The coronavirus has caused economies across to globe to adopt self-distancing as the de-facto public health policy to mitigate the spread of the disease. Nothing highlights the dangers of the virus and its spread more than the announcement that British Prime Minister Boris Johnson had tested positive for the disease.
While the fiscal and monetary policies adopted in Britain are laudable, they will most likely not be enough.
But the policy of self-distancing requires putting national economies into a coma to save lives. Simultaneously, the domestic British economy has suffered supply, demand and severe financial shocks that have likely ushered in the end of the current business cycle.
The shocks will result in an outsized decline in growth in the first and second quarters of the year, which will meet the technical definition of a recession.
While the fiscal and monetary policies put in place by the Johnson administration and the Bank of England are laudable, they will most likely not be enough. Mitigating these shocks will most likely require a more robust set of fiscal outlays and creative monetary policies.
Introducing the RSM U.K. Financial Conditions Index
The U.K. suffered a four-standard-deviation blow to its financial conditions, in line with shocks to the American, Canadian and Euro-area economies. The RSM U.K. Financial Conditions Index — which measures the degree of accommodation built into British financial asset prices – plummeted from normal conditions just four weeks ago to 3.9 standard deviations below normal levels of implied market risk.
The RSM U.K. Financial Conditions Index measures the degree of accommodation built into British financial asset prices.
Financial markets have become global, with distress in one market spilling over to markets worldwide. In the past 25 years, the U.K. financial markets have absorbed the Long Term Capital Management/Russia debt crisis of 1997-98, the Lehman Brothers collapse that became the financial crisis of 2008-9, and the European debt crisis of 2011-12. In return, the U.K. exported its Brexit fiasco worldwide. And now, in 2020, a catastrophic health crisis and the shutdown of normal life threaten to send the global economy into recession.
Governments are trying to muster a defense against the pandemic that sparked a worldwide equity market free fall at the end of February. It continues today, spawning a tightening of liquidity that threatens the global economic system. The U.K. finds itself in the midst of a three-week shelter-in-place order from the Johnson government that will result in a recession.
The RSM index is a composite of the performance of the British financial market assets and is structured such that positive values denote financial accommodation while negative numbers denote tightening of financial conditions, the unwillingness of investors to borrow or lend, and the depressed level of economic growth in future months and quarters.
- Currency market performance indicates the demand for the pound and U.K. products, expectations of the return of U.K. interest rates relative to foreign interest rates, and the relative ability of each economy to support higher returns on its assets.
- Equity market performance is an indication of accrued wealth and loss.
- Money market spreads are an indication of liquidity necessary for business transactions and act as a bellwether of implied financial risk.
- Bond market performance is an indication of near-term and long-term economic growth and perceptions of corporate health and default risk.
As the figure illustrates, financial conditions in the U.K. have dropped to levels not seen since the 2007-9 freeze-up of the global financial system that surrounded the collapse of Lehman Brothers in 2008. This most recent collapse, unfortunately, was to be expected. As of March 25, there have already been 465 deaths in the U.K. amid 9,600 reported cases of the Covid-19 virus since the start of the year — for a mortality rate of 4.8%.
But it was only on March 23 that the government required people to stay in their homes, despite earlier lockdowns in Asia and on the Continent that appeared to have slowed Covid-19’s spread. A model of cumulative cases in the U.K. shows that the number of cumulative cases doubled from the time that week that Johnson took steps to limit social interaction. It seems plausible for the cases to rise along that path for the next two to three weeks until the quarantine takes full effect.
The quarantine of the public, the lack of non-essential spending and the shuttering of businesses are bound to result in waves of demand shocks across the U.K. economy. The loss of income – if not replaced — will continue to loop back throughout the real economy and into its financial underpinnings. That’s where financial conditions play their part.
A loss of confidence in the economy increases the compensation demanded by lenders to account for default risk, resulting in the loss of market makers and the loss of liquidity necessary for short-term transactional requirements of day-to-day business. In the long-term, borrowers and lenders lose confidence in the expected return on investment, stifling the ability of an economy to grow.
The monetary authorities have learned to respond to these confidence killers with quick action. Still, while central banks can infuse the financial system with liquidity and reduce interest rates to promote investment, they can’t replace lost income or lost labor or replace the productivity of capital investment. Now it’s time for the fiscal authorities to quickly maintain household incomes while a vaccine is developed. These are indeed frightening economic times.
Performance of index components
The RSM U.K. Financial Conditions Index is an aggregation of the performance of eight indicators in the British currency, equity, money and bond markets. Components include the British pound-euro exchange rate and its volatility, the FTSE 100 and its volatility, the U.K. Ted and Libor/OIS money-market spreads, and gilt and U.K. corporate bond spreads.
FX market — The pound has lost 8% of its value since before the equity market crash at the end of February. Losses were equally against the euro and a basket of trading partners’ currencies, all on higher volatility. This loss of buying power is likely to have further negative implications for manufacturers and household balance sheets, acting as a further drag on profit margins and consumer spending in the months ahead.
Equity market — The FTSE 100 lost an incredible 21% of its value since February 21, on higher volatility. This decline followed the loss of confidence in the ability of U.S. authorities to manage the health crisis, which has afflicted the world’s major stock exchanges.
Money markets – Interest-rate spreads between credit-dependent money-market rates and government-guaranteed securities act as the canary in the coal mine for liquidity considerations. As the figure below illustrates, money-market spreads tend to blow out during crisis periods, with the current spreads approaching liquidity constraints during the European debt crisis.
Bond market — Ten-year gilt have yielded less than 0.50% since the equity market crash, and the government yield curve remains inverted. That signals concern for both short-term and long-term growth. And the corporate bond market is pricing in substantially more credit risk than before the coronavirus outbreak.