Fiscal support necessary, but not sufficient, for market recovery - Capital Economics
Capital Daily

Fiscal support necessary, but not sufficient, for market recovery

Capital Daily
Written by Oliver Jones

The extra fiscal support announced in the past twenty-four hours is a welcome and necessary step to limit the longer-term economic damage that the coronavirus outbreak could cause. But even a huge fiscal expansion, plus the monetary measures already in place, will not be able to prevent a major short-term hit. We doubt that it will turn markets around by itself either.

  • We expect the central bank of Brazil to cut its policy rate by 25bp
  • Further fiscal stimulus measures are likely to be announced in the US and the E-Z
  • You can track the spread of COVID-19 and its impact on our dedicated page here

Key Market Themes

The extra fiscal support announced in the past twenty-four hours is a welcome and necessary step to limit the longer-term economic damage that the coronavirus outbreak could cause. But even a huge fiscal expansion, plus the monetary measures already in place, will not be able to prevent a major short-term hit. We doubt that it will turn markets around by itself either.

The market reaction this morning to statements from the French government and the EU paving the way for extra fiscal support followed a now depressingly-familiar pattern. European equities opened higher, but the initial gains proved fleeting. We do not expect anything very different when the UK announces similar plans later today, or if the US gets in on the act with a much larger fiscal response of its own in the next few days.

Fiscal and monetary support can help to keep businesses afloat and the financial system functioning (France’s President Macron specifically pledged that no business should go bankrupt as a result of the coronavirus), which should help prevent recession from turning into depression. But the key point is that there is little that economic policy can do to mitigate the immediate damage caused by locking down parts of the economy, something which is now happening in some form in every major advanced economy. That is why we have argued that a sustained recovery in financial markets will require news that the spread of the virus is slowing, raising the possibility of lockdowns ending.

The enormous increases in fiscal spending likely to be required to keep businesses running might also create their own set of accompanying problems. Investors may well largely forgive countries issuing bonds in their own (reserve) currency – like the US, UK and Japan – a big increase in their debt-to-GDP ratios. But sovereigns issuing in a currency they do not control, or which does not have anything like reserve status, are likely to have a far harder time. Governments in the periphery of the euro-zone, and many emerging markets, risk being caught between a rock and a hard place – needing to spend to prevent mass bankruptcies in the private sector, but compromising the long-term stability of their own finances to do so.

We are arguably already starting to see signs that this could become a problem. When investors first started to worry about the coronavirus outbreak, government bond yields generally fell, or flat-lined. But since the start of last week, they have been rising, especially in the periphery of the euro-zone and in emerging markets, where they have surged. (See Chart 1.)

Chart 1: EM $ & Italian Government Bond Yields (%)

Sources: Refinitv, CE

In the euro-zone, the ECB has the power to keep peripheral bond yields under control, should it decide to do so. Despite its unwillingness to act last week, we suspect that its hand will ultimately be forced, given the threat of the so-called “doom loop” between the bloc’s sovereigns and financial system re-emerging. But no such backstop exists for emerging economies – the IMF has far less firepower. The countries whose bonds are most at risk are those who already have limited fiscal space, and large external financing requirements. We discuss where the risks are greatest in a forthcoming Update on our Emerging Markets service. (Oliver Jones)

Selected Data & Events




CE Forecasts*

Wed 18th


Interest Rate Announcement





Housing Starts (Feb)






Exports (Feb.)





*m/m(y/y) unless otherwise stated; p = provisional

Key Data & Events


The retail sales and industrial production data for February suggest that the economy was in reasonable shape before the coronavirus outbreak struck, but that won’t prevent activity from declining sharply over the coming weeks as confidence slumps and government restrictions to control the spread of the virus are ramped up.

