The trade-off

Compared to the spring we have higher economic activity today even with much higher coronavirus cases. However, we have currently reached a point where controlling the further acceleration of the virus means accepting new economic costs. Lockdowns are back and we don’t even have the nice weather to help us deal with being stuck at home. The current wave could peak in the next few weeks, but the economic costs will persist and that means it is important that there are new policy measures in the pipeline. The ECB is going further in December and the US should deliver on more fiscal support in 2021. However, the game changer will be a vaccine which will help reduce the health costs and boost economic growth. A bullish outlook for 2021 really relies on that happening.      

45 million and counting 

The news on the coronavirus pandemic has not been good. The global number of new infections is now running at over half a million per day and many countries are reporting increased levels of hospitalisations and deaths. The response from authorities has been to reintroduce restrictions on social mobility. This will curtail economic activity and Q4 economic growth will relapse as a result. In turn, markets need reassurance that policy support for the economy will remain in place or, indeed, be added to. The European Central Bank clearly set out its intention to take further policy steps at its December governing council meeting. Expectations of a cyclical recovery and a steeper yield curve which formed the narrative at the beginning of October, have given way to a gloomier outlook, at least in the short-term. It is true that we know more about the virus, we know how to operate with large parts of our economy closed, and we know that there has been progress towards an effective set of pharmaceutical treatments. However, with working from home being extended through the winter and additional restrictions being placed on travel, retail and hospitality, it is no wonder that volatility has stepped up.  

Votes count 

Calling markets in the short term is impossible. However, everyone is focussed on next week’s election in the hope that it removes one element of uncertainty from the outlook. Things can change but the polls point to a Biden win and a Democratic sweep of Congress. The importance of such an outcome is that it provides the opportunity for the US to take a different approach to dealing with the pandemic and to pave the way for a fiscal stimulus package. This would in-turn boost confidence and be reflected in higher stock prices. But ahead of the day, investors seem to be reining in risk and holding cash. Donald Trump may be correct in saying “the stock market is going to be great” but it might be because he’s gone!

The trade-off is complex 

What has become clear over the last seven months or so is that, for policy makers, there is a trade-off between supporting the economy and limiting the spread of the corona virus disease. The slope of that trade-off is determined by a complex set of factors that are not uniform across countries. These include demographics, the existing state of public health, the provision of and access to medical care, the deployment of test, trade and isolate policies, population density and the compliance of the public. All of these determine how effective policies are in preventing the spread of the virus. Countries that have been able to implement test and trade policies, ramp up medical provision and rely on their citizens to be compliant, have generally fared better in controlling the pandemic. Asian countries fit into this category with China, South Korea and Taiwan all able to post a very good record in control. The United States and parts of Europe have not. In the case of the US the problem is a fragmented medical provision that it not readily accessible to low income growth and mixed messaging from policy makers who have certainly emphasised minimising economic costs over public health.

More jobs or less virus 

The slope of the trade-off between economic and health costs is complex but it also needs to be seen in the context of society’s preferences. While it seems harsh to suggest that society can itself have preferences between levels of economic activity and public health, it is clear from the public discourse that this is the reality. Note that public demonstrations against new lockdown measures in Italy this week as an example. While the public might not have perfect information about the virus, they still express a preference over the need for more or less restrictions on activity given the perceived level of risk from the virus. Economists try to theoretically map this as a social preference or indifference curve where different combinations of economic / health costs provide the same level of public welfare. Theoretically there is, at any point in time, a societal optimal point where the policy constraint curve (the policy trade-off between economy and health) meets the society preference curve. Given the rate of infections and the associated mortalities, that optimal point is much lower in terms of total public welfare than it would be if the virus did not exist.  

Ideally both 

To improve things the trade-off between economy and health has to be improved. Governments are trying to achieve this all the time by refining their lockdown strategies – the focus in the most recent round has been to restrict hospitality opening hours or target certain localities with specific restrictions. Having a more effective test and trace policy and more demanding compliance of quarantine policies would also help., However, the game changer will be a vaccine or a proven, safe and readily available anti-viral treatment.  That will reduce the number of infections and deaths at all levels of economic activity and mean that the economic cost can be minimised without endangering public health (of course there is a financial cost of deploying medical treatment but the public health cost in terms of illness and death will be reduced). The shape of the trade-off will change, and this will allow a higher level of public welfare to be reached. In reality that means moving back to more ‘normal’ economic conditions and seeing a sharp fall in the epidemiological curve. Economic activity will be higher as both restrictions on supply (labour, services) and demand will increase at the aggregate level. 

