Economic and Financial Market Update: The Downturn In Context

Summary: 

• We are currently going through a very tough economic patch; 
• But interest rates are at record lows; 
• And the Government is allowing the budget deficit to swing to peace-time highs; 
• Their actions highlight that the RBA and the Government will do what is necessary to cushion the economic fallout. 

Every economic cycle is different but they often rhyme is an old economist saying. The current downturn has been caused by the unique decision to shut down large parts of the economy for health reasons. The consensus view is that this will lead to a significant slowing of activity in the first half of 2020. There will be a gradual pickup in the September quarter as the social distancing policies are relaxed. Most expect the economy to be moving back towards full speed by the December quarter and into 2021 as the restrictions are fully unwound (at least within the domestic economy).

Pictorially this creates a ‘v-shaped’ economic growth pattern (although there is a legitimate debate as to whether the economic pickup might be more protracted leading to a ‘U-shaped’ recovery).

Examining economic history gives us one way to benchmark the current downturn. The expected fall of economic growth for the whole of 2020 appears likely to be somewhere between 3-7%. If that is the case it will be the biggest annual decline in economic growth since the bust following the end of the Korean War in 1953 (and substantially less that during the Great Depression period in the 1930s).

Consensus forecasts for the unemployment rate is that it will shoot up to 8-9% by the middle of the year, and then start to decline by year-end as the economy improves. At first glance this looks to be an unusually low rise given the expected amount of the weakening of economic growth. But there are good reasons to believe the rise in the unemployment rate will be more muted. Most important is the Government decision to introduce the wage subsidy scheme. Employers will now be incentivised to keep on good staff. And the evidence from offshore is that wage subsidy schemes work. During the GFC Germany introduced such a scheme. At one point during the GFC German GDP fell by 7% but the unemployment rate only rose 1%.

Importantly the slowdown in economic growth is expected to be short (albeit very sharp). The longer that economic growth stays weak the more ‘scarring’ that occurs and the slower the eventual upturn. Sustained weak economic growth causes firms to remain cautious for longer, leaving them to feel they need to rebuild their cash buffers. This results in them being less likely to employ as many workers.

There are reasons to have optimism about the outlook. One is that the RBA has been very aggressive in ensuring that there is an ample supply of very cheap money available in the economy. This has meant that interest rates are at record lows (although other structural factors such as the global aging of the population have played a role). And they will be buying large amounts of Government (both Federal and State) debt in coming months. This will lead to the size of the RBA balance sheet to move to a record high relative to the size of the economy.

Another reason for optimism is the very aggressive response by Australian governments to support the economy and jobs. Never before in peacetime are we likely to see the Federal Government budget deficit to be as large as we will see over the next couple of years (and state governments will also be running decent size deficits).

Having a freely floating exchange rate is another plus. Financial markets look at the $A as a bell weather for the global economic outlook (because of the importance of commodities such as iron ore for our exports). If global economic prospects are not looking good the $A declines to a low level (as has happened now). And a weak $A not only makes our goods and services more competitive in global markets but makes imports less attractive for local buyers.

It is certain that economic growth will slow sharply and the unemployment rate will rise in the next few months. But interest rates are at record lows, the RBA will be buying plenty of bonds, the exchange rate has depreciated sharply and government deficits are going to be very big. All of this will help cushion the economic fallout and help with the subsequent recovery. Importantly their actions over the past month highlight that both the RBA and Government’s will do more if that is necessary.

We are currently going through a very tough economic patch. But with some luck with the progress of the virus and more help (if necessary) from policymakers we can come through this period with minimal economic ‘scarring’.

We live in interesting times!

Regards,

Peter Munckton - Chief Economist