Feature Stories | Jun 10 2020
Central banks have now exhibited just what extent of tools they have available. Fiscal spending means deficits for a long time. Rates will not just be lower for longer, but zero. Big Tech and China are virus winners.
-Zero rates for longer
-Lingering large fiscal deficits
-Big Tech domination
-China wins
By Greg Peel
Life After Covid, Part I (https://www.fnarena.com/index.php/2020/06/02/life-after-covid-part-i/ ) explored the assumption life will be very different once the pandemic risk subsides, from a household level to a global level. Such considerations will inform preferred investment choices in the years ahead.
The conclusion was that predictions of a vastly altered lifestyle are to a great extent exaggerated – an argument underpinned by evidence from past economic crises of life soon regressing toward what had been considered “normal” to that point. Certainly there will be differences, but most will reflect the acceleration of trends already underway, with online shopping a perfect example, rather than seismic shifts in consumption and industry.
While Part I focused more on our lives and on potential shifts in industry practice, Part II begins with an examination of predictions with regard post-pandemic debt and global ramifications.
Too Low For Zero
The San Francisco Federal Reserve recently published a working paper, the authors of which included a former PIMCO senior adviser. The paper explored the history of past pandemics and their economic impact.
Beginning in the fourteenth century.
From Black Death to covid, the world had experienced fifteen pandemics each costing more than 100,000 lives. The authors conclude these pandemics had long-lasting economic effects, lowering the real rate of interest for decades afterwards.
The authors speculate that the decline in the rate of return reflected depressed investment opportunities due to the higher cost of employing surviving labour, and/or a heightened desire to save due to increased precautionary saving or a rebuilding of depleted wealth. They also point out, nonetheless, two obvious caveats.
In every prior pandemic, economies were completely reliant on labour. The labour force was decimated. As sad as it may be, the victims of covid have mostly been older, hence the labour force has not been significantly impacted.
We might also note that the Spanish flu is estimated to have killed 50 million in a global population of 1.8 billion at the time. To date covid has officially killed around 400,000 in a population pushing the 8 billion mark. (Realistically that number is much larger, given most countries only count deaths in hospital, but still not a patch on 1918.)
The other caveat is the 2020 fiscal response, which the authors admit this time around is “very large”.
We can assume unemployment was not an issue following past pandemics, as it is in typical financial crises, but it will be an issue this time. However, while Edward III likely didn’t rush in to provide support for the masses after the Black Death – other than to sign them up to start a Hundred Years War with France – responses today in the likes of the US and Australia to provide labour force support are unprecedented in size and scope.
Both countries have adopted what we here call JobKeeper and JobSeeker support.
The authors don’t offer a third caveat, but I will.
Central banks appeared in Europe in the seventeenth century and the US even had two in the nineteenth century, but the Federal Reserve, in a vague form of what it is today, was founded in 1913 – just in time for World War I and the Spanish flu. It was only in the 1980s that central banks adopted a dual mandate of managing unemployment and inflation.
The then Fed provided no monetary support during the Spanish flu.
Higher fiscal deficits and debt levels should lead to significantly higher inflation, the authors point out, but this time the impact of the virus on interest rates is likely to be negative for the foreseeable future.
Firstly, while the public sector is “dissaving” by providing debt-supported fiscal support, the private sector is likely to want to “save” for years to come, as was the case following the four previous recessions, most notably after the GFC.
Clearly, Australian households will be once again shocked into reducing debt levels, as they were following the GFC, although this didn’t last very long given resultant historically low interest rates. A vast number of Australia listed companies have rushed to raise new capital to shore up balance sheets, and will be keeping a closer eye on debt levels from here.
Secondly, in an effort to prevent government bond yields rising significantly higher due to the level of debt taken on by governments, central banks will likely continue to implement QE and other measures in order to prevent governments having to switch into austerity mode in order to balance that debt.
The conclusion:
“In summary, while the health and humanitarian crisis of COVID-19 will eventually pass, and hopefully sooner than later, the depressing effects on interest rates will likely linger for a long time. Investors should brace themselves for a New Neutral 2.0 world of even lower real interest rates for longer.”
The Zombie Apocalypse
ANZ Bank economists agree.
The world started this downturn with low rates, but will finish it with rates genuinely at zero, which is now the new normal everywhere in the developed world. QE is now more common than not.