Economic costs will persist 

The curve has shifted since the world was hit by the virus. We are able to have a higher level of economic activity at the same time as arguably much higher rates of infection than was the case in March and April. That is due to more targeted policies and a better understanding of the virus. However, the trade-off is non-linear, and we are now at a point where policy makers don’t want to take the risk that health services become overwhelmed again and mortality rates rise to perhaps seriously undermine public confidence. Hence the new restrictions and the acceptance that, again, economic costs will rise. The problem is that dealing with the economic costs and the virus are not time consistent. If we get a vaccine that is successful, then we can perhaps see the virus reduced to a much more manageable problem going forward. However, economic costs today are likely to persist for some time given the permanent loss of jobs and businesses in some sectors, not to mention the damage done to human capital as a result of unemployment and mental and other health issues that have increased in incidence in recent months. This doesn’t directly get reflected in the stock market as much of the economy that is impacted is in the small business sector. Yet, overall growth and employment are. 

Keep in mind the bullish scenario 

The trade-off has improved but we are still waiting for the game changer. The news on the vaccine front is encouraging but financial markets are impatient and want even better news on this front to offset the current bad news. In the US, the bad news has also been that Congress has failed to deliver another fiscal package ahead of the election. While a major fiscal boost is likely to come after the election, near-term growth and earnings expectations have been tempered until there is more clarity on who will push that and what a post-election fiscal package will look like. As I have said before, the bull-case is that the election delivers a clear result, there is a fiscal package early in 2021 and vaccines start to be deployed. Global economic welfare will benefit significantly from that combination and equity markets should provide very strong returns next year. But we have to see all these things happen first.  

Spend 

I had the great privilege of hosting a webinar with Professor Joseph Stiglitz this week. One of his remarks struck me as incredibly important. He called on governments to heed the words of the former President of the European Central Bank and “do whatever it takes” to get the global economy going again. By that he meant spend. Governments have already spent a lot. Budget deficits have increased, and the aggregate level of global government debt is rising quickly. The OECD’s latest estimate of aggregate government debt to GDP for its members is now 111%. This will keep on going up. For some, this is a problem. “How will we pay that debt back? Will governments default? Can only inflation solve the debt problem?” My view is, don’t worry. Interest rates are super low which means the cost of servicing and refinancing debt is historically low. The OECD estimates that net interest payments on government debt are running at around 1.7% of GDP, down from 2.2% in the wake of the global financial crisis. The average interest rate governments pay on their debt will keep falling as more debt is refinanced or raised at even lower coupons. Look at Italy. The Treasury there issued bonds at record low interest rates this week. The yield on the 10-year Italian government benchmark issue is now just 0.74%. Moreover, many governments have extended the maturity of their debt profiles. The US, to be fair, has not done as good a job as others but there is little chance that the US government will run into any financing problems. A lot of debt comes due in the next few years, but this is a period likely to be characterised by interest rates that remain close to zero. 

It's a different world 

Dealing with higher debt now would be a disaster for the world economy. With rates this low and expected to stay low, it makes sense for governments to borrow money to spend in the economy. It is likely to be rewarded by real GDP growth that is significantly higher than the real cost of funding and, over time, that will mean debt-GDP ratios stabilise and come down. If central banks are willing to play their part in keeping rates low – as they have pledged to do so as long as inflation remains low – then all the better. I can’t be bearish on government bonds because of rising debt because the alternative would be to be much more bearish on growth assets if we saw a different approach to fiscal policy. Many may not like it, but we are in a deep economic hole and the only way out is to spend and this is what equity markets want to hear. More fiscal stimulus would support a rise in growth expectations, cyclical equity performance and – if done properly – an acceleration of the energy transition. There are significant investment opportunities that arise from that.  

Credit 

Of course corporate debt is rising too, and it is not so easy to be as sanguine about that. Low rates help of course and rising corporate earnings do too. However, as long as the global economy remains on the current trade-off between economy and health there are bound to be some credit problems in certain sectors. The policy setting has flattened the left-tail of the corporate credit return curve compared to what it would look like if there were not policies in place to support the credit markets. Yet the credit market is not where it was before the crisis. The European high yield market, for example, has more bonds trading below par and more bonds trading at distressed levels than was the case at the end of January. This means greater chance of credit portfolios incurring some losses. Don’t get me wrong, I am not bearish on credit but with spreads where they are today it is more of a carry trade than one that will deliver significant capital gains. Indeed, high yield spreads have widened a little in recent weeks, reflecting the diminished short-term economic outlook. Having said that, a fiscal stimulus next year and a vaccine would see high yield perform well and should be part of any growth-oriented portfolio strategy. 

Year of the Ox 

Finally, a word on China. Its record on controlling the virus looks to be so much better than is the case in western economies. On current economic forecasts, the Chinese economy will have significantly outgrown the US by the end of 2021. Its equity market has outperformed the S&P500 this year and its government bond market yields almost 300bps above the US Treasury market. If Joe Biden wins the election a less confrontational relationship between the US and China is likely to emerge – although there will be still an undercurrent of distrust on numerous issues, particularly around security. However, investors might be more encouraged to increase their exposure to Chinese assets given the better fundamentals. Next year is the Chinese year of the Ox, an animal noted for its diligence, persistence and honesty. These might be characteristics that make a Chinese bet a good one in ’21.