Cycle Rollover?

We noted last quarter that the only thing we could say with certainty was that the range of possible outcomes for markets and economies was huge. With respect to the economic outlook, the question was not whether there would be a recession; given the restrictions on social and economic life, this was a foregone conclusion. Instead, the debate was around how deep the contraction would be and how long it would last. We referred to a piece of research produced by the Bank for International Settlements1 as providing a useful framework for thinking about this question. The key insight from the work is that the arbiter of how severe a recession is lies with the financial cycle. If the financial cycle rolls over, a deep and protracted recession is all but inevitable. If not, the recession is likely to be judged with posterity to be relatively mild, at least in terms of the recovery.

A billion here, a billion there, and pretty soon you are talking real money.

Senator Everett McKinley Dirksen

The answer to the question would hinge on whether policymakers would have success in preventing a rolling over of the financial cycle. We noted that without state intervention there would almost certainly be a downturn in the financial cycle as the collapse in private-sector cash flows would inevitably subject the chains of credit that constitute the monetary economy to stress which, without intervention, would fray and break. Idiosyncratic credit stress would in turn metastasize into a systemic credit event, i.e. a rolling over of the financial cycle. If a downturn in the financial cycle was to be avoided, and with it a more malign economic downturn, the authorities would have to expand their own balance sheets to offset the collapse in private-sector cash flows and incomes.

This process had already begun three months ago, as developed- market governments committed to provide financial support on a scale never seen before. Three months later, the floodgates remain firmly open. According to the International Monetary Fund, global fiscal support now stands at around US$9 trillion,2 or 12% of global GDP (which amounted to US$76 trillion at end-2019 exchange rates). While much of the commentary framed the response in terms of stimulus, the operative principle was the prevention of insolvency and bringing to an end the dysfunction of the financial system.

With respect to the latter, policymakers have had considerable success. The collapse in liquidity behind the market turmoil of March has largely been remedied as central banks, led by the US Federal Reserve, used their balance sheets to ensure funding was available where needed. However, the prevention of insolvency will be a longer battle. As noted above, the size of the fiscal response is enormous, but there are issues around getting the money to where it is most needed. Many households and businesses are experiencing financial stress; many businesses have already failed and more will do so. Many companies, from US shale to venture capital-funded technology start-ups were burning cash before the crisis and will struggle to avoid insolvency now. Several hospitality and travel-related businesses will struggle as a result of persistent social-distancing measures and reduced customer confidence. The ability of such businesses to return to standing on their own two feet is very much dependent on the lifting of social distancing.

There are also genuine problems with commercial real-estate investment trusts, as shops and restaurants shutter and companies seek to reduce their footprint following the success of remote working. But the key measure of the authorities’ success is not whether it prevents bankruptcies – that is impossible. Rather it is whether unstressed and effective credit-market operation is in place for those parts of the economy that are not facing insolvency. Thus far this appears to be the case.

A Brighter Outlook?

The ebb and flow of markets over the course of the second quarter have reflected this titanic financial and economic battle. Global equities, as measured by the MSCI All Country World Index, followed up their second worst quarter since the index began in 1988 with their third best, posting a return of +19.4% in US-dollar terms. The remarkable rebound from the March lows left global equities down around -6% (in US-dollar terms) over the first half of the year.3

Based on the ‘V’-shaped recovery in equity markets, it is perhaps tempting to conclude that the policy response has been successful. But as we have seen over the post-financial crisis period, unorthodox monetary easing has far greater efficacy with respect to inflating risk assets than it does for nominal incomes. The corporate earnings outlook remains challenged; while limitations on economic and social life have eased over the course of the quarter, some restrictions remain in place. As such, investors continue to grapple with a lack of clarity around the earnings prospects for companies. To some, this has only confirmed the value of those companies that were able to grow their earnings in the low nominal-growth world following the financial crisis, widely referred to as ‘secular growth’ companies. It has helped that many of these businesses operate in a digital environment; with other activities restricted, time spent online has increased considerably.

The equity market witnessed a sharp, if brief, rotation in May. The catalyst appeared to be an unexpected push to reopen economies in the West which prompted a reassessment of the economic outlook. Cyclical sectors such as industrials and banks led the market higher while defensive sectors lagged. This cyclical leadership reversed in June as fears about the economic outlook returned to the fore with the continued deterioration of Covid-19 statistics at the global level, with developments in the south of the US proving a particular cause for concern.