Note that while the RBA does not have a zero cash rate, it decided there’s no point in going below 0.25% before introducing QE and other measures, which from a monetary stimulus standpoint effectively equates to zero rates or less. But that is not to say the RBA won’t change its mind on the cash rate, depending on how things play out from here.
ANZ Bank also suggests that talk of economic recovery following a V or U-shape is misleading, as they imply some symmetry in the cycle. “This recovery could well be more like untying a huge and complex knot”.
With fiscal balances deteriorating rapidly, there will be no low-debt economies, ANZ suggests. Fiscal repair will be harder to achieve as conventional monetary policy (lowering rates) has run out of room, making central banks less able to buffer any downside shocks.
QE policies are now underway across advanced economies and all the way to the likes of India and the Philippines. None of the central banks that implemented QE in the GFC had restored their balance sheets before the virus hit. The Fed started, but when Wall Street started going rapidly into reverse on fear of monetary over-tightening, the Fed immediately “pivoted”, later admitting its mistake.
We could go into an extended argument about how the Fed started the stock market rally from 2009 and thus never allowed for the market to find its true value, thus painting itself into a corner, and forcing it to readminister the drugs at the first sign of the market failing, but this is not the forum.
ANZ Bank does note that during this crisis, central banks have outwardly coordinated with governments and “deputised” banks to exercise forbearance (for example mortgage repayment deferral). We might also add that APRA, which is independent but answerable to parliament, has dictated a more general bank “forbearance” in the form of deferred or reduced dividends.
“We have drifted away from central banks independently targeting inflation under generally accepted rules of prudence,” notes ANZ. “We are now in a misty environment where rules are more ambiguous and accountability less clear.”
Governments have delivered aggressive and experimental policy extremely quickly, likely widening the perceptions of what is possible, ANZ suggests. Policies such as a universal basic income and wealth taxes may become more mainstream. Note that Spain has moved to introduce a basic income for the most vulnerable households in the wake of the virus. While Australia has a minimum wage, JobSeeker has doubled the dole.
Given the extent of criticism aimed at the government pre-virus, one must expect the dole will not fall all the way back post-virus to the level it was beforehand. The US has always eschewed a minimum wage, but it, too, has provided a JobSeeker-style payment during the virus.
Underemployment had already become a rising global issue post-GFC, referring to those working part-time who would rather work full-time, or at the very least have more hours. The GFC forced corporations to become “leaner”, pursuing cost efficiencies, and technology has accelerated the rise of the robots.
While economies may bounce back relatively quickly if the virus threat passes, substantial rises in unemployment following any crises typically take a long time to unwind, ANZ Bank notes.
Given this crisis happened very rapidly, it was assumed from the outset recovery could be just as swift if the virus could be contained. To that end the global fiscal response has included corporate bail-outs on the assumption those companies just had to ride out the storm. The US government has bailed out airlines, for example.
The more the downturn is protected, however, suggests ANZ, the more firms will survive that are no longer fit-for-purpose on the other side. These will be the “zombie companies”. This is not a new problem, but will likely take a leap forward this downturn and affect the speed of the recovery and the adjustment that is required.
The US government bailed out its airlines, as an economy needs airlines, notwithstanding the number of workers they employ. In 2008 the US government controversially bailed out General Motors largely because of the number of workers employed. While taxpayers did get their money back, we note today that GM has a market cap of US$39bn, while Tesla has a market cap of US$164bn despite having produced a comparatively miniscule number of vehicles.
Ah yes, but that’s all just EV hype and starry-eyed sentiment. Except that Toyota is worth US$172bn.
ANZ Bank also believes covid will force the EU towards fiscal integration, which was after all the original plan, shown to be starkly lacking by the fate of the “PIIGS” post-GFC. But I’d say the jury’s out on that one. The way things are going, if Brexit proves to be smooth the EU may go the other way.
Another bold statement made by ANZ Bank is that “G-zero is now embedded”. G-zero is a reference to the current “G7” group of leading global economies not including China or Russia, and the more extended “G20”, of which China and Russia are members along with Australia, with the EU counted as one bloc.
ANZ Bank does not go into detail with regard this assertion but one presumes the closure of borders, including to vital trade, implies an “every man for himself” attitude that flies in the face of G-anything. Not to mention the blame game.
