A new economic era beckons after this crisis
A new economic era beckons after this crisis
Nobody can know how long the Covid-19 crisis will last, but I think that regardless of this it will mark a profound long-term change in economic policy.
It is likely a turning point in history; historians may look back and say it marked the end of the 1980-2020 period of effectively unfettered capitalism in the West.
Right now we are seeing massive government intervention in the private sector, whether it be compulsory orders for landlords to offer rent-free periods, instructions for banks to cancel dividends, and government-directed bank lending.
All of these mark the end of economist Adam Smith’s “invisible hand”, which has operated mostly unconstrained throughout my 30-year investment career. This term, popularised in Smith’s seminal book “The wealth of nations”, refers to an unobservable market force that enables the supply and demand of goods in a free market to reach equilibrium.
In my view, we are moving to a new era for macroeconomic policy-making. The fusion of fiscal and monetary policy is about to become the norm.
Meanwhile, I think a number of things are coming to an end in many countries: the independence of central banks, quantitative easing, the financialisation of assets (where policy drives asset prices not the economy) and the belief that relatively unconfined capitalism is the best approach to economic management.
In the short-term, collapsing economies are likely to be deflationary and government bond yields could fall further. However, in the medium term (one-to-two years) we think the policies to offset the severe slowdown caused by Covid-19 are likely to be similar, ultimately, to some form of MMT (Modern Monetary Theory - basically where fiscal expenditure is primarily financed by the printing of money).
These policies may ultimately signal the end of deflation and the prolonged period of lower economic growth (also known as secular stagnation) we have seen since the global financial crisis in 2008.
Chart 1: Is the 40 year bull market in government bonds coming to an end?
Other trends are likely to combine with this, including:
- The end of rising globalisation and the optimisation of supply chains.
Globalisation was already starting to reverse (in terms of trade as a percentage of global GDP) as countries increasingly questioned an excessive reliance on China, and the complexity and risks of relying on supply chains in multiple far-flung places. Onshoring will likely become the increasing norm, especially for essential and critical areas like pharmaceuticals, defence and healthcare infrastructure and technology. This will call into question the development model currently pursued by many emerging economies.
- Big government will be the new popular mantra.
Again, like the trend in globalisation, this was starting anyway. Whether it be Mr Trump in the US with his populist policies or the new Conservative government in UK with its plans for a better society. Millennials and Gen Z are clearly much more open to big government and populism compared to the Baby Boomers and Gen X generations who remember the woes of the 1970s. Big government will mean governments increasing control and direct capital investment, research and development expenditure, and governments owning or controlling key critical economic infrastructure (transport, utilities, telecoms, banks).
- Higher taxes.
The rich will be expected to pay more, whether via income tax, sin taxes, capital gains, wealth taxes, property taxes – governments can be innovative, when it comes to taxes at least. Minimum income guarantees may also become entrenched in many countries especially those that have effectively introduced them due to the Covid-19 crisis.
- A Federal Europe.
The euro is finally stabilised/saved as Germany agrees to fiscal largesse and we move to a Federal Europe. Without this, the euro will probably collapse if the current crisis is prolonged. MMT-style policies may then engender the need for capital controls/financial repression (the forced holding of government bonds by domestic institutions such as banks and insurance companies) in many countries in order to ensure governments are not beholden to markets.
- Crony capitalism will be out.
Buy backs will be penalised as will CEO compensation that is set at extreme levels. The trend where CEO pay goes to ever-higher multiples of average employee earnings will reverse.
Chart 2: Is crony capitalism finally on the way out?
Clearly, the above is speculation, but we are fairly convinced by the direction of travel on the above issues, albeit not the speed. In reality the world in two years’ time may look more like the post WW2 period when governments in the West were faced with huge debt burdens and exhausted, war-weary populations looked to the policies above to create a fairer society and to inflate away unsustainable debt burdens. It is also interestingly a policy regime not so different from that which prevails in China today.
The investment implications
Moving on – what does this mean for investment? If we are correct on our thesis above, it is not a backdrop in which financial assets generally do well. Clearly cash and bonds are unlikely to do well. Some areas of property and equities should be a better inflation hedge – but key will be to be focus on those areas less prone to government intervention.
Asian equities themselves strike me as one of the better places to be as the crisis unfolds and the policy response comes through. Starting government debt levels in Asia are much lower than in the West, so the extent of the policy reset above may be less in Asia.
Whilst not immune from the structural changes above, I am less worried about the impact of the new “Big Government” on Asian equities. And of course in China “Big Government” is already the norm.
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