There has been a generational shift in the world economy and financial markets because of COVID-19. Where we may live in a non-COVID environment soon, the markets, the economy and social environment may have been changed forever.
The structures that have been around for 30 or 40 years have been upended. During World War 2 (WW2), Government deficits were 55% of GDP in a command-control economy. Post World War 2, the Governments and Central banks stepped aside, removing price controls, and lowering taxes, letting the private sector expand and borrow, fueling the post-war boom. When the private sector borrows, the Government does not, allowing them to reduce the National debt.
In the 1960’s, interest rates in the US were at an average of a relatively low 3.5%. There was a bout of deficit spending around 1967 (Vietnam war) that pushed interest rates to 7.5% by the end of the decade. This ushered in a recession in the early 1970’s. The Government’s cure, of course, was massive deficit spending, rising from an annual $60 billion deficit in January 1970 to $200 billion two years later. The US was expected to back their money printing by Gold, but there was a run on converting dollars to gold, with nervous foreign governments requesting conversion. The US, of course, suspended conversion in August 1971. The Government continued to print money, with the deficit rising to $400b by 1975 and by 1980 interest rates rose to 20%.
With the big inflation of the 1970’s and 1980’s, the reaction was to move to Central bank independence. Free from political interference, the newly elected Fed chief, Paul Volcker, adopted a pragmatic anti-inflationary monetary strategy that led to the dramatic recovery in the US economy in the 1980’s.
The structure of Central Bank independence from Government, after 40 years, may now be gone.
As mentioned, there now has been a generational shift in the world economy and financial markets because of the coronavirus. Central banks no longer have the policy lever of lowering interest rates. Since COVID, the Central banks have been relegated to the funding of the financial deficits. And they have quite a job ahead of them.
What comes from the debasement of money, how does it affect each country and the effects on exchange rates? FX rates will play a much bigger role over the next few years. Where previously you moved interest rates in each country to amend exchange rates, the interest rate mechanism is now gone. With interest rates at zero, to accommodate massively increased deficits, the interest rate could remain zero for the next 20 to 30 years, not unlike Japan.
If interest rates do not move, where does the relative value express itself? You should expect increased volatility in FX rates. This is no different to a view expressed by Hugh Hendry, former CIO of Electra Asset Management, who recommends that you should go long FX volatility in the future.
There has been the emergence of Modern Monetary Theory (MMT) which tolerates unlimited money printing to fund deficits only if excess demand in the economy does not exceed supply. Excess demand will cause inflation.
How will the equity markets react? Equities are behaving as a nominal asset, like hard commodity assets, where there is no alternative for the money flow to go. Eventually, it may end up like Japan after the 1990s, where the Government could not create growth in a zero-rate environment and the equity assets did quite poorly? The Nikkei index was 26,000 in 1990, which fell to 10,400 twenty-two years later, before rising to the current level of 20,700 today. That could be a likely scenario.
What does this mean for investing? Ben Melkman, CIO of Light Skymacro makes an example of a standard 60/40 portfolio, 60% equities and 40% Bonds. Bond rates are zero, so using bonds as a risk hedge against your equity assets is gone. You have a long duration asset that is not producing any return and is vulnerable to an inflation shock. With Bonds you have essentially present valued all your gains, so you have exposure to the present value of losses (ie interest rates going up), without much chance of any gain.
With your equity component, you have also present valued (ie falling interest rates) the future gains through the expansion of the price-earnings ratio. The value of shares is discounting the future cash flows at a discount rate, currently zero. You cannot get any more growth via lower interest rates, so the only chance of gains is if future earnings increase over time. Given the state of the post-COVID world, growth may be tough to achieve. Also, like bonds, if interest rates rise, the value of future earnings, when discounted, will fall. This obviously means that the share price will fall. Again, the outlook is not great.
Melkman makes the point that the coronavirus is not an issue that will go away once a cure is found. We cannot return to normal. Big social movements have burst onto the world stage – COVID was just the catalyst that brought it to the fore. The Australian Government, having run a $200 billion deficit in one year, cannot return to, say, a $50 billion deficit next year. The size of the fiscal contraction will be too great for the economy. Melkman says that we will have large deficits for many years.
Again, Governments lifting interest rates will cause Government interest payments to skyrocket. Paying high interest on excess reserves deposited by the banks with the Central Bank will be a political nightmare.
Central Banks, to control their fiat monetary systems will probably move to digital currencies. From Coindesk: The U.S. Senate Banking, Housing and Urban Affairs Subcommittee on Economic Policy conducted a hearing on “Winning the Economic Competition” between China and the U.S. on Wednesday. Once again, the idea of a Federal Reserve-administered central bank digital currency reared its head. Senator Tom Cotton said: “For us, maintaining the dollar’s supremacy is not only an economic matter, but it is also a critical strategic matter as well. It is what allows us to have such effective sanction regimes around the world as well as other benefits,” he said, before asking about the next steps in rolling out a digital dollar.
Last week, Federal Reserve Board Governor Lael Brainard said the U.S. central bank has been testing DLT (Distributed Ledger System) over the past several years to study what a digital currency might do to the existing payments ecosystem, monetary policy, financial stability and the banking sector.
Caijing, an independent magazine based in Beijing, reported selected employees at China’s largest banks are trailing the country’s much-anticipated digital currency “on a large scale”. The Digital Currency/Electronic Payments (DCEP) project, China’s digital currency, is one of the country’s most anticipated financial innovations and is expected to revolutionize the central bank’s control over the yuan.
Again, as mentioned, where we may live in a non-COVID environment soon, the markets, the economy and social environment may have been changed forever.