State Of The World

As we deal with the US Presidential Election, Brexit end date and continue to cope with the pandemic, it is increasingly obvious that the future economy is going to change profoundly, once the pandemic has passed, and Governments and the public sector will have a domineering role in the future.

Harvard Professor, Nicholas Christakis, writing in the Wall Street Journal, provides the most trenchant remark on the impact of Coronavirus (COVID-19): “The worse the pandemic gets, the more people will expect from the State”.

 

 

State Of The World

As we deal with the US Presidential Election, Brexit end date and continue to cope with the pandemic, it is increasingly obvious that the future economy is going to change profoundly, once the pandemic has passed, and Governments and the public sector will have a domineering role in the future.

Harvard Professor, Nicholas Christakis, writing in the Wall Street Journal, provides the most trenchant remark on the impact of Coronavirus (COVID-19): “The worse the pandemic gets, the more people will expect from the State”.

In the Financial Times, building on the work in the IMF Fiscal Monitor, Martin Wolf notes that “during lockdown, the onus has to be on cash transfers, unemployment benefits, support for short-time work, deferral of taxes and social security payments etc. During reopening, support has to be more targeted, with incentives focused on getting people back to work. During the post-COVID period, systems of social protection that the pandemic has shown to be defective will need reform. Meanwhile, attention must shift towards active labour market policies and big boosts to public investment”. Thus, Martin Wolf advocates for the IMF view that this will “strongly stimulate private investment”. However, Hoisington Investment Management notes that “current research indicates that the Government expenditure multiplier is negative after about three years”, which means borrowing to spend by the Government has less and less of a positive impact on the economy, as the overall level of debt increases – welcome to the law of diminishing returns.

Martin Wolf acknowledges that “all this spending is going to raise public deficits and debt substantially. The global general Government fiscal deficit is forecast to hit 12.7% of Gross Domestic Product (GDP) this year; in high income economies, it will reach 14.4%. The global ratio of general Government debt to GDP is forecast to jump from 83% to 100% of GDP between 2019 and 2022”.

What distinguishes the economic impact of COVID-19 from a run-of-the-mill recession are two factors. Firstly, Governments decided to close economies, effectively condemning large swathes of the economy to hibernation in the pursuit of public health goals. It is this that then leads to the second factor, which is unique in that this caused (not initially) a manufacturing recession in the classical sense, but a service sector led recession that saw consumer demand collapse. Dubbed “Corona Recession”, by Professor H. Woody Brock, he postulates that the shock brought on by COVID-19 saw a collapse of services > business contraction > huge unemployment > huge consumption loss.

This underpins the rationale for support, as opposed to stimulus, provided by the US Government to its population to-date that has significantly boosted the recovery, with 57% of those who received special unemployment benefits receiving more than they made by not working than when they were working. Since the end of July, the support has dropped off and as the third quarter ended and October began, the prospects for any further stimulus remain very much up in the air. However, post-election we expect, whatever the political colour of the next administration, that Washington will fiscally stimulate the economy. If there is a “blue wave” of Democrats, then you should expect trillions more stimulus to boost GDP growth and lower unemployment.

We know that many businesses have been hurt, as demand for their output collapsed or they were locked down. The second waves of the disease now crashing on to many economies are likely to accentuate the problem. As the IMF’s Global Financial Stability Report shows, financial fragility is increasing in already highly indebted sectors of Western economies, as well as in emerging and developing countries. But we also know that things could have been far worse. The World economy has benefited from extraordinary support from Central Banks and Governments. According to the IMF’s Fiscal Monitor, fiscal support has amounted to “$11.7trillion, or close to 12 per cent of global GDP, as of 11 September 2020”. This is vastly more than the support offered after the Great Financial Crash.

Whilst A Vaccine Is Not A Cure…

On 22 September 2020, statnews.com ran a long article titled “The Road Ahead.” It lists 30 key moments that could either change the pandemic’s direction in the US, or at least give us important information. At this point no one knows what any of them will bring, but they are worth considering. By December, several of the vaccine trials should have gathered enough data to either seek FDA authorisation or go back to the drawing board. This could be a real turning point if at least one candidate looks safe and effective. By April 2021, the first-generation vaccines should be widely available. The question will then become whether people will want them. The maths is stark here. Success = Effectiveness x Uptake. A 50% effective vaccine given to 50% of the population will mean only 25% of us are protected, and we won’t know exactly which 25%. It is not clear if that will be enough to change public attitudes and drive the recovery. Vaccines will be a big economic story next year.

