From macro to micro: the economics of Coronavirus

You can subscribe to receive these notes by email here.

GDP data around the world was the worst on record in Q2.  Even Australia, which got through the global financial crisis with only one quarter of slightly negative GDP growth, contracted by 7.0% qoq in Q2, entering recession for the first time since 1991.  And this was one of the better Q2 GDP readings across larger advanced economies.

Looking forward, there are some positive signs in the global economy.  World trade growth looks to be recovering, PMI readings are largely in expansionary territory, and domestic traffic measures are increasing. But I am still expecting a gradual, bumpy recovery process after an initial partial bounce-back; less V-shaped, more inverse square root.

A k-shaped recovery profile

However, even as the macro picture in economies around the world gradually improves, supported by unprecedented fiscal and monetary policy stimulus, there are substantial micro shifts underway at sector and firm level. These micro dynamics, accelerated by Covid-19, will be at least as consequential as the macro shock.

For example, there will be structural pressure on sectors such as international tourism and physical retail. Even in countries where borders have reopened, notably in Europe, international tourism remains well down.  International carriers are suggesting at least a few years before passenger numbers return to 2019 levels, and sluggish growth is likely beyond this. 

In contrast, technology is structurally advantaged – with a more rapid adoption of new platforms to support working from home, e-commerce, and so on, as economic activity shifts from physical to virtual. Similarly, renewable energy looks to be a winner, as consumer preferences continue to shift and as some governments act to accelerate the transition to a low emissions economy. 

These different sectoral dynamics have driven the highly concentrated profile of returns in the US market, with technology sectors generating out-sized returns even after the recent sell-off. 

This has been aptly called a k-shaped recovery profile, with a wide dispersion of post-Covid-19 economic outcomes depending on your sectoral exposure.

This sectoral profile can also be clearly seen across small economy equity markets.  From New Zealand to Switzerland and Denmark, technology and pharma indexes have out-performed, while physical retail, tourism, and finance stocks are well down.  At an aggregate level, top-performing markets, such as Denmark that has out-performed the S&P 500 in 2020, tend to have market compositions that skew towards advantaged sectors (pharma, renewables). 

Coronavirus has sped up transitions already underway, leading to a structural rebalancing across economies.  Governments, firms, and investors need to position themselves for this new world.

Covid-19 structurally disadvantages many labour-intensive sectors

An additional challenge is that several of the structurally disadvantaged sectors are heavily labour intensive, such as hospitality and physical retail.  The growth sectors are often more capital and knowledge intensive.  This will generate acute structural labour market challenges, with a need for substantial numbers of workers to move across the economy.  To give an initial sense of the scale of the shock, hours worked across the EU27 were down by a staggering 13.5% between Q4 2019 and Q2 2020.

At the same time, border restrictions will place structural pressure on the growth models of economies that have relied heavily on migration inflows to bolster headline GDP growth (New Zealand, Singapore, and others).  This will create some demand for local workers, but may also create an incentive for firms to invest more in capital to substitute for foreign labour. 

Countries need to support a structural adjustment

Simply relying on macro policy will not be enough.  In addition to supporting general economic activity through monetary and fiscal policy, policy needs to support the structural transition: developing new growth engines; helping households to cope with the substantial labour market disruption; and supporting individuals and firms to retrain and upgrade skills for new opportunities. 

Some economies are moving policy in this direction already; for example, Singapore’s Emerging Stronger Taskforce, as well as the skills initiatives recently announced by the Singapore government. This week’s announcements around the Dutch National Growth Fund provide another example.  

More broadly, many small advanced economies are well-placed to undertake this transition.  They have high levels of human capital, strong innovation capabilities (see last week’s Global Innovation Index), strong records of employment creation, and many have world-leading active labour market and skills policies (Denmark, Switzerland).  Agility is likely to be more valuable than scale in navigating this new world.

My last note described the variation in performance across advanced economies in managing the economic impact of Covid-19.  But looking forward, the performance of economies, firms, and investors will be contingent on how well they position themselves for the structural dynamics generated by Covid-19. 

Done right, countries and firms could come out of this experience stronger.  But the margin for error is small.  A failure to respond appropriately raises risks of substantial economic and financial losses, as well as a deepening political backlash against increasingly skewed income and wealth distributions.

Chart of the week

Global airport hubs in small economies (Amsterdam Schiphol, Singapore Changi, and Hong Kong) provide a stark view of the collapse in international air passenger traffic in 2020.

Elsewhere around the world

In the latest episode of the chaotic Brexit process, the Johnson Government is proposing to deliberately breach international law ‘in a very specific and limited way’ (sic) by unilaterally redrawing terms of the Withdrawal Agreement. It’s a long way from the vision of ‘Singapore on the Thames’.  It has been said that there are two types of countries: small countries, and those that have not yet realised that they are small. The UK is in the latter group. 

In completely unrelated news, Scotland’s SNP has announced it will publish draft legislation for a second independence referendum before Scottish elections next year.  Polls suggest growing support for Scottish independence, up to around 55% (45% voted ‘yes’ in the 2014 referendum).

From Belarus to Greece and Taiwan, large countries are applying pressure on their smaller neighbours. Small states are often where big power rivalry plays out, and we are seeing more of this in a less certain global environment.  It is a reminder that small economies need to be serious and to have friends and partners.

China’s recent diplomatic roadshow in Europe was not a huge success.  In addition to a public dispute with the German Foreign Minister, there were arguments with the Czech politicians about their engagement with Taiwan as well as warnings to Norway on the Nobel Peace Prize: Hong Kong activists are in the running, raising the risk of Chinese sanctions on Norway similar to those imposed after the 2010 Peace Prize award.  From Sweden to the Netherlands, small European economies are taking a much more cautious approach to China.

Israel and the UAE, the two small states that are the most dynamic economies in the Middle East, are normalising economic and political relationships.  Direct flights and some commercial discussions have started.

Other writing

I prepared a paper for the New Zealand Productivity Commission on strengthening New Zealand’s productivity performance, drawing from the international small advanced economy experience.  The paper is available here. 

Dr David Skilling

Director, Landfall Strategy Group

www.landfallstrategy.com

www.twitter.com/dskilling