In many European countries, lock-downs have been comprehensive. Now that we have more data, it is time to ask the question whether all types of interventions are equally effective. New research indicates that restricting large gatherings and public events is effective. Restricting international and internal travel is not.
Given the fact that the number of new cases continues to fall in Europe, even when more and more is opened up (link), I cannot help wondering whether all types of lock-downs are equally effective. It must so that some measures are more effective than others are. And, if some measures are not effective, they should be applied with greater caution if we will face a second wave of the Covid-19 virus.
It is understandable that lock-downs were comprehensive early on, as data and studies on the effectiveness of different non-pharmaceutical interventions were lacking. Now we have more data. A new study is interesting in this regard.
Nikos Askitas, Konstantinos Tatsiramos, and Bertrand Verheyden (link) use data from 135 countries to study the effectiveness of different types of non-pharmaceutical interventions. By studying such comprehensive data, Askitas et al. are able to exploit variation in the timing, type, and effectiveness of interventions within and across countries in order to identify the effects of different types of interventions. The data also allow the authors to control for the contemporaneous influence of multiple non-pharmaceutical interventions, i.e. they can do their best to isolate the effect of each type of intervention.
Askitas et al. classify interventions into eight different categories: (i) international travel controls, (ii) public transport closures, (iii) cancelation of public events, (iv) restrictions on private gatherings, (v) school closures, (vi) workplace closures, (vii) stay-at-home requirements, and (viii) internal mobility restrictions (across cities and regions). Their main results are here:
The figure reveals how the number of daily new infections develop prior
and subsequent to the introduction of different types of interventions. The
figure shows that the most effective interventions are cancellations of public
events and restrictions on gatherings. For instance, 35 days after the
introduction of interventions that cancel public events, the number of new
infections has fallen by 25%, compared to the number of new infections at the
event time, i.e. at the time of introducing the intervention, on average across
the 135 countries in the study. The figure also shows that the effect becomes significant
only after app. 20 days, i.e. it takes time before the interventions work.
On the other hand, international travel controls, public transport
closure, and restrictions on internal (within country) movements seem to have basically
no effect on the number of new cases. In fact, these types of interventions do
not seem to have any statistically significant effect on the number of new
School closures seem to have some effect, although it is barely
Other authors have studied the effectiveness of non-pharmaceutical interventions, even when these studies do not look as carefully as the Askitas et al. study on the effectiveness of different types of interventions. Robert Barro (link), for instance, studies data from the 1918 Spanish flu, exploiting variation in the intensity and duration of interventions across US state. Barro finds only little effect of interventions. Barro also reports, however, that this no-effect result is most likely due to the short duration of the interventions implemented during the Spanish flu. Most of the interventions back then had a duration of around one month. The figure above shows that interventions only start being really effective after one month or so. In this light, it is perhaps not surprising that Barro finds only little effect of non-pharmaceutical interventions.
Other studies, for instance link and link, also report a positive effect of non-pharmaceutical interventions but do not estimate as clearly the effect of different types of interventions.
So, the conclusion, at least to me, is that:
can be effective, in particular if their duration is not too short.
Some interventions are
more useful than others are.
restrictions of large gatherings and public events seem to be rather effective.
travel and public transportation does not seem to be effective.
Hopefully, results like these will be read carefully by politicians. If we will face a second wave of Covid-19, activities that do not influence how the virus spreads should not be shut down. On the other hand, we should be fast in implementing interventions that are effective, and their duration should not be too short. In particular, there is no need to uncritically just shut down “everything”. It is perhaps understandable that this was the approach taken in many European countries in March when evidence on the effectiveness of different types of interventions was missing. Today, we know more. Research indicates that it pays off to restrict gatherings of large groups of people, while restricting international travel and public transportation does not seem to pay off.
Has the lockdown been too strict and have we paid too high a price (in terms of forgone economic activity) as a result? Evidence from Denmark and Sweden helps answering this important question.
The fact that the number of deaths associated with Covid-19 falls in many European countries is unbelievably good news. As a result, European economies are opening up again. This is also good news. What is perhaps somewhat surprising, though, is that the number of deaths and new cases has not started climbing after opening up. This raises the question whether too many sectors were shut down and we, consequently, paid too high a price to contain the virus. Evidence from Denmark and Sweden suggests that the price was probably not as high as one might intuitively have expected.
Covid-19 in Denmark
prime minister announced the lockdown of Denmark on March 11. Death numbers
kept climbing until early April, but has fallen steadily since then, as this
that Covid-19 seems to be under control in Denmark is obviously very good news.
lockdown has been costly, though. Jobs have been lost, firms have closed down,
incomes have fallen, etc. Public debt levels will increase significantly.
started opening up again in mid-April. On April 14, private corporations that
had been asked to encourage people to work from home were now encouraged to let
workers return to their offices, subject to suitable safety measures. On April
15, kindergartens and lower primary schools opened up, and on April 20,
hairdressers, dentists, etc. were allowed to open. If the lockdown helped contain
the virus, one would have expected to see a rise in deaths and new cases after
easing the lockdown. This has not happened.
On May 11, retail shops opened. On May 18, restaurants. Again, if the lockdown was the primary reason why the virus stopped spreading, we should have seen the number of new cases increase after opening up. This we have (luckily) not.
