions are no longer a constraint, businesses will be left with the lessons they were forced to learn during the pandemic.
The long-term impact of productivity is likely to take place via changes in the behavior of individual businesses, where instead of returning to their pre-Covid-19 methods, by sensing new opportunities, new dynamic private firms will emerge. Japan, in particular, could gain much from a new working style. Its labor market is known for its low liquidity, which is largely a result of institutional settings. Covid-19 could trigger a significant change to that structure. Many Japanese firms have been forced to expand remote working and found it very useful.
We expect the US dollar to follow a path of reduced dominance and weaken over the long term. While the end of USD’s role as the world’s reserve currency has long been foretold, it has yet to materialize due to the lack of a viable alternative. This process could gather momentum due to innovations from other global CBs and private institutions. Although nearly every major economy governments are running deficits due to the Covid-19 crisis, the question in the long run will be a) which deficits become more difficult to finance and b) which deficits will prove persistent.
Another long-term trend and risk to USD is digital currency innovation, with the People’s Bank of China actively developing a digital RMB system. Although the digital RMB is currently domestically focused with pilot testing taking place, a successful implementation could set the stage for China’s technological dominance in digital currency that could expand internationally.
For further insight on the world post Covid-19, read our full report here.
Head of Global Macro Research
Chief US Economist
Chief UK & Euro Area Economist
Global Head of FX Strategy
Chief China Economist
Rates Strategist, Australia
Chief Economist, India and Asia ex-Japan
This content has been prepared by Nomura solely for information purposes, and is not an offer to buy or sell or provide (as the case may be) or a solicitation of an offer to buy or sell or enter into any agreement with respect to any security, product, service (including but not limited to investment advisory services) or investment. The opinions expressed in the content do not constitute investment advice and independent advice should be sought where appropriate.The content contains general information only and does not take into account the individual objectives, financial situation or needs of a person. All information, opinions and estimates expressed in the content are current as of the date of publication, are subject to change without notice, and may become outdated over time. To the extent that any materials or investment services on or referred to in the content are construed to be regulated activities under the local laws of any jurisdiction and are made available to persons resident in such jurisdiction, they shall only be made available through appropriately licenced Nomura entities in that jurisdiction or otherwise through Nomura entities that are exempt from applicable licensing and regulatory requirements in that jurisdiction. For more information please go to https://www.nomuraholdings.com/policy/terms.html.