A Black Swan for the 21st Century
Software developer turned philanthropist Bill Gates warned in 2015 that the biggest threat facing humanity was not war but a pandemic. He argued that the world was not ready for such an event, highlighting the cost of a lack of preparedness both in terms of the humanitarian implications and the potential damage to the global economy.
Any prospect of an end to the economic slowdown of 2018/19 ended with Covid-19. The spread of the coronavirus has been well charted. Investors and the general public have been inundated with analyses assessing the scale of the economic and financial damage wrought by the virus. Investors would be wise to pay little attention to most of those analyses. Forecasting economic outcomes is a fool’s errand even under ‘normal’ conditions; we believe the extraordinary circumstances that define today will only magnify the shortcomings of the statistical methods used to produce such forecasts. The unrealistic precision of the forecasts favored by the industry of financial commentary is, more than ever we think, outlandish at this time. The only thing we can say with certainty is that the range of economic outcomes is huge.
There is no debate to our minds as to whether we will see a recession recorded in national accounts. Rather, the question concerns how deep the contraction will be and, more importantly, how long it will last. In many ways, ‘recession’ is a misleading description of the economic consequences of the virus. What economies are grappling with today is a massive collapse in cash flows.
We are currently witnessing a decline in economic activity unlike any other – a health crisis which has become an economic crisis. What is also unprecedented is the response of Western democracies. Never before has there been a suspension of social and economic life on the scale we have witnessed in Europe and, to greater or lesser extent, other countries. Governments’ actions took place against a backdrop of historic, and in some cases record-breaking, market events. The 11-year-old bull market in US equities came to an end on March 11.1 On March 16 the S&P 500 chalked up its worst day since the stock-market crash of October 1987. 2 The already fragile situation was exacerbated by an aggressive oil-price war launched by Saudi Arabia, after Russia refused to agree to production cuts proposed by members of OPEC (Organization of the Petroleum Exporting Countries).
The equity-market volatility initially resulted in a flight into bonds, with the US 10-year Treasury yield falling below 1% for the first time in early March.3 However, the severity of the strain on markets and a rush for liquidity led yields on benchmark US, German and UK government bonds to surge later in the month as investors sought cash. Gold, traditionally a prominent safe haven, also suffered during the heat of the crisis from the need for mass liquidations.
Recession or Financial Crisis?
Despite the declines in risk assets, we think it is premature to declare that the first quarter of 2020 marked the beginning of a financial crisis, although it is perfectly possible. In a paper published in 2012, the Bank for International Settlements’ (BIS) Monetary and Economic department distinguished between the business cycle and the financial cycle.4 Despite the mainstream focus on the business cycle, the financial cycle has been shown to lead to greater volatility of economic activity. The BIS demonstrates that financial cycles can be well defined by the co-movement of cycles in credit and asset prices, in particular property. Conversely, equity prices do not fit the picture well. They exhibit a comparatively higher volatility at shorter-term frequencies and co-move far less than credit and house prices.
While the financial cycle and the business cycle are different phenomena, they are nonetheless related. Historically, downturns in the business cycle that coincide with downturns in the financial cycle lead to deeper and longer-lasting recessions. Conspicuous examples include the 2007-8 global financial crisis and the Great Depression that followed the stock-market crash of October 1929.
As noted above, a downturn in the business cycle seems a foregone conclusion at this point. How severe the recession will be, and in particular whether we see something akin to a depression, depends on whether we see a downturn in the financial cycle. Without state action, there will almost certainly be such a downturn. Given the collapse in cash flows, it is inevitable that the chains of credit that constitute the monetary economy will come under stress, fray, and, left to their own devices, break. Therefore, avoiding a downturn in the financial cycle is dependent on the extent to which authorities are willing and able to expand their own balance sheets to offset the contraction of private-sector balance sheets that is driving the collapse in cash flows and incomes. If a downturn in the financial cycle is to be avoided, authorities must be successful in preventing idiosyncratic credit stress from mutating into a systemic credit event.