Given that the number of deaths and new cases has been constantly falling since opening up, one may wonder whether the lockdown was too strict. It seems that voluntary social distancing, avoiding large crowds, and the washing of hands have been perhaps even more important. Doctors and scientists wonder whether the virus has mutated and turned less infectious, or warmer weather in April and May has caused a slowdown in new cases, but if I understand what they are saying, they believe that hand washing (and related precautions) is a main reason why numbers fall.
If this is true, we need to ask the question whether it was necessary to keep children and workers at home and close down as much as we did. Whether the economic costs have been too high. This is a sensitive and difficult question, though, because it requires that we evaluate how much economic activity would have fallen had we not shut down as much as we did. Surely, people would have cut consumption anyhow, as people would have been afraid of the virus itself and its consequences. So, what was the extra price we paid because of the lockdown?
Evidence from a clever study
A clever study (Link) by University of Copenhagen researchers Asger Andersen, Emil Hansen, Niels Johannesen, and Adam Sheridan helps us answering this question.
Asger, Emil, Niels, and Adam compare spending by Danes and Swedes. Denmark and Sweden are similar along many dimensions, but have followed different strategies when it comes to Covid-19. Denmark enforced a strict lockdown, as mentioned, whereas Sweden has kept primary schools, restaurants, bars, etc. open (though did close universities and encouraged working from home). If the lockdown was the main cause of the recession, economic activity should have suffered more in Denmark than in Sweden. Andersen et al. use individual bank-account data from a large Danish bank that operates in both Denmark and Sweden (Danske Bank) to address this question. They track spending of 860,000 individuals before and during the lockdown, studying their use of cards, cash withdrawals, mobile wallets, etc. They compare spending of Danes and Sweden from mid-March (when Denmark shut down) through early April. This figure contains their most important result:
The figure shows that spending of Danes fell 29% compared to a hypothetical spending path without the Covid-19 pandemic. A 29% contraction is enormous. But, and this is the main point, spending by Swedes fell by almost as much, 25%. This means that Danes cut spending by “only” 4%-points more than Swedes. Swedes could continue visiting restaurants, schools, etc., but Swedes cut spending dramatically nevertheless. The causal effect on spending, resulting from the extra lockdown in Denmark, is 4%-points and considerably smaller than the effect of the virus itself.
debate whether 4% is a small or a large number. In normal times, we would say
that a 4% drop in aggregate spending is large. The main cause of this recession,
at least according to this study, was not the lockdown, though, but the virus. In
other words, even if economies had not been shut down as much as they were, the
contraction in economic activity would still have been very large.
The broader picture
by Andersen et al. weighs in on an important debate about the underlying cause
of this recession. Is it due to a reduction in supply or demand? Their results
indicate that the demand effect is the important one. Spending drops even when
supply is less constrained.
But the strict lockdown in Denmark did cause an extra 4%-point drop in spending. Was it worth it? Nobody knows, but research from the MIT (Link) on the 1918 pandemic indicates that areas in the US that took more drastic measures early on, in terms of social-distancing measures and other public health interventions, had stronger recoveries after the measures were eased. There is debate how strong this result is, though (Link).
If all this is true, i.e. that the lockdown was not the main cause of the recession, but the main cause was the virus itself and the fear it created, and that the recovery is stronger afterwards in countries that imposed stronger interventions, we should see forward-looking measures indicating this. Early data from the Danish and Swedish stock market seem to point in this direction, even if the evidence is admittedly very tentative and a fuller analysis is obviously needed. This figure shows the Danish and the Swedish stock markets surrounding the date of the lockdown.
I have normalized the two stock-market indices to “1” on March 12, the day after the lockdown was announced in Denmark. The Danish and the Swedish stock markets followed more or less similar paths during March, but, since then, the Danish stock market has gained 29% whereas the Swedish market has gained “only” 20%. Again, one needs a more detailed analysis (the Danish stock market is heavily influenced by pharmaceuticals and other defensive stocks that do relatively well in downturns), but this early evidence indicates that stock market investors are more positive on the Danish stock market.
Furthermore, the number of deaths is currently much lower in Denmark than in Sweden (also on a per capita basis), which is of course also something to remember:
Denmark and Sweden vs. other countries
The idea of using credit-card and other payment-type information is great and has been used by a number of economists to obtain real-time information on the economic impact of Covid-19. Microdata indicate that consumer spending in France fell by 50% as a result of the virus (Link), in Spain by 50% (Link), and in the US by something like 50%, too (Link). It thus seems that the contraction in spending is somewhat smaller in Denmark and Sweden compared to other countries. The comments above should be viewed in this light.
case, a 30% or 50% drop in spending is a huge drop. But, a 50% drop in spending
does not mean that overall economic activity drops by 50%. Overall economic
activity includes public spending, exports/imports, etc. So, credit card
transactions provide useful information about consumer spending, but cannot
stand alone when judging overall economic activity.
At some stage, we need to evaluate carefully whether too much was shut down. Not to blame somebody, but to learn. It is important that we analyze thoroughly whether it is better to be very aggressive early on in a pandemic or whether less aggressive measures are enough. Currently, it seems that we shut down a little too much (and we are now too slow in opening up e.g. borders again), but that the price of doing so was not as high as one might have expected intuitively.
Some of the events we have seen during this crisis are so unlikely that we need tricks to calculate their probabilities. This is a journey into the world of very small probabilities and very large numbers. I admit it is somewhat surreal. But it is important as these small-probability events can have long-lasting effects on economic activity.
