State Of The World

Whilst the recovery in the second quarter was pleasing, it is important, as Pegana Capital point out, to take a long-term perspective. They point out that over the past five years alone we have witnessed:
– A concentrated growth-company bull market, driven by a handful of US tech companies now worth more than annual German GDP.
– Trump being elected President of the USA.
– Brexit.
– US-China Trade War.
– European debt crisis.
– Negative interest rates for the first time in human history.
– COVID-19.

 

 

State Of The World

Now The Dust Has Settled

Whilst the recovery in the second quarter was pleasing, it is important, as Pegana Capital point out, to take a long-term perspective. They point out that over the past five years alone we have witnessed:

– A concentrated growth-company bull market, driven by a handful of US tech companies now worth more than annual German GDP.

– Trump being elected President of the USA.

– Brexit.

– US-China Trade War.

– European debt crisis.

– Negative interest rates for the first time in human history.

– COVID-19.

The list could go on, but the key message is we have collectively experienced seemingly inexplicable events. After an initial market plunge, rivalling 1929 and due to the COVID-19 crisis, central banks rode to the rescue by cutting interest rates and pumping liquidity into the financial system, which fuelled a strong recovery in stock markets. Now, with rock-bottom interest rates seemingly here to stay for a generation, it is critical to be asset owners in the form of stocks and shares in appropriate companies, acknowledging there will be ups and downs from holding these assets, but over time the direction of travel has been positive.

We are now beginning to understand just what an exogenous shock COVID-19 has proven to be, on the entire planet’s economy, as well as tentative signs of how best to cope with it. Turning to the economic consequences; the World Bank indicates that a record 92.9% of the World’s countries are in recession in 2020. This level is well above the previous high recorded in the Great Depression of 83.8%. With over 90% of the World’s economies contracting, the present global recession has no precedent in terms of synchronisation. Therefore, no region or country is available to neither support or offset contracting economies, nor lead a powerful sustained expansion. As a result, recessions are either deeper or longer lasting when a very high percentage of the World’s economies are contracting, rather than when they are centred on a limited number of countries. A corollary of this is that a major slump in World trade volume has taken place. This means that one of the historical contributions to advancing global economic performance will be in the highly atypical position of detracting from economic advance as continued disagreements arise over trade barriers and competitive advantages between China, the US and EU.

ASR Research highlight that several lessons have emerged about the pandemic and the policy response to it. Each has implications for the global economy. ASR note that: “First, the virus is depressing activity far more than the lockdowns. For instance, some economists at the Bank of England have shown that the bulk of the decline in UK consumption occurred before lockdown measures were introduced. Second, social distancing has been successful. Timing has mattered too. A group of researchers from the World Bank have found that “a country that implemented a lockdown one week before the first death by COVID-19 was reported, saw a decrease in economic activity that was about 2% smaller than a country that implemented a lockdown on the day of the first death. On the other hand, a country that implemented the lockdown only one week after the first death by COVID-19 experienced a 2% larger decrease in economic activity. Each day of delay is estimated to be associated with a 0.3% additional decrease in activity.” Third, there’s no trade-off between beating the virus and protecting the economy. Those countries that have locked down earliest, hardest and most intelligently have tended to see a more sustained drop-off in the rate of infection. This in turn has allowed consumers’ behaviour to normalise to some degree. Fourth, no country is immune to a second wave. Fifth, policy support has (mostly) worked.” These suggest a true economic recovery will only take hold once the virus has been substantially suppressed and that re-opening too soon (hello Florida, Texas et al.) could raise the long-run costs.

Considering the depth of the decline in global GDP, the massive debt accumulation by all countries, the collapse in World trade and the synchronous nature of the contracting World economies, many have questioned just how asset markets could have seen any sort of recovery. As we noted above, the bigger picture is that the Federal Reserve has been the clear driver of equity markets, via the liquidity supply of US Dollars and money being fungible i.e. finding its way into assets.

It does not mean the ‘real’ economy is left by the wayside though as a consequence of the bounce back in the financial economy. Indeed, forward looking indicators and other high frequency economic data would indicate that a recovery from the economic nadir reached in the first half of 2020 is underway. The pace of this recovery will become clearer in the coming weeks and months. Ironsides Macro points out that: “unlike the Global Financial Crisis, the COVID-19 contraction is not the end of a financial cycle as it pertains to the US, and while aggregate US debt remains elevated due to Government debt at historically unsustainable levels, household and financial sector debt levels are low enough to support a favourable response to stimulus. Of course, were the stimulus to end abruptly, the household sector would react negatively. However, anyone who has been watching public policy reaction functions for the last decade would conclude there will be a deal before the summer recess [in early August].”

The onset of COVID-19 has allowed central banks to be more adaptive and supportive to their respective economies than may have previously been the case, but a more fundamental and profound change around inflation mandates could soon be upon us. This is important to bear in mind when we look back historically at how Governments have dealt with reducing gargantuan levels of debt, normally following a war. Taking the Federal Reserve (Fed) as an example, prior to COVID-19, the Fed was debating a strategy overhaul that was likely to include a change from a symmetrical inflation, to an average inflation target. Practically speaking this implied were inflation to undershoot the 2% target, the Fed should ‘allow it’ to remain above the target long and / or high enough, to average 2% through the business cycle. There was some reticence to implement this change late in a business cycle; however, it is now the beginning of a new business cycle, this change in strategy is probable.

Now, given the amount of debt issuance the US Treasury is undertaking, to support the real economy, if you combine yield curve control (when a central bank acts to cap the level of interest that a bond can rise to in the market) together with raising regulatory obligations for financial institutions to hold US Treasuries and an inflation rate that could be allowed to rise above 2% you may well have a solution to reducing debt, which coincidentally is what the US did more or less after 1945. As we said at the start, in these circumstances an investors’ bias should be focused on real assets.