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JPM Decorative Letter - V

Fallout from COVID-19: Global Recession, Zero Interest Rates and Emergency Policy Actions

The global economy is now in recession, while market liquidity and depth have virtually disappeared in a number of asset classes. Policymakers around the globe are taking extraordinary steps to support financial markets with more than 50% of the world economy at or near the zero bound, while fiscal stimulus will exceed the response seen in the aftermath of the 2008 global financial crisis.

March 27, 2020

The speed of recent market moves is historically unprecedented and policymakers are taking extraordinary steps and moving beyond the toolkit used in the 2008 global financial crisis (GFC) to minimize the economic damage from the sudden stop in economic activity as the COVID-19 pandemic spreads globally. At the same time, market dysfunction is prompting a feedback loop between volatility, liquidity and flows that has resulted in increased market fragility.

What’s the Outlook for Global Growth?

J.P. Morgan Research now expects a double-digit contraction in global growth in the first half, with GDP contractions rolling through the global economy through much of the second quarter, until the outbreak fades. The global economy is likely to experience a historic decline in output in the second quarter. We forecast only the second global contraction since World War II and the eighth global recession in the past century.

J.P. Morgan’s economic forecasts see lasting damage from the COVID-19 shock. A two-quarter GDP contraction is expected in both the U.S. (-10% and -25%) and the Euro Area (-15% and -22%). Our forecast continues to embed an assumption that the virus runs its course by June and that the global economy will rebound in the second half of the year, with U.S. GDP projected to climb to 6% growth (annualized rate) over the final two quarters assuming that social distancing policies are significantly relaxed by mid-year. This leaves the level of U.S. economic activity 10% below the pre-virus baseline. China’s first-quarter growth will experience an unprecedented 41% decline, but is still on track to experience a V-shaped recovery, rebounding by 57% in the second quarter. China’s full-year GDP growth forecast has been lowered to 1.1%, from an initial starting point of 5.9% at the beginning of the year.

“Governments are acting with extreme measures to contain the virus, and that is broadening the disruption with an unprecedented downturn in economic activity. The key outlook issue now is gauging the depth and the duration of the 2020 recession,” said Bruce Kasman, Chief Economist for J.P. Morgan.

Labor markets will also be hit hard and a record 3.3 million Americans filed for unemployment benefits in the week ending March 21, far exceeding the previous record for initial jobless claims set in 1982. J.P. Morgan Research expects the U.S. unemployment rate to rise by 5 percentage points to nearly 8.5% before gradually declining in the second half of the year.

Central Banks Move Beyond Easing to Extraordinary Measures to Address Impaired Market Function

Policymakers are acting in unison and central banks around the world have called emergency meetings and have eased by an average of 59 basis points since the beginning of the year. The Federal Reserve (Fed) slashed its target range for the Fed funds rate by 100 basis points (bp) to the zero lower bound and 50%-60% of the world in GDP-weighted terms is now at or near the effective lower bound. In total, 24 central banks have eased since the start of the year and J.P. Morgan’s Economic Research team is forecasting 20 more rate cuts by central banks by mid-year.

Market function remains impaired and the Fed is doing whatever it takes to stabilize the U.S. Treasury and funding markets. Market depth remains at the lows of 2008 and Fed liquidity facilities have been launched and reintroduced. In contrast to the 2008 global financial crisis, when the crisis began in the credit markets, risk-free assets are at the epicenter of the current liquidity crisis with a near-total breakdown in market microstructure that has sent volatility skyward. This shock began in the Treasury market, but has since spread to commercial paper.

There has been a sharp pullback in liquidity provision by likely high frequency trading participants, who have come to represent 70-80% of market depth.

“Liquidity conditions remain dire for the deepest and most liquid bond market in the world,” says Jay Barry, Head of USD Government Bond Strategy at J.P. Morgan.

The 30-year bond traversed a 110 basis point range this past month, the largest since October 1987, while market depth in 10-year notes has averaged just $19 million, or the single lowest week for depth since 2008.

