Let us begin with the obvious caveat that the Covid-19 situation is extremely fast-moving and leaves huge uncertainties in relation to a wide range of economic measures related with conquering this pandemic. It is as if many of us are living out some surreal film script in which most of the things we take for granted are challenged on an almost daily basis.
There’s no doubting that this crisis will have a multitude of deep and long-lasting impacts that will require thoughtful consideration in the months ahead. Our thoughts are now moving onto what the world may look like after this has passed and what impact it may have on asset pricing conditions.
The coronavirus is a ‘black swan’ event which, in large part, resulted in another ‘black swan’ – the breakdown of OPEC plus agreement. The compounding effects of these have already had massive implications.
The adverse impact of the coronavirus has left no corner of the world untouched, disrupting supply chains and stalling industrial activity in unpredictable ways. Any hopes of a meaningful recovery in 2020 have been dashed, as these two exogenous shocks have created an environment of panic and uncertainty. Markets immediately discounted the short-term news flow, and risk assets crashed, in a fashion not dissimilar to previous crashes (see graph). However, we correctly predicted the following month presented a great buying opportunity. The subsequent rally we have witnessed may continue, absent of a prolonged period of economic shutdown.
The Response – Let’s get ready to rumble!
We can now see that business activity in most areas has essentially come to a halt, with most countries suffering restrictions stiffer than anything seen in recent history. Q1 GDP figures released on the other week showed an annualised decline of 4.8 per cent, which was worse than expected, and indicates that predicting when a stabilisation might occur would be nothing more than guessing at this point. To put the decline into perspective, the fastest drop in real GDP in any quarter in the past 73 years (so, since 1947) was the first quarter of 1958, when the US was hit by the Asian flu and fell at a 10 per cent annualised rate.
But, in what appear desperate times there is some good news. The global monetary policy response has been immense and already far surpasses that of the global financial crisis. Central banks and governments learnt many lessons from 2008/9 and could see what would happen if they didn’t not respond in a quick, concerted and “do all it takes” manner.
After effectively cutting rates to zero, the Fed has introduced unlimited quantitative easing, will begin to buy some corporate and consumer debt and expand its purchases of municipal debt and commercial paper. The European response has been one of the greatest relative to GDP and sums to at least five times more stimulus than during the global financial crisis. The US, with its recent $2trn in fiscal support amounts to nearly 10 per cent of GDP and surpasses GFC fiscal stimulus, which amounted to around 6 per cent of GDP.
The long-term implications
Several profound changes will likely result. The first and most obvious impact is the expansion of global debt. Whilst a lot of this can effectively sit on expanded central bank balance sheets it still leaves the global financial system with a massively expanded debt burden.
As William White, former chairman of the OECD Economic and Development Review Committee and head of the Monetary and Economic Department at the Bank for International Settlements, points out: “The most worrying fact was that global debt ratios had, by the end of 2019, risen to levels well above those prevailing prior to the last crisis in 2008.”
Moreover, the expansion of debt, especially corporate debt, had extended well beyond the advanced countries to many emerging countries also. When off-balance sheet obligations are added, many commentators now conclude that most governments of advanced economy countries have already made promises that they will not be able to honour without major tax increases.
While this reality can be masked for a time, by central banks providing financing at low rates, this also threatens to exacerbate the ‘imbalances’ referred to above. Whether this process ends in depression or very high inflation – and there are many historical examples of each – a potentially serious problem still looms.
An adjunct to this and a potentially very worrying development is the reluctance of EU governments to agree a common ground on fiscal measures, use of the European Stability Mechanism (ESM) and the issue of a ‘coronabond’ to finance the fight against the pandemic. The obvious protagonists – Italy, Spain, Greece – are arguing for such a bond, whilst the major creditor nations of Germany, the Netherlands and Austria, signalled their opposition. If this crisis cannot force terms to be agreed for the benefit of all EU citizens, then what can? The recriminations from a lack of agreement could create a massive divide in public opinion on the future viability of the EU.
Secondly, the matter of global trade. In particular, national food and health security are critical and immediately evident issues due to the pandemic. There is a growing recognition that many countries are vulnerable to the goodwill of others. This adds further impetus to president Donald Trump’s trade ambitions.
Mark Harris is head of multi-asset at Garraway Capital Management. The views expressed above are his own and should not be taken as investment advice.