The news that Oxford/AstraZeneca has created a vaccine that is potentially 62% effective with two full doses and 90% effective if a person gets a half a dose followed by a full dose is a much-needed boost for a beleaguered U.K. economy. This will bolster U.K. financial conditions and economic prospects heading into the end of the year.
We anticipate that the British economy will shrink by 10.8% in 2020 and will be followed by a robust 5.3% recovery in 2021.
New cases of coronavirus infections in England are being reported at a rate of more than 25,000 per day. That’s five times higher than at the peak of the initial outbreak in April. And COVID-19 deaths are increasing again, but the latest average of 425 deaths per day is less than half the number at their peak.
Despite reasonable expectations for a vaccine, it’s hard to imagine that a fivefold increase in coronavirus infections won’t have at least some impact on fourth-quarter economic activity that will carry over to the new year. We anticipate that the British economy will shrink by 10.8% in 2020 and will be followed by a robust 5.3% recovery in 2021.
The vaccine cannot come soon enough, both in terms of human misery and the economic fallout. As we found after the last existential shock to the economy – the 2008 global financial crisis – the longer and deeper the downturn, the greater the likelihood of long-term detrimental effects on the labor force, reduced and delayed investment, and diminished potential economic growth.
Now add to this scenario the continuing saga of Brexit negotiations. Deal or no deal, the fact that the government is hell-bent on installing sleeping policemen between England and its closest trading partners should be a concern for business planning and a further drag on investment.
Though service-sector employment has taken the brunt of the pandemic lockdowns, the outsized role that the manufacturing sector plays in the direction of the overall economy will be a concern if trade between the U.K. and its trading partners is hampered, or if European Union industries were to look elsewhere along the global supply chain. (That’s certainly what has happened to U.S. agriculture in retaliation to U.S. tariffs placed on Chinese goods.)
After 10 months of a pandemic and 11 months into the final year allotted for Brexit negotiations, there remains the potential for two existential shocks to the economy. A vaccine seems imminent, but it will take months for the population to feel safe and for life to get back to normal. Just think of the toll on the economy during the first coronavirus shutdown.
Meanwhile, the likelihood of the Brexit negotiations resulting in a sane solution for maintaining the current level of trade seems to be dwindling as we come down to the wire.
While the Bank of England has done its part in maintaining financial stability and commercial viability through an extremely accommodative monetary policy stance, the fact that financial conditions remain below normal is troubling.
We designed our RSM U.K. Financial Conditions Index to quantify the degree of risk being priced into the asset markets. We would expect the index to mean revert as the business cycle progresses, with values greater than zero indicating reduced stress within the accommodative financial environment necessary for investment and growth.
Conversely, index values less than zero indicate increased levels of risk and a tightening of financial conditions, suppressing the propensity to borrow and lend, and implying slower growth in coming quarters.
Our index has reacted accordingly to external shocks, dropping significantly below normal by two standard deviations during the late-1990s LTCM/Russia financial crisis, dropping to 10 standard deviations below normal during the 2008-09 financial crisis, and then more than two standard deviations below normal during the 2011-12 European debt crisis.
The financial markets have similarly responded during the Brexit era, with financial conditions worsening by 1.4 standard deviations at the time of the Brexit referendum and then again during the pre-Brexit political turmoil. The collapse of the equity market to the outbreak of the coronavirus in March sent the U.K. Financial Conditions Index to four standard deviations below normal. Financial conditions have since recovered to roughly 0.5 standard deviations below normal, indicating lingering perceptions of inordinate market risk.
As such, we expect the Bank of England to retain its defensive posture and to continue its role as the facilitator of emergency fiscal policy. The central bank’s mission will be to fund government spending to keep cash in the hands of consumers and to avert a depression, and then to keep long-term interest rates low in order to finance the cost of pandemic-incurred debt over time.
That financial conditions remain negative argues that it is up to the political establishment to re-establish a fully employed and productive labor force and maintain expectations for economic growth.
In the figures that follow, we take a closer look at the performance of financial assets, assessing the amount of risk being priced into the markets, which determines the degree of financial accommodation in our composite financial conditions index.
Equity market
Despite its rebound, the yearly return on a FTSE 100 investment remains significantly below pre-pandemic levels. Although equity market volatility has subsided since the crash in March, it remains higher than what would be expected.
The equity market is not the economy, but it does provide a measure of investor confidence (or overconfidence) in the ability of corporations to increase profits. Accordingly, the surge in price volatility in March – which rivals the 2007-09 financial crisis – and its current elevated level is an indication of what could happen should the vaccine’s implementation be delayed or if Brexit concerns are not adequately resolved.
Money market
The money market is essential for business transactions and short-term funding. A shock to the financial sector causes lenders to build additional default risk into funds available to the business community. The interest rate difference between commercial rates and risk-free rates is a measure of that default risk.
During the financial crisis, money market spreads climbed to 250 basis points. This year, though money market spreads spiked in response to the March equity market collapse, the swift injection of liquidity into the commercial lending market by the Bank of England and other central banks managed to prevent the freezing of commercial borrowing.
Because of the central bank’s swift action, the financial sectors are awash with cash. And with policy rates at the zero lower bound (or less), and with the ongoing compression of interest rates, British T-bill rates are negative, Euro-pound rates and OIS rates are a mere 5 basis points, and money market spreads remain negligible.
Bond market
The bond market provides funding for longer-term investing by businesses and governments. The yields of long-term bonds are determined by expectations of policy rates (which are determined by expectations for economic growth) and by a risk premium that investors require for the uncertainty that the path of short-term interest rates will deviate from the expected path sometime over the life of the bond.
That deviation takes into account the possibility of event risk, resulting in either a negative or positive shock to economic growth and inflation or deflation. Brexit, the U.S. trade war and now the coronavirus pandemic were negative events that are ready to be resolved – for better or for worse.
We are also at the end of what has been a secular decline in long-term interest rates. The worldwide decrease in 10-year government bond yields corresponds to the development of a global labor market and to the success of inflation-targeting policies among the central banks of the developed economies.
In the most recent period, the fixed-income market began losing confidence in the potential for British economic growth as Brexit moved from pipe dream to reality. The consequences of putting a boundary between England and its largest trading partner have investors pricing in larger risk for growth. Investors are therefore demanding compensation for the increased risk of recession and deflation. Gilt yields are range-trading below 0.5% because of Brexit anxiety, with recent slight increases in reaction to promising news of a vaccine.
The yield-curve spread between 10-year gilts and three-month Treasury bill rates has been increasing, with higher spreads indicative of expectations for a vaccine and the prospects of improved economic growth. The decline in the yield-curve spread since the financial crisis is attributable to the compression of interest rates, with short-term rates approaching zero and long-term rates falling because of reduced expectations for inflation and an increased risk of slower growth and an increased risk of deflation.
Finally, the interest rate difference between corporate bond yields and the guaranteed return of a government-issued gilt is a measure of corporate default risk. Shocks to the real economy or to the financial sector can cause lenders to build additional default risk into funds available to corporations.
So the corporate spread that was 250 basis points at the start of the pandemic – levels seen only during the financial crisis and the European debt crisis – has now receded to about 115 basis points. We would attribute its low level in such a fraught atmosphere to the compression of long-term interest rates and the prospect of the Bank of England stepping in should conditions deteriorate further.
For more information on how the coronavirus is affecting midsize businesses, please visit the RSM Coronavirus Resource Center.