However, other market developments over the course of the quarter pointed to a better outlook. Emerging-market equities began to outperform their developed-market peers. While there is, of course, considerable dispersion across the emerging-market universe, such outperformance has historically been one of the most reliable indicators that global US-dollar liquidity conditions and economic momentum are supportive of the economic and market outlook. The advance of gold continued over the quarter, but, interestingly, copper began to outperform. Underpinning all of this, safe-haven government-bond yields remained nailed to the floor, with real yields firmly in negative territory, underpinning the general advance of asset prices.

The question is whether exceptionally easy financial conditions can spur a recovery in the non-financial economy. Arguably they are a necessary condition but they are not sufficient: if economies are to recover, restrictions on economic and social life will need to continue to be lifted.

So Bad It’s Good?

The debate around the economic outlook has been reductively distilled into a number of letters. As is typically the case with debates about the economy framed in terms of GDP, it neglects the all-important detail – detail that is particularly important when deliberating the implications for financial markets. According to the statistics, the global economy is currently enduring its deepest and sharpest contraction in history. In light of this, as investors we have to ask: is it so bad that it is actually good?

First of all, the broad global equity market had done little for the two years prior the pandemic, albeit picking up in late 2019. Over this period, corporate profits had been under pressure, and so too returns on invested capital (ROIC). This was a function of two things: a tightening of monetary and fiscal policy at the global level from late 2017, and declining profit margins as the marginal cost of the factors of production increased with capacity utilization rates. The former we have discussed at length in previous pieces; the latter is a normal cyclical phenomenon: as economies begin to operate closer to capacity, labor gets the whip hand over capital and wages begin to rise at the expense of corporate profitability.

With the economic downturn, capacity utilization rates have collapsed. Historically it is when the factors of production are idle – ‘economic slack’ in economics parlance – that returns on capital have the greatest room for improvement. The upward pressure on wages that had been building prior to the pandemic is over for now. In the current environment, furlough schemes are lubricating this process, with those workers deemed surplus to requirements simply not being rehired. Cost-cutting takes place as businesses seek to take out unproductive expenses. As an example, the virus is likely to have accelerated the substitution of business travel with video conferencing now that workforces have been forced to become au fait with online meetings on a daily basis. Some businesses will fail, but as they do, industries consolidate, leaving the survivors with greater pricing power. This is the capital cycle in action.

Then, as the economy begins to recover and the survivors dust off their equipment, operating leverage serves as a tailwind for returns on capital. Empty shops, empty factories, falling prices and falling wages – this is when the outlook for aggregate ROIC is at its best.

The risk is an increase in the human cost of Covid-19 which leads to renewed restrictions on social and economic activity. This is of course possible, but on the balance of the evidence available today the probability of this happening is declining. Even in the south of the US, where the virus statistics have deteriorated in recent weeks, it appears that the disease is being better managed than when it first emerged. The lifting of restrictions on social and economic life may pause, as we have already seen in parts of the US, but it seems unlikely that we will return to the nationwide lockdowns seen earlier this year. Furthermore, away from the US south, Asia and Europe have continued to reopen. At this juncture, in our view the biggest risk is not the coronavirus but a return to fiscal rectitude.

Build, Build, Build…

In 2011 at the G20 meeting in Canada, world leaders, confident that the economic recovery from the financial crisis was assured, agreed that fiscal deficits should be reined in. In 2020, a collective return to fiscal discipline looks unlikely. There was more evidence over the quarter of the continuing shift towards an increased role for the state in economies. UK Prime Minister Boris Johnson pledged that his government would “not go back to the austerity of ten years ago”.4 This was a watershed moment for the country as the leader of the Conservative Party, traditionally the party of fiscal prudence and free markets, is committing to large and sustained budget deficits and a greater role for the government. It is an act that is echoed in countries around the world.

Unlike a leopard, a politician rarely finds it difficult to change his spots. Politics is a power game and rarely do principles stand the test of time as well as the willingness to adapt to control the levers of power does. In reality, politicians rarely lead a nation; more often the victorious politician is the one who senses the winds of change and gets ahead of them. Today, there is a demand for more, not less, government.

Who Will Pick Up The Tab?

