We are witnessing a global economic collapse without precedent in modern times. As investors we must think about what the world will look like when the pandemic has passed. This is difficult to do because the information we have is so uncertain and fragmentary. Sandy McGregor offers his thoughts on some of the features of the post-pandemic world.
The collapse of global economic activity that we are currently witnessing is without modern historical precedent. Conventional measures of economic activity have lost all meaning and we have become reliant on sound bites of information to form a picture of what is going on. It seems that China and other North-East Asian economies are slowly starting to get going again as their shutdowns end, and that the health crisis is reaching its peak in Europe and the United States. In South Africa, the lockdown has contained the spread of the virus, but we have yet to see whether this is sustainable.
There is growing controversy about whether total shutdowns are a sustainable solution to the crisis. Some argue that the cost of massive unemployment is greater than the toll of the pandemic. It is questionable whether a long-term closure of the economy is a viable option. Some countries, such as Brazil, are not going into lockdown for this reason.
Normally after a deep recession, the initial bounceback is very strong
As an initial lockdown comes to an end, difficult choices will have to be made. Italy has chosen to extend its lockdown for another three weeks. Alternatives include extensive testing and isolation of anyone who tests positive for the virus. This has been done successfully in Taiwan. Another approach is to quarantine vulnerable groups, for example those over the age of 50.
While one cannot speak with any certainty, judging from similar flu-like epidemics and the recent Chinese experience, the pandemic should run its course during the northern summer, and an economic recovery may start to gain momentum in the third quarter. The rate of recovery will depend on the damage done to corporate and household balance sheets and the pace at which those who lost their jobs during the lockdowns are rehired.
Normally after a deep recession, the initial bounceback is very strong. This time round, consumer confidence could be the critical determinant of the pace of the recovery. Consumers must feel safe enough to get out of their homes to go shopping.
My sense is that it will probably take at least two years to get back to where we were at the end of 2019, and possibly much longer. For emerging markets, such as South Africa, global trade is a key driver of economic growth. The pace of the return to normal will depend on when and how international trade recovers. Fortunately for commodity producers, China, which is the biggest importer of raw materials, is likely to be the first country to get manufacturing going again.
it will probably take at least two years to get back to where we were at the end of 2019
The liquidity crisis
Already in September 2019, a liquidity crisis had developed in the US money markets, which the Federal Reserve (the Fed) was addressing by creating new money at a rate of about US$60 billion per month. With the onset of the global crisis in early March, things got far worse, with a stampede for cash causing much greater liquidity problems.
Throughout the world, central banks have responded with aggressive monetary easing. The European Central Bank (ECB) made EUR700 billion available, and the Fed is injecting some US$2 trillion into the system – with the promise of more to come if required. Developed economy interest rates have been slashed to zero. Simultaneously, any sense of fiscal discipline has been abandoned as governments rush to put in place subsidies deemed necessary to keep the show on the road.
When the pandemic has run its course, it will leave a lasting legacy of hugely inflated monetary aggregates and unsustainable fiscal deficits. Over the past decade, one of the notable features of the economic management of developed economies has been what is euphemistically called quantitative easing (QE), but more accurately described as large-scale money printing. It is noteworthy that all this QE has failed to significantly boost economic growth, but it has massively inflated asset prices.
The outcome of the current orgy of money creation is unlikely to be any different. As the present crisis has cascaded from bad to worse, central banks have been playing a vital role in maintaining a degree of financial stability by ensuring markets and businesses have access to the cash they require to continue operating. However, the experience of the past decade suggests that as markets return to some new equilibrium, most of the new money created will migrate into equities, bonds and property.
Increased state intervention
It is worrying that in many countries, fiscal deficits are growing so large that funding them will require perpetual QE. The political pain involved in restricting spending to what can be financed conventionally is regarded as unacceptable. Prior to the current crisis there was already a widespread political shift in favour of increased government spending and intervention in the economy. The failure of a decade of QE to generate inflation has promoted complacency about the ability of governments to fund greatly expanded fiscal deficits. For example, the latest UK budget, tabled just before the health crisis struck, abandoned Margaret Thatcher’s legacy of fiscal prudence. Meanwhile, President Donald Trump has presided over an increase in the annual US fiscal deficit to over US$1 trillion. Measures being implemented to combat the coronavirus will more than double this. It is to be feared that the present crisis will accelerate the already established trend towards big government.
the resumption of our traditional exports will promote a return to normality
Huge fiscal deficits funded by printing money will have all sorts of unintended adverse consequences. Governments will respond not by tackling the real problem, which is that they are spending too much, but rather by attempting to sustain the unsustainable by a plethora of regulations. State intervention in economic activities and in our lives will increase. Ultimately, all this will end in grief as it did in the now forgotten 1970s, when inappropriate monetary and fiscal policies aimed at sustaining economic activity led to very high inflation and ultimately recession.
One of the legacies of the pandemic will be a string of bankrupt companies. These will be concentrated in certain industries, for example airlines. Many of these companies are too important to be allowed to fail. Some will find that they are unable to raise in private markets the capital they require to stay in business and the state will have to intervene, possibly becoming a major shareholder. This will be a repetition of what happened in 2009, when in many countries the state became a major bank shareholder. Direct state involvement in business will increase and the long-running tendency of states to disengage from business activities will end.
An inflation risk
In Quarterly Commentary 4 2019, I wrote about inflation, mentioning the threats which could end a long period of price stability. The massive acceleration in monetary easing, and the expansion of fiscal deficits in response to the pandemic, reinforce these risks. There will be some respite from the collapse of oil prices towards US$20 per barrel, however, all this money creation could be inflationary.
The interruption of supply chains may cause shortages, which in an environment of abundant money will cause significant increases in prices. State interventions almost inevitably put up the cost of doing business, which firms have to recover through higher prices. Once the inflation genie is out of the bottle, it may be difficult to put back. This would be a terrible shock to investors, who have experienced four decades of continually declining inflation rates.
South Africa has plunged into a corona crisis, following a path similar to that of other countries, with a 21-day lockdown, which was subsequently extended to 35 days. We, too, face difficult decisions about whether lockdown is a sustainable strategy. Whatever choices are made, the damage to business, employment and personal balance sheets will be substantial. It is too early to come to definitive conclusions about the full nature and extent of this damage. All one can say is that it will be large.
We also experienced a financial meltdown at the onset of the crisis, as overleveraged investors tried to sell illiquid assets, and the traditional bond market-making system collapsed under a wave of one-way selling. The South African Reserve Bank acted to restore stability, providing banks with the liquidity they require and reinforcing the bond market-making system.
To add to the pain, Moody’s finally reduced its South African rating to a non-investment grade, which will result in our exclusion from the FTSE World Government Bond Index (WGBI) on 30 April, and Fitch downgraded our rating one notch further into junk. So far the market reaction has been muted, but this could change as the 30 April deadline draws closer, because portfolio managers who are restricted by mandates to investment-grade assets will be forced to sell their South African bonds.
With the drying up of export revenues the rand has been weak, and this is likely to continue as long as international trade remains paralysed by lockdowns.
Where to from here?
As the world recovers, so will the South African economy. Initially, the resumption of our traditional exports will promote a return to normality. Of significance will be a recovery in global auto sales, which are a significant market for South African exporters. We shall come out of the crisis with a hugely bloated fiscal deficit and government debt. Recovery will be slow.
Things have never been bad enough for our political leadership to take the hard decisions required to fix the economy. Hopefully the extent of the current crisis will create the opportunity to implement the many reforms that are necessary to return the country to sustainable growth.