Month: April 2020

The economic aftermath of COVID-19 is difficult to judge, but whichever landscape we emerge into over the next 12-24 months will have fundamental impact on which are the most appropriate asset allocations and investing styles (which we will post on separately).

Simplistically we can expect one of four broad global economic landscapes:

• Deflation (US 2007-2009 or in extremis Japan 1990-2020 and US 1930s Depression);
• Stagflation (1970s economic stagnation with price inflation, in extremis hyperinflation);
• Inflation (hopefully 1990s high growth with controlled inflation);
• 2010s anaemic growth (low growth with low inflation);

In turn we find it helpful to consider some key emerging themes and the broad global economic landscapes they push us towards:  

• Record low interest rates: Inflation or 2010s  
• Record high unemployment: Deflation
• Companies suffering losses and negative operating cash flow: Deflation  
• Emergency loans to backstop companies and furloughing policies to avoid unemployment: Anti-deflationary but not inflationary – as loans / guarantees / subsidies are being used to bridge losses (or revenue shortfalls) rather than finance investment / growth i.e. increased supply of money is offset by decreasing GDP and therefore reduced velocity of money)
• Balance sheet recession (corporates and consumers more cautious about their spending / borrowing, irrespective of lower interest rates): Deflation
• Quantitative easing: Deflation or 2010s. Precedents include Japan prior thirty years, US prior ten years, Europe prior ten years. These regions saw very limited real economy price inflation, probably due to a combination of dropping velocity of money, balance sheet recessions and dropping productivity
• Monetary financing of fiscal spending (central banks finance government deficits): Inflation with risk of hyperinflation (if fiscal and monetary levers cannot be effectively used to control inflation, and/or if balance sheet recession cannot be overcome)
• Reconstruction Programmes yet to be announced (i.e. Marshall Plan II): Inflation
• New social contracts including wage subsidies and improved compensation for healthcare workers: Inflation
• Accelerated digitalisation and automation: Deflation
• Deglobalization and shortening supply chains: short term inflation (production costs increase due to higher labour costs / input costs) but long term deflation (due to investment in automation to replace labour cost)
• Potentially delayed launch of treatments for Covid-19, combined with ineffective testing and contact tracing, leading to recurring waves of outbreaks and economic shutdowns (e.g. Hong Kong / Singapore / China): Deflation or Stagflation

We will explore some of these themes in further detail in future posts.

Sources: N/A

The psychology behind why coronavirus was predictable yet people did nothing.

Before Covid-19 there were multiple near misses included Sars in 2013, H5N1 in 2006, Ebola in 2013, Mers in 2015. In mid-February after epidemiologists warned that Covid-19 had “gone global”, financial markets responded only slowly. Even by mid-March many Western governments were still unprepared, with Boris Johnson jovially declaring people would be “pleased to know” he was still shaking hands with everybody at hospitals treating coronavirus patient.

The residents of Pompeii watched Vesuvius’ eruption for hours without evacuating; on the Titanic people refused to head evacuation orders; Hurricane Ivan only narrowly missed New Orleans just 11 months before Katrina devastated the unprepared city; experts at the Fukushima nuclear power plant were convinced that a multiple reactor meltdown was not possible. 

These behaviors are replicated in controlled psychological experiments. For example, smoke was pumped into rooms. When the subject was sitting alone, he or she tended to note the smoke and calmly leave to report it. When subjects were in groups of three, they were much less likely to react: each person remained passive, reassured by the passivity of the others.

Normalcy bias is the tendency for people to believe that things will function in the future the way they have normally functioned in the past, underestimating both the likelihood of disasters and their possible effects.

Herd instinct is a lack of individual decision-making or introspection, causing people to think and behave in similar fashion to those around them.

Optimism bias is the tendency for people to be unreasonably optimistic of their own chances of being the victim of an unpleasant fate (crime, accident, disease) whilst overwhelmingly believing unpleasant fates await their peers. 

Experiments and post disaster interviews suggest around 70% of people display these behaviours during a disaster – just 10% to 15% act quickly, calmly, and efficiently. Irrespective of disaster type (sinking ship, burning plane, financial crisis, global pandemic), personality types do not correlate to susceptibility, so being a particularly decisive or assertive person does not help. US aircrash investigators suggest some of the strongest mitigants to override these instincts are to be self-reliant, well informed, and preempt with a plan.