Trapped

At this stage, it is worth rewinding back to 2008 and the monetary and fiscal response to the Great Financial Crash then, and what subsequently impacted the pace of recovery. Demographics in the Organisation for Economic Co-operation and Development (OECD) countries meant that attempts to create growth didn’t function properly. So Central Banks tried devaluing currencies, bringing interest rates to zero or below, but still with no growth or inflation, which as a result meant debt did not go down relative to GDP. Now, having seemingly learnt from that time, already heavily indebted Governments are trying fiscal largesse – it is gigantic, but crucially (as previously mentioned) it is not stimulus, it is support, which is missed by most people. The support across the World is replacing lost income for the corporate and household sectors. Moreover, there remains evidence that it is not being spent, as households fear, quite rightly, prospects for second and third waves of the virus, lockdowns and the attendant impact on employment.

As Martin Wolf advocated above, more stimulus will come as it is backed by the IMF / OECD, but this does mean that Government debt expands and so does the amount of the economy controlled by the State. In Q2 2020, hedge fund manager, Felix Zulauf, notes that the US Federal Government’s share of the economy went from low 20s to mid 40s percent of GDP. In Europe, the Government’s share of the economy already exceeds 50% of GDP in many countries, and now post-COVID exceeds the private sector.

It is not alarmist to say that in such circumstances, we are effectively in a planned economy, with the free market pushed out, so fiscal authorities and Central Banks end up running the show, which may stifle innovation. Any subsequent negative market surprises are met by further State interventions and market manipulation in an attempt to smooth these out, which results in increased Government control, in extremis.
Historically, these circumstances eventually led to a hyperinflation and eventual monetary reform, but the demographics now across Western nations mean the hyperinflation may not be attainable. If Central Banks directly finance Governments, then hyperinflation could appear in weaker economies, but in Western economies money could be made electronic, allowing the State control over all transactions in an attempt to force people to spend by threatening to tax savings further.

Despite the risks inherent from a larger public sector on future growth and the historical analogue, public opinion in Western economies has swung firmly in a more collectivist direction, fuelled by years of rising inequality, stagnating real income growth and mounting existential environmental threats, all of which have been thrown into sharp relief by the pandemic. The implication is obviously for a larger Government role in the economy and substantially greater income redistribution. It is a very safe bet that taxes on the wealthy and large businesses will increase in future years.

The resulting size of a Government’s role in the economy acts counter-cyclically to economic growth, which then brings forward widening social consequences between the haves and have nots, leading to yet more Government interventions and a further slowing of economic growth, leading to a race to the bottom for countries. Immediately, we are going to see more fiscal support in 2021, with monetary policy remaining ultra-loose for years.

Market Impact

Investment Letter writer, John Mauldin, notes “…staying mostly home, people need supplies to sustain themselves. Furthermore, they continue wanting things that, while not strictly necessary, make life more comfortable. The problem is how to get those things without exposing yourself to crowds. The answer: have them delivered to you. Sounds simple, but it’s economically profound. Now they (consumers) want the goods brought to them. And, as it always does, the market is responding.”

The initial thought is obviously to add Amazon, but the changes we are seeing are more impactful than just that. Economic forces are creating new logistic jobs. Working from home is engendering a nascent boom, even if it proves temporary in the US and UK housing markets, as people reassess where they need to live if they aren’t going to the office every weekday. Demand for new homes and items from Amazon has to be met by a supply chain encumbered by COVID-19, which has kept humans out of work places, meaning employers are looking for greater innovations through technology such as robotics and AI. Perhaps the greatest surprise is, despite the prevalence of bigger Government, new business start-ups / formations across the World are up significantly, according to Swiss bank, UBS. This means a portfolio of equities needs to look to encapsulate these trends now.

We view this current period as a time to be very humble in terms of forecasting the future, but the rising involvement of Government in the economy now, coupled with the lessons learned from this experience in the past and combined with the impact of COVID-19 and geopolitics on global supply chains, does presage a probable increase in future inflation levels versus the recent past. In this situation of rising inflation, those holding nominal assets could suffer materially. Quality and liquidity will be a premium. Less liquid investments could become totally illiquid. So, despite the bouts of stomach churning volatility seen so far in 2020, you stay with large-cap equities and commodities. If Governments turn to massive issuance of debt, then conventional Government bond yields (the rate of interest they pay the bearer) will become the focus of acute attention. Will we finally see an end to the 40 year bond bull market? Fiscal stimulus could see yields double, but in that scenario the yield on the US Government 10 Year Treasury Note only goes from 0.7% to 1.4% and that may not cause any loss of sleep, but what matters is if the credit quality of the borrower (US Government) goes down and at some point yields may end up rising precipitously as a result.