Too Many to Fail
The crisis is playing out in societies that have been conditioned to expect bailouts. Every crisis of a neo-liberal capitalism dependent upon the expansion of debt and credit has been met with a ‘do whatever it takes’ bailout. With the 2008 bailout of the banks still fresh in the minds of Western democracies, politicians may not be able to refuse to compensate those affected by government-ordered halts to economic activity. Most financial commentary continues to discuss the policy response to the current crisis in the language of ‘stimulus’. In reality, the operative principle is the prevention of insolvency, and the efforts of policymakers are better viewed not as stimulus but as compensation.
Large swathes of society are faced with a cash-flow crisis and, with many agents in the household and corporate sector highly leveraged, we believe that failure by governments to offset lost incomes will inevitably lead to an insolvency crisis and an economic depression. Rather than ‘too big to fail’, this time it is arguably a case of ‘too many to fail’. It is thus unsurprising that the policy response has been unprecedented. Western governments have already committed to providing compensation and support on a scale never seen before. In the UK, we have seen a center-right Conservative government tear up 40 years of small-state, free-market doctrine, first promising to spend £330bn,5 and then committing to pay 80% of the wages of workers who have had to down tools, and 80% of the incomes of the self-employed, with “no limit” on the funds available. Just as there are few atheists on a sinking ship, perhaps there are no free marketeers in a pandemic.
The UK, the US and Germany have all announced economic programs amounting to at least 10% of nominal GDP, and other countries have also announced large program. On top of direct wage and salary or transfer-income support for individuals, households and companies, governments have set out large programs of loans and grants to firms, and of mortgage, utility-bill and tax-payment relief. The recent G20 meeting set a target of US$5 trillion of support for the global economy,6 or nearly 6% of global GDP, which is about four times as much as that provided in the global financial crisis.
The US, the UK and Germany have already committed to half of this target, and there will no doubt be more to come.
On the monetary policy front, central banks have eased aggressively. Asset purchases had already been resumed in 2019 – a response to the economic slowdown and financial stress that began in 2018. As a result of the Covid-19 crisis, these programs have been accelerated and broadened significantly in scope. To take the US Federal Reserve (Fed) as an example, the bank has launched an ever-lengthening list of new lending facilities, with a new-found focus on corporate credit. These new facilities will enable the Fed to support this asset class by intervening in the secondary market and, even more strikingly, in the primary market. As a result the central bank is now serving as direct lender of last resort for those companies able to issue bonds. Furthermore, the Fed has announced the launch of the ‘Main Street Business Lending Program’, dedicated to the financing of small and medium-sized enterprises. In combination with a ramping-up of purchases of government securities, these new facilities saw the Fed’s balance sheet increase by US$1.5 trillion in the three weeks to April 2, 2020, a 34.4% increase.7
Rubicons are now being crossed on a near-daily basis. Central banks that have previously abstained from quantitative easing, such as the Bank of Canada and the Reserve Bank of Australia, have jumped in on the action. Even some emerging-market monetary authorities are looking to fire up the printing press. Policy rates, increasingly a relic of a bygone age given that most now reside just above the ‘effective lower bound’, have been cut to the bone where further cuts were possible.
Liquidity Crisis Averted?
Critical to how solvency and systemic risk evolve in the weeks and months ahead will be liquidity. The outbreak of the coronavirus may well have been the catalyst for the recent market declines, but neither the unprecedented speed of the equity-market decline nor the broader market dysfunction can be attributed to the coronavirus alone. Behind the scenes was an acute contraction of liquidity.
In the real economy, households and businesses, facing the prospect of lost incomes, have cut their expenses in order to increase their holdings of cash; where possible, companies have drawn down on lines of credit. In financial markets, a self-reinforcing dynamic was established as a deterioration of liquidity combined with increased perception of risk, higher volatility and deleveraging to further undermine liquidity. As the flight to safety and deleveraging gained momentum, many financial markets became completely illiquid, leading to the usual stampede into US-dollar funding. Stress was writ large across the funding markets that form the visible edge of the world’s financial plumbing, and was evident in the surge in the dollar’s value.
The Federal Reserve has been in full-blown firefighting mode to ease dollar liquidity conditions, not just in the US but globally. Alongside its efforts to ease domestic liquidity, the Fed has restarted swap lines with other major central banks and established a facility that enables foreign central banks to repo (sell and commit to buy back at a future date) their holdings of US Treasuries to the Fed in order to access dollar funding.