The defining characteristic of this recession is the speed with which markets and economies started freefalling. From one day to the next, economies were shut down. Economic activity came to a complete sudden stop in some sectors. In different blogposts, I have used words such as “unprecedented”, “completely crazy”, “horrifying”, “tremendous”, etc. to describe what happened.
like these is adequate, I think (I admit I was shocked by what happened), but I
have come to a point where I want to be more precise. As economists, we want to
put numbers on things. I want to calculate the probability of the events. This
turned out to be more complicated than I had first imagined.
The probability of a 121-sigma event
On Monday, April 20, the oil price (West Texas Intermediate) closed at USD -38 for a barrel of oil. I describe this here (link). This was a drop of 306% relative to the closing price the previous trading day. Based on daily data since 1983, the average percentage change in the oil price is 0.03% and the standard deviation 2.5%. I called the event “completely crazy”, which I still believe is a fair description. Now, I want to know “how crazy” it was. What was the probability that it would happen?
happy-go-lucky Professor of Finance, i.e. me, opens his Excel spreadsheet and
enters the command used to find the probability that an event of -306 happens
when data are normally distributed with mean 0.03 and standard deviation 2.5.
“Enter”. Excel returns “0”. The Professor of Finance thinks this look strange
and increases the number of decimal places. Excel just shows “0.000….”.
According to Excel, this is a zero-probability event. It could not happen.
But it did
happen. I start remembering the statistic classes many years ago, and recall
the discussions on low-probability events.
have helpful colleagues. I write CBS Professor of Statistics Søren Feodor
Nielsen. He tells me that the probability I am looking for is below the
“machine precision”. He also tells me that the probability itself might be
extreme, but the logarithm to the probability is probably not. We calculate the
log-probability (using a different statistical package than Excel). It is -7495.137,
i.e. the likelihood is exp(-7495.137). This is, unfortunately, such a low
number that a computer cannot calculate this either.
calculate the log base 10 probability. Now we have the result. The probability
is 0.799 x 10^(-3255).
This is a
zero followed by 3255 zeroes, and then 799. Practically zero, but not exactly zero.
The event happened, but it is extremely unlikely. We can call it “completely
crazy”, but we can also say that the probability is 0.799 x 10^(-3255).
There is another way to illustrate how unlikely this event was. When the probability is 0.799 x 10^(-3255), we should see this event happen every 1.2516 x 10^(3255) days. I.e., a number with 3255 numbers before the decimal place. I simply do not know what such a number is called (link). This is where it starts getting surreal.
is this? We have calculated it, but Søren tells me we should not put too much
faith in its precision. Tail-probabilities in the normal distribution are
calculated by numerical approximations, and it is questionable how precise they
are when we are that far out in tail. Admittedly, the question is of course also
how important it is that it is precise that far out in the tail. The probability
is unbelievably small. That is the main thing. Exactly how small is perhaps not
shows daily percentage changes in the S&P 500 throughout the last 50 years.
13, the S&P 500 fell 12%. The average daily percentage change in the
S&P 500 (calculated up until March 12) is 0.03% and the standard deviation
likelihood that we will see a 12% drop in the S&P 500 on a daily basis,
given the behavior of the S&P 500 during the last 50 years, is very small,
but not so small that it cannot be calculated in Excel. Excel says it is 1.0827 x 10^(-29).
daily data. If we assume 250 trading days per year, we should see this event
happen every 3.69 x 10^(27) = 3,694,454,429,465,560,000,000,000,000
year. I.e., every 3.694 octillion year.
This is also somewhat surreal.
There are many caveats. We are again so far out in the tail that we should not put too much emphasis on the exact number of decimals and the exact number after all the zeroes. Also, all these calculations are based on the assumption of normally distributed data. Given that we saw a 21% fall in the S&P 500 on Black Monday, October 19, 1987, we have seen two very unlikely crashes within the last three decades. According to these calculations, they should happen much more seldom. We use the normal distribution, but data might follow a different distribution. For most practical purposes, however, it is not necessary to know the exact distribution of these extreme events. The important thing to know is that the likelihood is very small.
In this post (link), I describe how the initial jobless claims soared, confidence indicators fell, GDP dropped, etc. As an example, the likelihood that we should see almost 7 million people filing for jobless claims on March 28, given the complete previous history of jobless weekly claims, is 0.97 x 10^(-841). This is again such a small probability that Excel cannot even calculate it.
There is a broader
point to these discussions. Events like those described above might have
long-lasting consequences for economic activity.
are unlikely, we assign low probability to their occurrence. One hypothesis is
that we keep on assigning low probabilities to their occurrence. In this case, future
investment decisions of firms and future consumption decisions of households
are unaltered by the events we have been going through. It was a temporary
shock. It has very low probability. It will not influence how we form
expectations going forward.
An alternative hypothesis is that we have become so scared by the event that it will haunt us for years to come. We update our beliefs disproportionally much.
Which of the two scenarios play out is important for the recovery from this recession. Will we start consuming when economies open up or will we hold back because we have become scared?
Kozlowski, Veldkamp and Venkateswaran (2020) have an important paper on this (link). Their main point is that events like those studied above, i.e. events that are very unlikely but have large impacts, will have persistent effects on beliefs. They write that “tail events trigger larger belief revisions” and that “because it will take many more observations of non-tail events to convince someone that the tail event really is unlikely, changes in tail beliefs are particularly persistent”. This is an important insight. If this is how we form expectations, it will slow down the recovery from this recession. Kozlowski et al. also show, however, how government interventions can reduce the effect, but not eliminate it.
we are seeing infection rates declining in many countries and economies opening
up again. These are very good news. Let us hope we can start returning to some
kind of normality. It will take time before we are back to where we came from,
though. Some things might even have changed for good. One thing is for sure: we will not get back as fast as economies
and markets fell in March. What happened was very unlikely. But it did happen.