With the Fed having already announced emergency policy measures on Sunday evening, the FOMC meeting originally scheduled for Tuesday and Wednesday this week has been cancelled. In the absence of any other economic data or events, attention is turning to Congress as lawmakers work towards a potentially major package of fiscal measures to fight the virus and cushion the blow to the economy. (Andrew Hunter)


Euro-zone governments appear to be moving towards providing a significant fiscal response to the crisis, though the details and scale of any support are still not clear. The Eurogroup of finance ministers did not agree any substantial steps at their meeting on Monday, but they did say that they would do “whatever it takes and more to restore confidence”. A number of substantial pledges have now been made by national governments, including €300bn (12.5% of GDP) of loan guarantees from the French government. We expect more stimulus measures to be announced in the coming days. A key issue is whether euro-zone governments are willing to underwrite the debt of the weakest economies, notably Italy, either by using the ECB’s balance sheet or through issuing joint-liability debt (‘euro-bonds’). Meanwhile, the sharp drops in the ZEW measures of German and euro-zone investor sentiment in March came as no surprise, and point to sharp falls in GDP. Things are likely to get much worse in Q2, when we expect the euro-zone economy to contract more sharply than in the depths of the global financial crisis.

In the UK, we now think that the economic effects of the coronavirus will result in a 15% q/q fall in GDP in Q2. We also expect the Bank of England to cut interest rates from 0.25% to 0.10% soon and to relaunch its QE programme by increasing its balance sheet by £150bn. Moreover, the government will probably need to act as a backstop for banks and other sectors to prevent a deeper and longer-lasting recession. (See here.) The Chancellor is expected to unveil a host of new measures to support the economy on Tuesday afternoon. Finally, while the labour market was strong in January, a plunge in employment in the coming months appears inevitable. (See here.) (Melanie Debono & Thomas Pugh)

Other Developed Markets

The Bank of Canada’s announcement yesterday that it will begin buying up to $0.5bn of Canada Mortgage Bonds per week has led some to claim that the Bank has launched its own QE program, but in our view these hardly qualifies as “large-scale” asset purchases. For instance, the Federal Reserve’s latest commitment to purchase $700bn of assets “over the coming months” will increase its balance sheet by an amount equivalent to 3.3% of US GDP. For the Bank’s CMB purchases to reach 3.3% of Canadian GDP, they would have to continue for three years. Meanwhile, the manufacturing sector started the year poorly, with a fifth consecutive decline in sales in January.

While the New Zealand government’s $12b stimulus package will soften the blow from the coronavirus outbreak, it will not prevent a recession. As such, we still expect the RBNZ to launch quantitative easing in the coming weeks.

Japan’s exports are likely to have picked up slightly in m/m terms in February. However, that should not be interpreted as a sign of resilience amidst the spread of the coronavirus, as it was largely a result of the shift in the timing of Chinese New Year. (Stephen Brown, Ben Udy & Tom Learmouth).

Other Emerging Markets

In Emerging Asia, Pakistan’s central bank slashed its policy rate by 75bp to 12.5% in response to the worsening outlook for the economy. We think that further rate cuts are in store in the coming months.

In Emerging Europe, Turkey’s central bank cut its benchmark one-week repo rate by 100bp, to 9.75%. With the coronavirus outbreak in Turkey starting to escalate and containment measures elsewhere likely to hit the economy hard we expect another 100bp of rate cuts, probably before the next scheduled meeting in late-April. Beyond that, however, the scope for further monetary support will be limited by weakness of the lira. Meanwhile, the National Bank of Poland became the latest central bank in Central Europe to respond to the coronavirus outbreak by cutting interest rates by 50bp, to 1.00%. We think that the central bank will prefer to adopt more targeted measures to provide liquidity and coordinate with the government to support the economy. But if economic disruption intensifies, further interest rate cuts are likely.

In Latin America, we think that although Brazil’s central bank is clearly concerned about the recent fall in the real, it will still cut its policy rate by 25bp, to 4.00%.

In the Middle East and North Africa, Egypt’s central bank cut its overnight deposit rate by 300bp, from 12.25% to 9.25%, and we expect it to lower its policy rate further in the coming months. The central bank of Morocco also cut its policy rate (from 2.25% to 2.00%) due to concerns about the economic hit from the coronavirus outbreak and the intensifying drought in the country.

In Sub-Saharan Africa, we expect inflation in South Africa to have remained stable at 4.5% y/y in February. We think that the central bank will lower its benchmark rate later this week in an effort to boost the ailing economy. (Gareth Leather, Jason Tuvey, William Jackson, James Swanston & Virág Fórizs)

Published at 16.33 GMT 17th March 2020.

Editor: John Higgins (+44 20 7811 3912)

Enquiries: William Ellis (+44 20 7808 4068)