Waves of COVID-19 infection continue to lap around the world. Developing markets such as Brazil, India and South Africa are struggling to contain the disease, while a number of other countries are easing lock-downs and starting to revive their economies. The battle is far from won, but six months on from COVID’s arrival we can begin to take stock.
The collective fight against the virus means that we now know much more about our enemy and its effects. Some of the news is good, much is bad but unlike that famous spaghetti western, where you knew the last in the trio was ugly, many things that will profoundly affect markets remain complete unknowns.
The Good: it’s not bubonic plague and GFC MK2 has not happened
First the good news. COVID-19 does seem to be a milder disease than was initially feared. Studies around the world show that about two-thirds of people who test positive show no symptoms. The overall infection fatality rate is thought to be less than 1%, even if you are at considerably higher risk because you are older or in poor health. A study of 20,000 UK patients admitted to hospital with coronavirus showed that the median age of those who died was 80 years, and that of these 89% had pre-existing chronic diseases.
Two further fears which spooked markets at the start of March have dissipated. Western democracies have contained and reversed the spread of infection in a few short months. Many commentators worried that democratic societies would not be able to replicate the success which an authoritarian state such as China had in marshalling its resources to fight the disease. Secondly, fears of a second global financial crisis triggered by strain in credit markets in March have not been realised. The awesome scale and speed of central bank intervention put paid to that.
The Bad: debt escalates, unemployment surges, globalisation in retreat
However, support for the world economy has come at a heavy cost. Developed market debt to GDP is expected to grow by 15-20% if we can avoid a significant upsurge in infections in a second wave. If the virus makes a significant return it will be worse still. Recent analysis by Goldman Sachs points to government debt in developed markets reaching levels last seen in the closing year of World War 2. The rise in government debt leaves France looking perilously like the new Italy and Italy uncomfortably like the new Greece. Meanwhile, the UK has suffered the steepest fall in output since the great frost fair of 1709.
Such calamitous falls in GDP have had a stunning impact on levels of employment, with the fastest and steepest rise in joblessness on record. Many hope that this will reverse sharply as soon as the pandemic dies down. But such a shock leads to thriftier habits, and the lingering effects of social distancing will put a huge strain on the high street, the leisure industry and tourism. In its latest update, the Fed is expecting levels of unemployment two years hence to be considerably higher than they were before the pandemic. They are not forecasting a rapid rebound.
A third sizeable cost comes in the form of national retrenchment. This pandemic has laid bare the risks of outsourcing essential supplies to countries on the other side of the world. When you add this to the rising tone of anger against China from a Trump-led White house, the retreat from global trade and globalisation seems set to accelerate.
The Unknown: COVID-19, the eurozone and inflation
We may know more about the virus than we did, but we are clueless as to where it is heading next. Good and bad news jostle for attention in the daily media, with reductions in the number of virus cases in some countries countered by surges in others. For developed markets that appear to have beaten back the illness, the possibility of a second wave is of enormous importance. Any confident views on the future pathway of this virus should be followed with as much trust as the faith we would put in the person betting all on black at the casino table.
The future of the eurozone is as great a mystery. It is the world’s second largest currency and for the last 23 years the impossible has happened. A pyramid built upside down has managed to stay standing in spite of all the economic gales. Why the analogy of an inverted pyramid? Simply because a currency is usually the apex of a political and fiscal union. It is the capstone for a community which has agreed to sacrifice sovereignty in exchange for transfers from the strong to the weak. But ever since the start of the single currency there has been no such political or fiscal union. Northern states have been adamant that they never signed up to a ‘transfer union’, whilst weaker states have been ever more resentful of the highly conditional help which they have received from their richer European brethren.
Ten years on from the Global Financial Crisis, this new crisis looks to make or break the euro. The ruling of the German constitutional court in May, calling into question the legality of the European Central Bank’s (ECB’s) bond-buying programme, seemed to spell the end of open-ended support for the euro by the ECB. That looked like a decisive catalyst for a break-up. Now, some 60 years after the Treaty of Rome, Franco-German proposals seem to be laying the ground for the start of a genuine fiscal union. Discussions are ongoing and the amounts talked about are symbolic, but there is no denying the significance of these talks. If tentative steps to a fiscal union grow into something more significant, then the eurozone has a much more promising future than many of its critics allow.
The third big unknown is something that could wrong-foot much of the investment community. I started my career 26 years ago, and like a stone on a beach being progressively shaped with every passing tide, my investment style has been formed by the ever receding levels of inflation.
Owning lots of expensive factories, buildings or ships doesn’t make much sense when it is difficult to push up prices. When inflation is low they are seen as a drag on profitability, and the pressure over the past three decades has been to become ‘asset-light’, and focus on a business which benefits from growing demand but does not require heavy investment in physical ‘stuff’.
What if inflation starts to creep back? Variable costs such as wages will start to rise and margins will be squeezed. If you own a business that can’t do without a great big factory, then you will be covering your fixed costs with much greater ease just by increasing prices. Your margins will be rising.
For the moment, the market does not believe in the return of inflation. Who can blame them? Demand has collapsed around the world, but is rising inflation in a couple of years’ time so implausible? Under the pressure of huge central bank and government stimulus, measures of broad money growth have risen sharply. Governments have a vested interested in getting some ‘inflation tax’ back in the system to recoup the huge outlays they have made to get their economies through this crisis. When you combine this with the muzzling of dis-inflationary forces from China as globalisation recedes, it is completely feasible to see a return of inflation.
Hoping for the Beautiful, preparing for the Ugly
Synonyms of the word ‘crisis’ are various and include ‘turning point’, ‘climax’, ‘crux’ and ‘crossroads’. As this crisis unfolds, we know what is good, we know what is bad and we can see the paths which the world economy could go down at this fork in the road, although it is too early to tell which path will be taken.
We are ever mindful of not locking ourselves into a settled conviction at this crucial time when the facts are not there to support such a stance. We might end up with the Good, the Bad and the Beautiful, but we maintain a clear-sighted acceptance that after this hinge-point in economic history the last character in our trio could be the Ugly.
 Financial Times,15/06/2020
 Bank of England, 07/05/2020
 US Federal Reserve, 09/06/2020
 German Federal Constitutional Court, 06/05/2020
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Expiry date: 23 June 2021
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