The rebound in stock markets has been spectacular.
One may wonder whether it is sustainable.
What does it actually mean that the stock market is “too optimistic”? Doesn’t the stock price always reflect the average expectation of all investors? True, and, in this sense, the market cannot be “too optimistic”. On the one hand, the market is always right.
On the other hand, the legendary economist Paul Samuelson famously noticed that the “stock market has predicted nine of the last five recessions”. Stock markets also appear “excessively volatile”, as Shiller showed already in 1981. I.e., the stock market might always be right, but perhaps we are going through a period of excessive volatility where markets were overly pessimistic in March and are overly optimistic now.
In any case, if the stock market is always right, so is the futures market. Investors in the futures market expect huge drops in dividends over the next year. If stock prices behave as they usually do during recessions, stock prices should drop even more, that is dropping even more than dividends.
Before we start this attempt to explain things and look ahead, let us review the facts. This graph shows developments in the Danish, the US, the world (MSCI All countries), and the emerging stock markets since the start of the year, all MSCI indices (Danish index is in Danish kroner, the rest in USD):
markets did well in the beginning of the year, fell dramatically from mid-February
through mid-March, and have rebounded spectacularly since then. Today, the
Danish stock market is above its January 1 value, the US market is 10% down,
the world market is 15% down, and emerging markets are 20% down.
What could explain current stock prices?
prices are by definition discounted future cash-flows. That is easy to say. The
difficult part is to find the expected future cash-flows and the appropriate
start with a positive view on markets and see what is needed to support this.
To begin with, let us keep the discount rate fixed. Let us also, as a starter, assume that valuation ratios are constant. For instance, let us assume that stock prices closely follow developments in real economic activity. Under these assumptions, we would, largely, be able to understand recent market movements. These assumptions would also support a rosy view of the future. Afterwards, we discuss if this is a likely scenario.
for economic activity in light of the corona crisis start coming in. Late
April, we got the WEO from the IMF and forecasts for the US from the CBO, and
this week we got forecasts for Europe from the EU-commission. This figure shows
the expected path of real GDP in the US and EU:
This recession is enormous. GDP is expected to fall by 15% in Q2 this year, compared to late 2019. Luckily, economies are expected to rebound sharply after this quarter, too. The EU commission expects a strong recovery in the EU in 2021, with 6.1% growth in 2021. The CBO expects 2.8% growth in 2021 in the US. Whether this difference is realistic, I do not want to discuss here.
drops by 15% in Q2. If stock prices follow GDP, as we assume for now, stock
prices should have dropped by 15% in Q2. This is almost spot-on.
would also predict that we have a great year in front of us. Economic activity
should improve by something like 15-20% until late 2021. If stock prices
follow, stock prices should also increase with something like 15-20% from here.
What about the huge drop in March? This we can also explain, I think. Basically, it had little to do with underlying economic fundamentals. Some leveraged hedge funds got squeezed, they received margin calls, they dumped everything to raise cash, there was panic, spreads widened, and markets feared a replay of 2008 (I comment on it here and John Cochrane has a nice and more detailed explanation here). Stress on markets almost reached 2008 levels, as, for instance, the St. Louis Fed Financial Stress index indicates:
banks intervened and provided liquidity. Markets calmed down. The stress index
is still somewhat elevated, but much lower than in March. Markets started
looking at economic fundamentals again. With lots of liquidity around, and low
yields, investors bought stocks. This was a temporary crash.
intermediate conclusion is that if stock prices follow GDP, stock prices should
drop by something like 15% during Q2, only to rebound afterwards. And, as of
today, stock prices have in fact fallen by something like 15% since the start
of the year, with a bumper on the road in March. If we stop here, everything
would be fine and we should expect substantial stock market gains going forward.
Under these assumptions, markets are expected to rebound by something like
15-20% until late 2021.
Cash-flows do not always follow economic
Unfortunately, we cannot stop here. We need to go back to the definition of stock prices: Discounted cash-flows. I truly believe that cash-flows relate to economic activity in the long run (I have research demonstrating this), but I also believe that there are temporary business-cycle deviations between cash-flows and economic activity. And these deviations can be substantial.
We have expectations to economic activity from IMF, CBO, EU, and so on, but how do we find expectations to cash-flows? Niels Joachim Gormsen from the University of Chicago, a smart former Ph.D. student at Copenhagen Business School, has, together with Chicago Professor Ralph Koijen, developed a method that can be used to back out expected changes in dividends from dividend futures. They also estimate a relation between dividend growth and GDP growth, such that they can back out expected GDP growth, too.
Their latest estimates are from April 20. Compared to January 1, 2020, Gormsen and Koijen estimate that US GDP will be 3.8% lower over the next year (precisely, Niels tells me, they compare expected growth from April 1, 2020 through April 1, 2021, to expected growth from January 1, 2020 through January 1, 2021). This is not far from what the CBO expects (the figure above shows that GDP will be something like 5% lower ultimo 2020 compared to primo 2020).
The scary thing is that Gormsen and Koijen show that markets expect dividends to be 18% lower over the next 12 months, i.e. drop by 13%-points more than GDP. An 18% drop in dividends is a very large drop in historical terms.