Interestingly, Trump has now put forward the notion of bringing Russia back into the G7 (G8) – a move totally opposed by the likes of Canada and the UK – or at least bringing in India, South Korea and Australia (G10) – an invitation Scott Morrison has accepted.
There is one obvious omission. China is reportedly also moving to build its “own” internet.
To complete ANZ Bank’s predictions of post-covid changes, here is a simplified list:
-Bigger government
-More localised manufacturing
-More working from home
-More sovereign focus on food supply
-Increased infrastructure spending, most likely on smaller-scale projects
-A reassessment of the globalisation of education
-Immunisation history on passports
-Ongoing protections for aged care homes
-Permanent changes in consumer behaviour
Debt Forever
There are two things that indicate the world will never quite be the same, suggests Citi.
The first is that the policy response to the crisis has reminded us policy makers are never truly out of tools. The second is the aftershocks of a staggering amount of debt issuance will likely linger for decades.
To date the Fed has resisted the notion of negative interest rates. The RBA has also rejected such a policy, albeit not quite out of hand, and now we saw respected Australian economists suggesting it is probably a good idea.
Citi points out that negative interest rates have not been “the panacea policy makers had hoped for”. Witness the experiences of the eurozone and Japan, both of which had moved to negative rates post-GFC and neither of which had managed to crawl out of their economic holes to a point rates could be restored.
The lack of impact from negative rates will put more pressure on QE to combat economic contraction, Citi suggests, essentially blurring the lines of policy as central banks lend directly to corporate borrowers. “We are entering a new era of direct intervention in asset and lending markets”.
In less than three months we’ve witnessed monetary policy break all bounds of what was considered possible, and fiscal policy is there to accompany it. Fiscal policy has taken a backseat to monetary policy in recent years, notes Citi, but now fiscal policy has vaulted into the lead as mega-deficits become the new normal.
Note that during the post-GFC European debt crisis, the ECB turned on the QE tap but Germany became the EU central fiscal bank, if you like, lending money to financially stressed members while enforcing austerity in return. Austerity may help reduce debt but does not stimulate an economy. Hence, we might say, it didn’t work.
Last week the ECB went all-in on QE and the German government caved and began a massive fiscal support program.
The lingering effect of fiscal debt is a “no going back” feature of this crisis, suggests Citi. In the GFC there was an “astonishing” amount of debt issued to rescue economies. Leading to calls from many to end the “debt supercycle” as debt loads exploded to perceived unsustainable levels. The decade since has, however, shown us that debt was, in fact, sustainable.
The monetary/fiscal debt response to the virus has made the GFC response look like pennies in the dollar. Can debt still be sustainable? asks Citi.
Debt is not necessarily a bad thing if the return on assets exceeds financing cost, Citi admits, but as ANZ Bank economists noted (earlier in this article) debt is the equivalent of “dis-saving”, and for every dis-saver there must be a saver to fund it. The swing to dis-saving in this crisis has been surprisingly large. Will anyone be left, asks Citi, to provide the global savings to address this imbalance?
Rollerball
Long before the crisis, governments across the globe were becoming concerned about the sheer power and penetration of US Big Tech, being the likes of Facebook, Google and Amazon. Yet despite all that governments have tried to throw at these companies, in the areas of tax, privacy, censorship and monopoly, their stock prices continue to rise into blue sky.
The virus has only served to underpin that trend.
Over the past few months, both consumers and businesses have tried and adopted new technologies to survive and thrive. Morgan Stanley believes this faster pace towards a more digital/online/mobile and cloud-based economy is the new normal.
And who are the big global players? Facebook, Google, Amazon, Apple, Microsoft.
One of the best “future predicting” movies of the 1970s, along with Plant of the Apes and Soylent Green, was Rollerball. Rollerball depicted a future in which the world was no longer run by governments, but by corporations.
Given the ever-growing popularity of the services the aforementioned provide, only to become even more popular during the crisis, these companies also now dominate growth in advertising, along with the likes of Twitter, Snap, Spotify and (China’s) TikTok.
From long before the virus, traditional media companies have been fighting a losing battle to remain relevant, and competitive. Only by shifting to digital has there been any chance of survival, as the likes of FTA television, radio and print media slowly become the future’s quaint history museum exhibits, along with the stump-jump plough, grandma’s mangle, and the rotary-dial telephone.
