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Investment insights from Capital Group

Washington’s sweeping $2 trillion fiscal stimulus, while unlikely to prevent a recession, should prevent a disorderly downside scenario. The relief package includes one-time cash payments to individuals, expansion of unemployment benefits, grants and loans to large corporate sectors, loans to small businesses, and aid to state and local governments. This direct support to the U.S. economy represents about 10% of U.S. gross domestic product, and its impact on quarterly growth would be double that if the spending is concentrated in the second and third quarters of 2020. 

Incoming U.S. economic data are already demonstrating the severity of the contraction. This is not a situation where distress and bankruptcies will occur over an extended period. Rather, it is a total shutdown of large segments of the U.S. economy. 

U.S. economy’s sharp slowdown is underway

Trying to forecast precisely how bad things will get is pointless, because we are likely to see unprecedented shifts in the economy. Rather, the area to focus on now is how long it will last, and how extensive the damage might be. Assuming the coronavirus pandemic wanes in late spring or early summer, there are three possible scenarios: 

• Activity rebounds sharply in late 2020 once the virus ebbs (probability: 35%);
  
• A more sluggish recovery, but no lasting damage to the economy (probability: 30%);
  
• A recession that extends into 2021 (probability: 35%).

Risk of an extended downturn

The duration of the downturn matters for the outlook. If individuals and businesses feel that they face an event with a finite time frame, and that they will be supported during that event, then they are less likely to make changes in their behavior that have long-term economic implications.

That would require getting back to “business as usual,” or something approaching it, within a few weeks. In that instance, it is likely that most people who have lost their jobs would be rehired. However, if the shutdown extends much beyond that, then the loss of income and demand at the individual and business levels could make for a nasty, and extended, downturn. 

Fiscal stimulus will help – assuming it can be implemented quickly for the many affected sectors and individuals. But it essentially needs to replicate an economy that is not at a standstill by allowing businesses to maintain cash flow and workers to maintain income.  

Monetary policy response 

Policymakers at the U.S. Federal Reserve have moved rapidly to stabilize financial markets and prevent a disorderly outcome in the near term. While these actions won't likely prevent a recession, they show the gravity with which policymakers are viewing COVID-19’s impact on the economy.

The Fed made two emergency cuts to bring short-term interest rates to near zero, and it unleashed a major escalation of asset purchases. This includes unlimited buying of Treasuries and mortgage-backed securities, as well as purchases of corporate debt and securities backed by consumer loans. It also announced the Primary Market Corporate Credit Facility, which will provide credit to investment-grade companies “so that they are better able to maintain business operations and capacity during the period of dislocations related to the pandemic,” and it indicated that it would establish a Main Street Business Lending Program to “support lending to eligible small- and medium-sized businesses.” The Fed will also receive an additional $400 billion in funding from the U.S. Treasury that it can leverage to $4 trillion, adding further support for key industries affected by the virus. 

Assuming all of the relief measures can be implemented quickly and effectively, the trajectory of the spread of COVID-19 cases remains the final key unknown. Income support could allow for a rapid recovery once the virus wanes, but only if the duration of the shutdown does not extend beyond a few weeks. It remains to be seen how quickly the U.S. can reach a level of coronavirus testing that gives reasonable assurance that social distancing has been effective in slowing the spread, and that activity in at least some portions of the U.S. economy can resume. If the shutdown extends into the summer, then the probabilities noted above will shift in favor of a more damaging recession.

A hit to the U.S. fiscal position

To be sure, the massive spending associated with the coronavirus response will weigh heavily on the U.S. fiscal position. The chart below depicts the trajectory of the U.S. federal debt-to-GDP ratio prior to the impact of the virus. The virus response could push the debt burden to 110% of GDP.

U.S. debt burden likely to accelerate

One final caveat: Leveraged loans, which have been considered a risk to the current expansion, are not directly supported by any of the stimulus measures noted above. Currently, this market is experiencing significant stress. It is still possible that this weakness could create contagion that leads to additional problems in the economy. However, that appears less likely to occur in the face of trillions of dollars in fiscal and monetary stimulus. Most likely, it remains a problem for another day.