This graph shows how investors update their expectations to future dividend growth rates during the corona crisis:
For the EU, Gormsen and Koijen expect GDP, respectively dividends, to drop by 6.3%, respectively 28%. The market is always right, right?
Unfortunately, we cannot stop here either.
Stock prices react excessively to cash-flows
We need to talk about the last part of the definition of stock prices: discount rates. Research shows that discount rates move counter-cyclically, increasing in bad times and dropping in good. From our definition of stock prices, this means that stock prices should fall by more than dividends in bad times, if discount rates increase in bad times.
Tim Kroencke from the Univeristy of Neuchatel has an interesting paper that studies how stock prices move in relation to dividends during recessions. The central graph in the paper is this one:
The graphs shows how dividends (and earnings) fall during recessions and how stock prices fall even more (there are two stock price indices. Read Tim’s paper to get the explanation for the difference. The point is that stock prices fall more than dividends.)
The figure shows that US dividends drop by 10% and US stock prices drop by ten percentage-points more, i.e. 20%, on average during US recessions. It also shows that stock prices do not drop ahead of the drop in dividends, but alongside. This is not good news.
Koijen’s estimates say that we should expect dividends to drop by 18% for the
US and 28% for the EU over the next year. Kroencke says that on average stock
prices drop by 10%-points more. This means that stock prices should drop by close
to 30% in the US. If we use the 10% drop in the price-dividend ratio for EU
data, EU stock prices should drop by close to 40%. Today, stock prices are down
We might hope that this recession plays out in a different way than recessions usually do. We might also hope that stock markets react in a different way than they usually do. We might hope that everybody starts spending when economies open up, companies start producing, and earnings and dividends do not suffer. In this case, the drop in dividends might not be that large. And, we might hope that stock markets do not fall by more than dividends, in contrast to what they normally do. This could for instance be because central banks are marginal investors in many markets now, driving asset prices away from what they would have been if prices were solely determined by private market participants. This is what markets hope. And, of course, this might turn out to be the case.
We might also fear, however, that companies will start facing problems given the severity of the crisis, i.e. this turns from a liquidity crisis to a solvency crisis. Should this happen, earnings and dividends will drop. The market is always right. The futures market expects dividends to drop by something like 20% for the US and 30% for Europe. If stock prices react as they normally do during recessions, stock prices should drop even more. The 15% drop since early 2020 seems small in this light.
PS. Did you by the way notice the German Constitutional Court ruling this week? Given last week’s post on the Italian situation, I might just inform you that the Italian yield spread to Germany widened as a consequence. Not a lot – 15 basis points or so – but in the wrong direction.
There are similarities between Greece in 2010 and Italy today that make me nervous.
Do you remember the Greek drama in 2010-2012? Following the financial crisis in 2008-2009, Greece saw it public finances deteriorate, as did most other countries. The special thing about Greece was that they had fudged the numbers. In autumn 2009, the new Greek Prime Minister, George A. Papandreou revealed that the former government had lied about the deficit. This, and the recession, brought public debt to 146% of GDP in 2010. It later turned out that Greece had also falsified the numbers – via different swap contracts, willingly helped by US banks – prior to the introduction of the euro, making the whole thing even worse. With debt running at close to 150% of GDP in 2010, investors lost faith. Greek yields skyrocketed (see below). Greece received a number of rescue packages from the EU commission, IMF, and the ECB (the so-called “Troika”). Eventually, in 2012, Greece restructured its debt in the largest sovereign default in history. Investors faced a loss to the tune of EUR 100bn.
Why do I repeat this sad story? Because the IMF Fiscal Monitor Report contained a forecast for Italy that has, in my opinion, not received enough attention. The IMF predicts that Italy will reach a public debt level of 150% of GDP this year, exactly like Greece in 2010. Will this lead to a replay of the European debt drama?
First, the data. We are in the middle of a terrible recession. Italy has been severely affected by the corona virus, and has as a consequence enforced a strict lockdown. IMF expects that Italy will be one of the worst hit countries. Italian GDP is expected to fall by 9.1% during 2020.
IMF also expects that the fiscal deficit will be 8.3% of GDP in 2020.
This is a large deficit, but other countries face even larger ones. The US, for
instance, 15.4% of GDP (this probably requires another blog post…..), China
11.2%, Spain 9.5%, and so on.
The problem in Italy is that public debt levels are already very high, at 130% of GDP. Few countries match this. In fact, only Japan and Greece. What is noteworthy, in my opinion, is that the combination of the already high debt level, the severe recession, and the fiscal deficit will most likely take the debt level to more than 150% in 2020:
The figure superimposes a dotted line indicating the 146% debt-to-GDP
level Greece reached in 2010, which sparked the Greek problems. Italy is
expected to cross this line in 2020.
Contributing to my concern is the fact that financial markets seem to
treat Italy and Greece somewhat similar this time around, in contrast to 2010.
This time, movements in the Italian yield spread to Germany largely mirror movements
in the Greek yield spread:
The spread between Greek and German ten-year government bonds is a little higher than the spread between Italian and German government bonds, but movements are very similar. Only between the ECB/Christine Lagarde blunder on March 12 and the introduction of the PEPP (see below) on March 18, there was some divergence between Italian and Greek yields. Otherwise, they have moved in tandem.
