Corona virus: A Playbook for Investors — Part 3
While the outbreak may start to subside, the knock on effect of Covid-19 on the global economy and financial markets is just getting started.
After one of the fastest declines in history, investors all over the world have been busy wondering whether markets have bottomed. A combination of history, sentiment and technicals suggest otherwise. Yet the essential question to ask may be another one: will policymakers succeed in averting the most severe deflationary spiral since the Great Depression?
First in China and now in Europe the curve of Covid-19 daily cases is flattening. Even in the US, latest data is encouraging pointing to a relatively successful, albeit belated, retracement of the pandemic. The cost of containing the virus however, may turn out to be as bad or worse, as the pandemic itself and its impact on the economy and financial markets is just starting.
The effort to contain the virus has required in most OECD countries the shutdown of large sections of the economy. The shock ensuing has been threefold. Economic as both demand and supply of goods and services has collapsed. Financial as households and businesses are depleting their savings or borrowing to make up for the loss of income. Lastly fiscal as governments are confronted by severely reduced tax income. The aggregate impact on Gdp is gigantic. According to the IMF, the global economy will shrink 3.0% in 2020, from a positive 3.6% estimated last December. A $5.8 trillion shortfall and the deepest from the Great Depression. Furthermore, even if the virus is successfully contained, it is unlikely that economic activity will resume to pre Covid-19 levels any time soon. The containment of the virus will still require social distancing and other restrictive measures until a cure and/or a vaccine are finalized and deployed, most likely in the second half of next year.
To start understanding what may happen next, it is crucial to bear in mind that the economy has entered the Covid-19 crisis with an unprecedented amount of debt: a record 355% of global Gdp at the end of last year. Research shows that the combination of exceptionally high level of debt and low interest rates, “zombifies” industries and businesses and saps the system’s ability to react to external shocks. The pandemic has therefore hit businesses and households at a time of extreme weakness. What happens to this colossal stock of debt is going to be the defining issue over the next months and years.
The distribution of the possible outcomes looks like a bi-modal curve whereby the bulk of probability falls into the two tail ends of the curve. More simply put, the possible scenarios are either a systemic default or the wholesale debt monetization. Tertium non datur as the customary “kicking the can down the road” this time is not going to be an option. While some very well respected analysts are forecasting the former, a global default, Occam’s Razor points to the latter. Policymakers will need to print whatever amount of money is necessary to serve as “buyer/investor of last resort”. The downside risk associated with any credit event is simply not acceptable given the intricate web of counter-party risk that is the global economy. In other words, as we have learnt in 2008, we are all on the same boat and a debt default would trigger systemic insolvency and spark a global deflationary spiral.
As opined on the previous installments of this three-parts series, governments and central bankers appear not to have any other option but to proceed in full “whatever it takes” mode. The daily barrage of announcements of monetary and fiscal intervention points precisely to that. It was especially extraordinary to see the US Fed, in essence, nationalizing the corporate bond market last week with no consideration for existing debt accumulated or moral hazard. Desperate to cushion the blow from the pandemic, governments have already unleashed close to $10 trillion. It is likely they will need more over the next months and years and governments will err on the side of fiscal largess hoping to avoid the truly first global economic synchronized depression in history.
If we hold the above assumptions correct, then the only issue that matter for investors is whether the policy makers will succeed in reflating the economy. After all, inflation is the only way to reduce debt beside default or debt cancellation, neither of which is appealing to incumbent politicians. Before Covid-19 inflation targeting was important precisely for that reason. Now it has become paramount.
Likewise, history suggest pandemics are powerful accelerators of pre-existing trends. The move toward fiscal stimulus/MMT, deglobalization and the the rise of populism predate Covid-19 and these trends are all inherently inflationary. Moreover the virus is fostering increased government intervention, more regulation and the re-shoring of large sectors of the economy. Such changes affect the supply of goods and services and impact efficiency and productivity. Lastly, the financial shock triggered by the pandemic will impact the competitive landscape, lead to more consolidation and reduce capacity, hence decreasing competition and putting pressure on prices.
The other major trend that the pandemic has accelerated is the expansion of governments balance sheets. Barely two months into the emergency and it is already clear we are bound to reach unprecedented levels of sovereign debt globally with the US, already at 113% of GDP. As any increase of taxation or reduction of expenses is politically out of question, the only viable way to manage debt is the devaluation of the currency in which the debt is denominated. Lastly, policy makers’ bias not to increase interest rates for fear of political retribution or to over tightening, contributes to the perfect set up for inflation to flourish.
Interest rates will continue to stay at zero for as long as the eye can see and there is no reason to believe that loose financial conditions paired with unlimited “buying of last resort”, will fail to reflate financial assets, at least on a nominal basis. If market participants believe policy makers will succeed, it would not be surprising for markets to find a bottom and start to move up again regardless of the extent of the post-virus economic recovery.
Make no mistakes however as the next decade will hardly look like the past one from an investment standpoint. The pandemic is fast tracking change but the reaction function to Covid-19 was in place way before the pandemic started. Inflation is the one thing that would be a game changer for investors as they have gorged on credit and US dollars for decades and are cognitively ill-prepared for any reversal of trend. While sovereigns can monetize debt in perpetuity, they will not be able to reverse a crisis of confidence if currencies start to look like they are no longer a reliable mean to store value — the proverbial toothpaste getting out of the tube. The epoch started in 1944 with the creation of the Bretton Woods System is about to end and the US dollar will lose its reserve currency status.
This scenario will take time to play out. We are likely to go through a deflationary phase first followed by multiple waves of fiscal programs aimed to reflate the economy. The political backdrop of “populists” governments and MMT becoming the ubiquitous policy tool will do the rest. A turning points may be the introduction of the digital versions of national currencies. These instruments enable far more sophisticated and targeted deployment of fiscal and monetary policy. The digitization of national payment systems was already on its way and the pandemic simply accelerated it. The claim that paper money may facilitate infection will conveniently provide additional political cover for the transition. Digital currencies replacing paper notes may be the endgame in the battle for inflation and debt debasement. China is already testing a consumer-facing banking/payment app and it will likely be the first major economy to launch a digital currency after which EU and US countries are likely to follow suit.
Once the dust settles over the pandemic, investors will rush for “harder” stores of value and wealth will move into assets whose value is driven by a combination of scarcity and wide enough consensus to ensure liquidity. The gradual migration from “fiat” to “real” assets that begun in the last decade and will only accelerate. Gold price is the “canary in the coal mine” as it has made new all-time highs against all currencies except the US dollar. New technologies that enable the transfer of assets with unprecedented speed and ease will also play a key role. Companies like fabrica.land, for example, already provision remote and almost instant outright property transaction in US. It is totally digital and and the transfer of the asset is completed in minutes. (disclosure: I am an investor in Fabrica).
Covid-19 is bringing the future forward. Rather than wondering if the S&P 500 has bottomed, cognizant investors may want to start to understand what’s coming and how to best position for the brave new world ahead.
The information on this document should not be interpreted as or deemed to be a recommendation to any investor or category of investors to purchase, sell or hold any security, currency or cryptocurrency. Any investment decisions must in all cases be made by the reader or by his or her investment adviser. The views expressed on this article are solely those of the writer.