There is clearly a question of sustainability. We are already seeing opinion pieces starting to appear debating government options for reducing their obligations. Many of these focus on initiatives to accelerate economic growth or inflation as a means with which to reduce debt/GDP ratios. The unfortunate reality is that this is exactly what has been attempted, with no success, since the global financial crisis. In reality there are only three possible ways in which a debt can be resolved: repayment, default, or debt monetization. Option one is untenable as it is anathema to current social contracts. Option two is untenable given the financial and economic upheaval it would create. This leaves option three as the path of least resistance.

We maintain that the debt being issued to finance current deficits will simply be monetized and effectively eliminated: the respective central bank will purchase the debt and transfer principal and interest to the government when it is received. In reality this has already started to happen. As societies become increasingly comfortable with a greater role for governments, state spending will continue to be financed by central banks.

After the financial crisis, it took the central-banking community a number of years to understand that the normalization of balance-sheet and monetary operations was not feasible. Indeed, the full acceptance was not apparent until Jerome Powell announced in April 2019 that the Federal Reserve would bring to an end its balance-sheet reduction program. We suspect that investors and policymakers will need to go through a similar process of learning and acceptance, whereby fiscal authorities will regularly attempt to normalize, only to discover that it is no longer feasible politically, socially or economically.

Europe – Getting The House In Order

One could argue that in the second quarter we saw the channeling of policy along the path of least resistance in Europe. Since the eurozone debt crisis, the centrifugal forces of growing calls for independence at the national level have grown in stature, increasingly competing with the centripetal forces of unification centered in Brussels.

The Covid-19 crisis threatened to further challenge the forces of unification. With Italy and Spain particularly badly affected by the virus, European Union (EU) fiscal rules limited the ability of the country’s respective governments to provide support, with the fiscally conservative nations of the north resisting calls from southern partners for larger fiscal deficits. Once again, a European crisis was being fought along the lines of fiscal discipline, threatening to reopen old wounds that had barely healed.

That was until Germany effectively capitulated on what had hitherto been a red line of debt mutualization, as the country’s Chancellor Angela Merkel, together with French President Emmanuel Macron, put forward a joint proposal for an EU bond, and with it an increase in the EU budget, in order to fund the Covid-19 response. There is of course resistance: the so-called ‘frugal four’ of Austria, Denmark, Sweden and the Netherlands have voiced concerns. But with Germany no longer resisting fiscal largesse, the voice of the fiscally conservative is considerably diminished on the European stage. With the EU increasingly close to the legislative accommodation of debt mutualization, the stage is set for monetary financing of fiscal deficits in the one major economic bloc where, until recently, it had seemed a distant prospect.

Leaving aside views on whether a federal Europe is desirable or not, should it come to pass it has the potential to drive significant change at the global level. For much of the post-financial crisis period, the EU has relied on monetary policy alone to ‘stimulate’ the domestic economy. Regardless of the internal imbalances that this has created, it has also meant that the mechanism through which ‘stimulus’ operated was the currency. By attempting to stimulate the economy via a weaker currency, the EU bloc has been a persistent deflationary force at the global level, not only via weak demand but also, critically, via a stronger US dollar. A shift towards fiscal unification and an increased appetite for fiscal stimulus is an important development for the EU bloc and the world.

Volatility Awaits

Based on financial-market price action since late March, it would be tempting to conclude that the reflationary forces are winning. However, although economies appear to be regaining some momentum as restrictions on economic and social life are eased, until a vaccine is found for the virus there will be restrictions and costs of doing business that did not exist before. Furthermore, the risk remains that a resurgence of the virus could overwhelm health-care systems and cause additional economic damage.

Investors face a variety of other challenges including the forthcoming US presidential election, rising tensions between China and the US, and the ‘fiscal cliff’ likely to be created if Congress fails to pass a new stimulus bill. The growth outlook will also be influenced by a number of structural factors, including the worsening global debt burden, and an accelerating trend towards digitalization.

Against this distorted backdrop, volatility looks set to continue to be a feature of financial markets over the coming months. This can unearth compelling opportunities for long-term investors, and we believe it will be critical to focus on the securities of companies with the qualities that will help them survive the crisis and emerge stronger. These include resilient earnings streams, robust balance sheets, and sustainable business models.

3 Source: FactSet, July 1, 2020.

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