Original Articles: https://www.ft.com/content/74e5f04a-7df1-11ea-82f6-150830b3b99a, http://content.time.com/time/printout/0,8816,1053663,00.html and https://en.wikipedia.org/wiki/Normalcy_bias

Mohemed El Erian believes that economists and markets are underestimating the economic impacts of the Great Shutdown. The restart process will be inherently messy.

He highlights growing evidence: trends of larger companies suspending earnings guidance with profits deteriorating; an avalanche of credit ratings downgrades; a rush to raise precautionary cash through debt issuances (supported by central bank market interventions far exceeding those of the 2008 global financial crisis); large-scale layoffs in the space of three weeks equivalent to the highest unemployment rates during the globally financial crisis.

Emerging risks include challenging earnings outlooks; higher levels of indebtedness; larger dispersion between winners and losers; growing entanglement of government in private sector activities; potentially long lasting risk aversion in the real economy not seen since the Great Depression (including frugal consumer behaviour); and most importantly a huge number of bankruptcies.

The market misunderstands: fiscal and monetary policies announced to date can assist with short term liquidity and market stresses, but they can neither avert corporate and developing country defaults nor restart the economy quickly.

Investors should take this opportunity to prepare for the massive ensuing economic shock in three ways: (i) move exposure to the strongest companies and sovereigns (large cash buffers / limited short term debt / strong and defensible cash flow generation); (ii) position for emerging themes (physical to virtual / less outsourcing / less global supply chain / deglobalisation); (iii) keep cash on hand to take advantage of attractive opportunities presented by a big, but reversible, market failure. Investors should retain the potential for returns in case the Fed continues aggressively backstopping markets.

Markets and economies will rebound once there are effective methods for identifying and containing the spread of the virus, effective treatments are developed and immunity is increased. There remain substantial uncertainties relating to the duration and severity of the shutdowns. The longer the economic shutdowns continue, the greater the risk that otherwise healthy balance sheets become contaminated, making the subsequent recovery harder. Central bankers, governments and multilateral institutions should be ready to intervene accordingly.

Original Articles: https://www.ft.com/content/acc0414e-527c-43e2-826b-c87ab1fa5f79 and https://www.bloomberg.com/opinion/articles/2020-04-12/coronavirus-more-shock-and-awe-stimulus-may-be-needed

Mohamed El Erian is the former CEO and co-CIO of Pimco where, together with Bill Gross, he was responsible for building and managing the world’s largest global fixed income investment company including the actively managed $270 billion Total Return Fund.

A study of 15 major pandemics in each of which over 100,000 people died, stretching back to the 14th century, shows consistent and significant macroeconomic after-effects persisting for about 40 years.

Real rates of return (adjusted for inflation) were substantially depressed over multiple decades. This was possibly due to depressed investment opportunities; excess capital per unit of surviving labor; and/ or heightened desires to save, possibly due to an increase in precautionary saving or a rebuilding of depleted wealth.

In contrast real wage growth was elevated, presumably due to a reduced labour force (e.g. the Black Death saw a 25-40% drop in England’s labor force size, 100% increase in real wages, 5-8% decline in rates of return on land).

Researches also controller the data set for the impacts of wars, as these often coincided with plagues (e.g. Spanish Flu / World War I). After wars, real rates of return were substantially elevated. This was possibly due to the burden of raising large sums of debt financing (crowding out effect); higher risk premiums (to compensate for elevated defaults); and/ or due to capital scarcity created by wartime physical capital destruction (e.g. property, equipment and infrastructure).

COVID-19 is likely to be one of the most devastating pandemics in the last 100 years with 0.5-2 million deaths globally. If the trends play out similarly to history, the global economic trajectory will be very different from what was expected in January 2020, with lower real interest rates sustained for decades. That would offer a welcome fiscal space for governments to mitigate the consequences of the pandemic.

The major caveat is that past pandemics occurred in times when virtually no members of society survived to old age, whereas this time the vast majority of deaths (c. 90%) are adults over the age of 70. Due to the interconnected and consumer-centric nature of the modern global economy, combined with likely recurring aggressive suppression strategies, the economic impacts may be closer to those of war than pandemic. This time may be different.

Original Article: https://www.frbsf.org/economic-research/files/wp2020-09.pdf

For interest, we also wanted to show readers Figure 1, depicting the already well documented decline in real interest rates over time, from 10% in medieval times, to 5% at the start of the industrial revolution, to around 0% today. Interest rates were historically more volatile due to fluctuations in harvests and armed conflicts which pre-industrial societies were exposed to a much greater degree than today.

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