This is different from 2010. In 2010, Greek yields spiraled out of control, reaching close to 50% on the worst days, but something like 25% for the worst month on average:
The Italian spread also increased in 2010, but, back then, markets clearly distinguished between Greece and Italy. Today, markets view Italy and Greece as being in somewhat similar situations. Rating agencies have started to act (Link).
Will we see a repetition of the Greek
The Greek yield spread was close to 50% on the worst days in 2010, and currently we are talking something like 2.5% for Italy, i.e. very far from 50%, though up from 1.5% in the beginning of the year. This is clearly not as bad as in 2010. I thus hope that we will not see a repetition of the Greek story in Italy, but I dare not rule it out.
Let us start with the good news. Yields are lower today than in 2010. In 2010, Italian yields were around 4%. Today, they are around 2%. Hence, if yields stay low, Italy can afford a larger public debt compared to the situation in 2010. Also, everybody is aware that problems in Italy will mean problems for Europe, as I describe below, i.e. everybody wants to avoid such a situation.
On the other hand, the situation could turn to the worse if the recession in Italy will be deeper than the IMF expects, if the Italian political situation takes another turn to the extreme, if political negotiations at the EU level about a recovering plan do not bear fruit, or if some other negative shock occurs. Should some of this happen, Italy might find itself in something like the Greek situation at some point. The situation is fragile, as shown by the widening of spreads and the downgrade of Italy.
Italy is important for the European project. It is a G7 country. It is
one of the founders of the EU. The foundation of the euro would be threatened
if Italy runs into trouble. It would have global repercussions. At the same
time, Italy is probably too big to bail out for the rest of the Eurozone/EU.
Some say that the ECB will make sure that this will not happen. Perhaps,
but this is not as obvious as some claim. We get into technical nitty-gritties
here, unfortunately, but it is important to understand.
ECB is buying bonds like crazy at the moment, keeping a lid on yields, including Italian. The ECB’s PEPP (Pandemic emergency purchase programme) implies that the ECB will buy public and private securities to the tune of EUR 750bn during 2020. I.e., the PEPP will help keeping Italian yields down.
Furthermore, at the ECB Governing Council meeting Thursday, April 30, it was decided that “The Governing Council will conduct net asset purchases under the PEPP until it judges that the coronavirus crisis phase is over, but in any case until the end of this year” and “The Governing Council is fully prepared to increase the size of the PEPP and adjust its composition, by as much as necessary and for as long as needed”. Hence, the PEPP might last longer than throughout 2020 and accumulate to more than EUR 750 bn.
BUT, the important sentence in the PEPP programme is this one: “For the purchases of public sector securities under the PEPP, the benchmark allocation across jurisdictions will be the capital key of the national central banks. At the same time, purchases will be conducted in a flexible manner. This allows for fluctuations in the distribution of purchase flows over time, across asset classes and among jurisdictions.” (Link).
This point here is that that ECB cannot – and I repeat cannot – buy unlimited amounts of Italian debt at the moment. The proportion of Italian bonds the ECB can buy (as a proportion of all Eurozone sovereign debt ECB buys) is restricted by the Italian fraction of ECB capital. At the moment, this is, to be very precise, 13.9165%.
It also says that this will be interpreted in a “flexible
manner” – and I am sure the ECB will be flexible – but they cannot be too
flexible. ECB just cannot buy unlimited amounts of Italian debt under current
There is an escape clause: OMT (sorry for this soup of abbreviations; ECB, PEPP, OMT,…). OMT is “Outright Monetary Transactions”. OMT allows ECB to buy unlimited amounts of Italian (and other Eurozone) bonds, should this be necessary. But, and this is a big but, only when the relevant country has entered into a program with the European Stability Mechanism (ESM; one more abbreviation…). An ESM program means that the country will face demands with respect to its conduct of fiscal policy; think about the discussions about the role of the Troika in the Greek drama. To some extent, this is a loss of sovereignty. Entering into a program is also a signal that the country cannot handle the situation on its own. This will make it even more difficult to sell bonds on the market. At the moment, Italy very clearly opposes an ESM program. At the end of the day, this however means that ECB cannot buy unlimited amounts of Italian debt should this become necessary. ECB cannot save Italy.
Other people say “look at Japan”. Japan has a public debt of more than
200% of GDP. IMF expects it to reach 252% of GDP in 2020. Yields in Japan are
very low, in spite of this massive debt mountain. I.e., Japan shows that you
can accumulate lots of public debt without causing yields to rise, some claim.
True, but remember that Japan has its own currency and its own central bank.
The Japanese central bank can buy all the public debt they want, keeping Japanese
yields down. Italy does not have its own central bank and its own currency. The
ECB cannot buy unlimited amounts of Italian bonds. Greece is the example that
shows that the situation of a Eurozone country is different from the situation
of a country with its own currency and central bank.
(Here, I do not want to get into a discussion whether a country with its own currency and central bank faces no limits on the amounts of public debt it can raise, as argued by proponents of the “Modern Monetary Theory”. Basically, I disagree with that policy implication and think there is a limit, but this is for another day).
So, in the end, if worst comes to worst, ECB cannot save Italy, unless Italy enters into an ESM program. Some kind of political solution at the EU level would be needed. I hope we will not get there. At the moment, we are not, but I dare not rule that we might get there. I will follow the Italian situation.
A couple of weeks ago, I collected some graphs revealing how deep this recession is (Link). Two weeks have passed. New data have arrived. They are still horrifying.