Treasury market depth has declined to levels not seen since 2008

*Market depth is the sum of the three bids and offers by queue position, averaged between 8:30 and 10:30am ET daily

Source: J.P. Morgan

Significant selling pressure has emerged in the credit space in money markets, with $100 billion of prime fund outflows and $300 billion of inflows into government funds as flight-to-quality took hold. The Fed launched the Money Market Mutual Fund Liquidity Facility (MMLF) to assist money market funds to support the flow of credit to households and businesses. “MMLF has provided a lifeline to prime Money Market Funds as they faced significant redemptions, and is providing them an outlet to access liquidity,” notes Alex Roever, Head of U.S. Interest Rates Strategy.

Authorities are taking steps to backstop the broader credit markets, in many ways exceeding the response during the 2008 Global Financial Crisis. On March 23rd, the Fed announced that it is turning its latest quantitative easing (QE) program into an open-ended one and expanded the list of securities to be purchased. The Fed also announced the creation of new credit facilities to purchase or lend to corporations in the primary and secondary credit markets, broadening out credit support that is much more meaningful. These announcements follow the Fed’s re-introduction of programs that were in place during the 2008/2009 financial crisis to ease liquidity pressures, including the Commercial Paper Funding Facility (CPFF), the Primary Dealer Credit Facility (PDCF) and the crisis-era term asset-backed securities loan facility (TALF). In addition, the Fed announced that they expect to establish a Main Street Business Lending Program.

“In broad terms, the Fed has effectively shifted from lender of last resort for banks to a commercial banker of last resort for the broader economy,” said Michael Feroli, J.P. Morgan’s Chief U.S. economist.

The proposal just passed by Congress would provide around $450 billion for the Treasury’s Exchange Stabilization Fund to use as credit protection to help distressed companies and industries. Levered up with funds from the Fed, this amount could potentially support around $4 trillion in lending.

“Numbers in this ballpark are what the economy will likely need. The Federal Reserve has already added a few new tricks to the playbook developed during the GFC and fiscal policymakers have crafted a package of stimulus checks, bailout loans, assistance to state and local governments, and other programs,” Feroli added.

Joyce Chang Quote The monetary response is impressive, but the more aggressive fiscal response and clear signs that the virus is peaking are essential to restoring market stability. Joyce Chang Chair of Global Research J.P. Morgan

The COVID-19 pandemic has also sparked the fastest reassessment of equity market fundamentals and risk in the last 30 years. The S&P 500 recorded its quickest bear market ever, with a 20% sell-off from the peak in just 15 trading days.

“The VIX has experienced its largest spike since the 2008/2009 global financial crisis and exceeded 60 for only the second time in its history,” said Marko Kolanovic, Global Head of Quantitative and Derivatives Strategy at J.P. Morgan. “U.S. equity markets have seen substantial deleveraging by hedge funds and systematic strategies. Over time, there could be a large rotation out of bonds and into equities, with the S&P 500 recovering by early next year. ”

Broad Fiscal Stimulus: Trillions in the Train

As with the financial crisis, one of the larger legacy costs will be fiscal finances, with deficits for developed markets projected to surge to roughly 5 percentage points of GDP this year. The U.S. Congress just passed the $2 trillion stimulus package, consisting of both spending and funding for loans/loan guarantees. Together with Fed intervention, the legislation amounts to a $6 trillion stimulus. By comparison, the $831 billion American Recovery and Reinvestment Act enacted in 2008 was about 6% of GDP. We pencil in deficits greater than $2 trillion and 10% of U.S. GDP for both fiscal 2020 and 2021, or a fiscal thrust of around 3% in 2020 and 1.5% in 2021. In total, fiscal policy is projected to add 2.2 percentage points to global GDP this year, on par with the fiscal thrust in 2009 during the global financial crisis.

“The monetary response is impressive, but the more aggressive fiscal response and clear signs that the virus is peaking are essential to restoring market stability,” said Joyce Chang, Chair of Global Research at J.P. Morgan.

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