Unsurprisingly, the investment industry appears to be attributing the recovery in risk assets since March 23 to the great government bailout. It seems clear to us that the crucial intervention has been that of the central banks, led by the Fed, to arrest the massive dislocation in the funding and credit markets. Despite corporate credit spreads spiking sharply higher, corporate bond markets remained open for business, with the quarter seeing a number of records in terms of the amount of corporate paper issued. While many companies are no doubt raising cash to help navigate the tough times ahead, the fact that the corporate credit markets remain open for business indicates success, so far, in preventing a funding crisis.
In assessing how systemic risk is evolving, we are reassured that we are able to highlight these positives. However, the battle against an insolvency crisis is far from over.
The Return of Big Government. And Inflation…
If a financial crisis is avoided, it is highly likely that life will return to something resembling normality. Notwithstanding the dire human and economic costs of the coronavirus, humanity has never been better equipped to deal with such a crisis. That said, not everything will return to pre-crisis ways. One legacy of the Covid-19 crisis is likely to be the return of big government.
Sharp increases in the role of the state have historically taken place during times of war. Today, politicians are declaring war on Covid-19. It is already clear that the coming surges in public debt and public spending will be on par with those seen during prior periods of major military conflict. Before too long, we are likely to see the return of a related but forgotten phenomenon – inflation.
With many economies already highly indebted, the scope for further increases in borrowing is limited. In this context, central banks are likely to form part of the solution. It is likely that the Covid-19 crisis will come to be seen as a ‘through the looking glass’ moment for monetary policy. The response to the crisis will alert the general population to a variety of financial and economic possibilities previously thought impossible.
We noted above how central banks are responding to the crisis. What makes this a watershed moment is the simultaneous commitment of central banks both to purchase government debt and to direct fiscal spending by governments to support household and corporate incomes. In effect this is the monetary financing of government deficits, which severs the ties between taxation and spending – the most important macroeconomic policy relationship for our lives as both investors and citizens These ties have been fraying for over two decades, but we believe that what remained of any pretense of a link between government revenues and expenditures has now been expunged.
In his book Monetary Regimes and Inflation: History, Economic and Political Relationships, Peter Bernholz shows that the monetary financing of government deficits leads to a sustained acceleration in inflation. In the current environment, inflation is likely to remain muted, at least initially. The continuing halt to economic activity and the attendant financial and credit stress is a powerful deflationary force. However, if the policy response is successful in preventing a financial crisis, when life returns to normal, the global economy will return to work aided and abetted by monetary and fiscal stimulus on a scale never seen before, at least during peacetime. Under these conditions, we see a very real chance that there will be sustained increases in the prices of goods and services.
Most countries currently maintain inflation targets of around 2%, and it is very likely that these will be raised. Even before Covid-19 put the global economy on ice, we have already seen central banks publish research suggesting that a temporary overshoot of current inflation targets is necessary to make up for the years of ‘low-flation’ that have followed the global financial crisis. In truth, what we are likely to witness in the coming years is the tried and tested mechanism for dealing with high debt burdens: monetary financing of government expenditures. The road to inflation is paved with good intentions but, once the inflationary cat is out of the bag, it has a habit of being highly destabilizing and could have profound implications for investors.
The Road Ahead
Taking one step at a time, it will first be necessary to navigate the deflationary shock that a locked-down global economy has created. Initially, we believe financial markets are likely to remain volatile and the range of possible outcomes is vast. Over the short term, we think greater clarity around a path to exit the current restrictions on social and economic life will be key. Such clarity is likely to come from more widely available Covid-19 testing, an increase in the capacity of health-care systems, and the prospects of treatment (though not necessarily a vaccine). It is not necessarily about eradication of the virus, but rather reducing panic and creating a better understanding of how to cope with what could be a permanent addition to our way of life.
A big question mark hangs over the ability of authorities to prevent an insolvency crisis from mutating into a financial crisis and economic depression, and we will continue to monitor how the situation develops. Given near-term uncertainty, we continue to favor those companies with durable business models, robust cash generation, solid balance sheets, and sound environmental, social and governance profiles – which we believe should help them to survive the current downturn and return to growth once conditions normalize. Beyond the near term, if we are indeed in the foothills of a new monetary regime that puts us on the road to inflation, investors are facing a world potentially very different to the one they have grown accustomed to over the last three decades.
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