We now have
aggregate numbers for Europe. In the first quarter of 2020, Eurozone GDP
dropped more than it did during the worst quarter of the financial crisis of
GDP figures are aggregate data. They show how total economic activity has developed. That’s why they are important. They are, however, also a snapshot of the level of economic activity, collected with a lag. The latest figures deal with the first quarter of 2020. So what about asking firms and households how they feel and how confident they are? If people and firms think this will be a short-lived recession, they should be confident. The EU commission publishes confidence indices for firms in the industrial sector, the services sector, and for households in the EU. Confidence indices drop, as we have never seen before.
The industry, the service sector, and households all have no confidence in the economy.
Next, I collect trailing averages of initial jobless claims in the US during the preceding six weeks. During the past six weeks, more than thirty million Americans have lost their jobs. It is not just a historical record. It is very sad.
Most likely the unemployment rate will come in at close to 20%.
Behind all these numbers and figures, there are real firms and real people. Firms will be forced to close. Individuals will lose their jobs. Households will struggle.
So, how does the stock market do? Given the scale of the recession, you would expect it to suffer tremendously. It does, however, great.
From its temporary trough on March 23, the SP 500 has gained 32%. It tanked heavily in late February and early March, but it is today (May 1) “only” 13% below its peak on February 19. I write “only” as the stock market often losses something like 50% in a recession (Link). This recession is unprecedented, as shown above, so you would expect unprecedented losses on the stock market. This is not what we see.
It is not unusual that the stock market starts rising before the end of the recession . And the stock market did fall very fast early in the recession. In the US, it was the fastest bear market ever (Link). But given the depths of the recession, stock markets have rebounded surprisingly fast.
all stock markets have rebounded. The Spanish stock market (MSCI Spain) is 30%
below its peak on February 19. So is the Italian. And, the Argentine is down
stock markets have rebounded strongly, but others have not. Let us try to get
an overall picture.
This is a global recession. The aggregate value of global stocks markets is USD 44 trillion on April 29 (FTSE All World Index). On February 19, it was USD 52 trillion. At the bottom on March 23, it was USD 35 trillion.
This means that 20,000 billion USD(!) was lost on the stock market from February 19 through March 23, globally. It also means, however, that almost 10,000 billion USD have been gained during the last month or so.
Given the severity
of this recession, it is – frankly speaking – somewhat surprising that global stock
markets have not lost more than something like 15% since mid-February. Stock
markets seem disconnected from the real economy. Why?
Of course, stock markets are forward looking and all that. And, yes, luckily, it seems that the corona virus is on retreat. These are very good news and give some hope. But, given the depth of the recession, I think it will leave scars. It will take time before unemployment in the US reaches 4% again, as an example.
The reason why stock markets in many countries have done great during the last month, when economy activity has suffered like never before, is actually rather simple. Central banks exercised the “central bank put”.
Central banks were every fast to enact even very large rescue packages. They started doing so in mid-March. This helped stabilize financial markets, depress yields, and flooded markets with liquidity. The goal, of course, was to support the real economy. It saved stock markets, too. Shortly after the announcement of all these comprehensive measures, the stock market started rising.
With lots of liquidity around, and low yields everywhere, markets convinced themselves that central banks would save the world. Markets bought stocks, and stock markets surged.
This is what I believe explains it. Otherwise, I cannot make sense of the fast rebound in the stock market. But I do believe markets have thereby become somewhat disconnected from the real economy. And this is strange to witness.
participated in a number of live appearances during the last couple of weeks,
most of them in Danish, though.
I gave a webinar (in English) on the economic impact of the corona virus: Link.
I participated in a program (in Danish) on the consequences of the crisis on real estate prices: Link. I am on at 2:20, 14:05, 18:40, 21:20, 24:45. This is also described here: Link.
I participated in a program (in Danish) on the consequences of the crisis on savings: Link. I am on at 2.20, 6.30, 17.40, 26.30. It was a popular program. Around a third of Danes watching TV that evening tuned in.
I participated in a radio program (in Danish) on the global economic outlook: Link.
happened on the oil market this week was completely crazy.
I believe everybody noticed the headlines, but it is worthwhile to pause and reiterate, as this was another sign of the very unusual and severe recession we are going through: For the first time in history, oil prices were negative at minus USD 38 for a barrel of oil. I think this graph nicely illustrates how unusual this was.
shows daily changes in oil prices since 1983. Until April 16, the average daily
price change is 0.03%. The standard deviation of daily price changes is 2.5%.
On April 20, Monday, the price of oil fell by 306% compared to its price Friday.
This is a 121-sigma fall. Almost surreal, but true.
of oil fell because demand for oil has tanked as a result of the recession.
When economic activity falls, as it does right now, demand for oil falls. When
we do not travel, when we do not drive our cars to work, when production
facilities are closed down, and so on, we do not use oil. When supply of oil is
not reduced, or at least not reduced as much as demand for oil falls, prices
If oil is produced but not used, it needs to be stored somewhere. Traders panicked on Monday, as they feared that there is simply not enough physical space to store oil. If you possess thousands of barrels of oil and have nowhere to store them, you are willing to pay somebody to take care of it. FT explains it nicely: “Analysts believe a lack of available storage capacity at the WTI contract’s delivery point of Cushing, Oklahoma — known as the Pipeline Crossroads of the World — set off panic among traders holding derivative contracts, who found themselves with nowhere to put the oil.”