And the pace of technology development has already seen New Digital replace Old Digital. The VHS was replaced by the DVD, the cassette by the CD, and FTATV to a great extent by cable. Now all are being usurped by streaming.
Traditional media companies were already struggling before the virus as advertising revenue migrated to new platforms. The lockdowns saw advertising dry up and sent many a stock price to near-death levels. Now the lockdowns are easing, investors are looking for bargains among such long-standing companies.
Morgan Stanley believes these investors are set to be disappointed. The economy will recover, and thus advertising will recover, but traditional media will not join in the spoils. The spoils will be enjoyed by Australian corporates and SMEs that become more digital, more mobile, and more cloud-based in the running of their businesses, all of which feeds into the major global providers.
“If the global tech players continue to grow revenue double digits in Australia,” says Morgan Stanley, “but the total pool of ad revenues is only increasing 2-3% pa, there is necessarily a ‘crowding out’ of ad spend left for domestic Media companies to pursue.”
“Corporate society takes care of everything. And all it asks of anyone, all it's ever asked of anyone ever, is not to interfere with management decisions." – Rollerball, 1975
And let’s not stop there.
Macquarie Wealth Management believes two ideas are likely to dominate the next decade – artificial intelligence and blockchain.
“These will up-end every human endeavour,” suggests Macquarie, “from self-driving cars and robotics to central banks, allowing some countries and companies to leapfrog others.”
AI and blockchain technologies also have the capacity to disrupt the “cloud of finance”, just as AI, automation and 3D printing are disrupting the physical world. Hence there is good reason, says Macquarie, why everyone from the BIS (Bank of International Settlements), Fed and ECB, to China and Russia, to banks such as JPMorgan and tech giants such as Facebook, are all exploring crypto-currencies and blockchain technologies.
“It is as much of a threat as an opportunity.”
Rise of the Dragon
China is “razor-focussed”, Macquarie suggests, on the threats and opportunities arising from these technologies. Digital renminbi is already closer to fruition than most currencies while China’s AI spending continues to lead the world. Although AI relies on Western intellectual breakthroughs, progress over the next decade is likely to be more reliant on more dependent availability of capital and data rather than new discoveries.
“Unlike the West, China has no limitations in harvesting these prerequisites”.
China is already challenging all aspects of the new world from hardware to software, robotics and surveillance. While most emerging and developed world equity markets remain stuck in conventional businesses, Macquarie notes, from banks to telcos, commodities and utilities, China is witnessing an explosion of leading-edge themes. Only the US has a similar vitality, which brings us back to Big Tech.
“We think investors will be better off buying into the future.”
The Chinese economy has been the fastest emerging market and will surpass the US soon. China’s economy is already now twice the size of next-placed Japan. To continue to call China an emerging market is “preposterous”, says Supercharged Stocks’ Andrew O’Donnell.
China will roar ahead faster than the US following this year's pandemic, O’Donnell suggests, and significant gains will be made in mining. Beijing has set the foundation for expanding at a rapid pace through its One Belt, One Road initiative, 5G smart city construction, focus on battery energy materials and enormous batteries, energy grids and production, and by stockpiling resources while maintaining a massive low wage, high output workforce.
The virus has brought to light that China also produces many of the prescription drugs Americans need and take. Essentially, all the manufacturing of importance, pharmaceutical production and/or critical components of a nation is undertaken by China.
On the political side, China is pivoting more towards open markets while the progressive movements of the West are moving towards more totalitarian, state-run systems, O’Donnell puts forward.
Electrification of the future is an increasing theme and China has created a foundation for being a leader in new energy.
We may recall that before the virus, markets were dominated by a US-China trade war. O’Donnell suggests there really is no trade war – the US had simply not realised it had already lost.
“China has amassed and produces, and uses most metals, both basic and critical to all technology,” notes O’Donnell. “China has stockpiled enormous resources but since it makes, well, just about everything, it was expected that a considerable reduction in demand would come from the coronavirus”.
“The issues of trade war are more of a political and media story that hides the real factor: China controls the supply chain for all technology, infrastructure and pharmaceutical. Yes, China makes your medicine. How much of a trade war do you think you have been in if your opposition controls all the critical resources for military, technology and healthcare?”
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