The negative price of oil relates to West Texas Intermediate, the US benchmark oil contract. The price of Brent oil, the international benchmark, has been positive, even on Monday at USD 17 per barrel. This indicates that Monday’s event was more of an issue with storage of oil in the US, and the expiration of futures contracts, than a general issue with storage of oil. E.g., Brent oil can more easily be stored at sea, at least as long as tankers are available. One should also notice that the price of WTI was back in positive territory already Tuesday and stayed positive during the rest of the week. This was, even if very dramatic, a one-day shock.
Prices of both WTI and Brent have been falling since the outbreak of the virus in China in early 2020, however, particularly in early March when Europe and the US started shutting down. Except from the astonishing event on Monday, the price of both Brent and WTI have followed the same path. The agreement from April 10 limiting oil production has thus failed to slow the fall in oil prices.
The behavior of oil prices reflects the severity of this crisis. The drop in oil prices since the start of the year tells a different story about the recession than does the stock market. The stock market has sprinted ahead since mid-March, indicating that stock market investors believe the recession will soon be over (the stock market did fall on Monday and Tuesday, though, due to the turmoil on oil markets). Oil markets, in contrast, indicate that the recession is very much still ongoing. What signal do you believe – the one from the oil market or the one from the stock market?
How will this recession play out and how will the recovery look? Will we get a short recession with a fast rebound (V), will we get a longer recession before the recovery (U), will we get a new lockdown in autumn resulting from a second wave of the Corona virus (W), or will economies remain depressed for a long time (L)?
Nobody knows, particularly this time around when the shape of the recovery will be determined by a virus and how this develops.
Supporting the V-shaped recovery, this recession is not caused by economic imbalances, such as an overvalued housing sector, too much debt, a fragile banking sector, or the like. Also, we know from history that recessions last longer and are deeper if they are caused by financial crises. This is also not the case this time around, in contrast to 2008, for instance. This means there is hope for a reasonably fast rebound, if we manage to get the virus under control.
other hand, if we get a second outbreak, e.g., in autumn, and economies are shut
down again, the path of economic activity will probably take the shape of something
like a W.
What we do know is that the depths of the recession is unprecedented. The fall in economic activity and the increase in unemployment is mind-blowing, and very scary (link).
This makes one fear that the recession could drag out. When economies open up, it will take time to find jobs for those who get unemployed during the recession. Firms will probably be reluctant making new investments until we have a vaccine. Consumers want to go to restaurants, cinemas, on vacation etc., but will probably hold back until they feel on safe ground, too. Uncertainty abounds.
In this environment, one would imagine that the stock market suffers tremendously. With a recession impeding, and with so much uncertain surrounding the future path of economic activity, one would imagined that stock markets, like economic activity, would be in freefall. This is not the case.
In the beginning of the lockdown, the stock market tanked. It was the fastest bear market ever (link). It reminded us very much about the dark days of autumn 2008. This graph shows the SP500 on a daily basis during the 2008 financial crisis and this crisis. “0” in the figure is September 19, 2008, respectively February 21, 2020.
Financial markets were in stress in mid-March, when even yields on safe assets increased (link). Fearing a replay of 2008, central banks and governments came to the rescue, and the stock market started its recovery. Since the bottom on March 23, the S&P 500 has gained an astonishing 28%. This is remarkable, given all the uncertainties and the depth of the recession. The contrast to the autumn of 2008 is stark. The stock market kept on falling throughout 2008 and early 2009, only to start its recovery in March 2009.
The stock market seemingly believes this recession will result in a V-shaped recovery. Let’s hope it is right. One might fear that it is not.
The corona crisis is unique in many ways, not least with respect to the speed with which economies have started freefalling. Literally, from one day to the next, economies have been shut down, with grave consequences for economic activity.
economic figures, such as GDP, consumption, etc., are collected and published
with a lag. Normally, this is not a big problem, as changes in business cycles
are typically not too abrupt. But this time, it has been a problem. In the
early phase of the crisis, we had to rely on data from selected sectors that
provided real-time insights. Restaurant bookings completely collapsed, footfall
(number of people entering retail shops) fell, flight traffic dropped, etc.
This was dramatic and foretold that economic activity more generally contracted
significantly. But we did not know exactly how much.
getting the aggregate numbers now. They reveal with horrifying clarity that
this recession is unprecedented.
Initial claims for unemployment insurance in the US has been published weekly since 1967. The average from 1967 through March is 350,000, i.e. on average 350,000 people enter unemployment per week in the US, with a peak at 700,000 in October 1982 and another high of 665,000 during March 2009. In mid-March 2020, the number was a staggering 3,3 million, only to reach more than 6 million getting unemployed during the last couple of weeks, with the number last week being 525,000. In just four week, 22 million people have lost their job in the US. It is mind-blowing. And very sad.
We have today received the latest GDP figures for China, for the first quarter of 2020. China has published quarterly GDP data since 1992. Annual growth has always been positive, even during the Great Recession of 2008-2009. In the first quarter of 2020, Chinese GDP was 6.8% lower than in the first quarter of 2019. An unprecedented fall.
We have also just received the latest figures for US industrial production. The drop in industrial production in March 2020 was the largest monthly drop since 1946. Industrial firms in the US cut production with 5.4% relative to February 2020. We also notice, though, that monthly drops in industrial production were larger during the Great Depression in the early 1930s and at the end of the second world war.
pictures tell a horrifying story about the freefall in economic activity. Expect
more sad numbers to come. Hopefully, when economies start opening up again, we
will see a rebound in economic activity. But the recession will leave lasting scars.