Calling a "VU" shaped recovery and creative destruction induced by GVC
I am getting asked a lot about what we think will happen once we pass through the Global Virus Crisis' (GVC) two key regime-changing events that I discussed over the weekend, namely: (1) a demonstrable decline in new infections in the US/Europe (ie, evidence containment is working); and (2) key developed nations getting their working-age populations back into jobs and revving their economies back up while quarantining the very vulnerable 65+ years cohort until we get effective anti-viral drugs and/or a vaccine.
The best way I can think to describe our central case is a "VU" shaped recovery characterised by an initial pop, or sugar hit (the V), which is then superseded by a second, much slower growth phase (the U) that is dulled by a huge increase in debt repayment burdens and big creative destruction-induced output gaps (or excess productive capacity) as the virus forces the global economy to effectively rewire itself (I might trademark "VU shaped recovery"!).
With such an interwoven and networked global economy, the GVC is truly an unprecedented event in terms of its complexity and the first, second and third order consequences. I have jotted down some quick thoughts on how we are thinking through all of these contingencies and dependencies:
- The global economy is going to be burdened by a great deal more public and private debt as a result of the enormous fiscal policy responses, which will need to be serviced through tax revenue and corporate/household earnings. This will clearly drag on future global growth after the initial pop in activity as businesses are spun back up and the working-age population gets back into their day-jobs.
- One question I've been repeatedly asked is whether this then precipitates sovereign debt crises. While we expect to hear a lot more talk of sovereign debt servicing concerns, and potentially see some genuine market turmoil, ultimately the central banks can cauterise this problem by continuing to do what they are currently doing: ie, funding their domestic treasuries by buying government bonds via QE.
- A friend commented that central banks were originally created to fund governments during times of war, and that is arguably where we find ourselves right now (ie, on a war-like footing). At the limit, there is nothing stopping central banks printing unlimited quantities of money and buying all their countries' government bonds, with the clear precedent here being Japan in recent times (the Bank of Japan owns about half of all Japanese government bonds).
- Another follow-on question is whether the GVC evolves into an inflationary shock. We expect the deflationary impulse of the GVC via the huge sudden increase in labour supply to overwhelm the inflationary impulse of the crisis over the short-to-medium term (ie, in the next year or two). The near-term inflation pressures obviously come through supply-chain rigidities as labour is taken temporarily offline.
- We think that a key consequence of the GVC will be to compel much greater internalisation of supply-chains, especially those that service critical infrastructure and security-sensitive goods and services. This process was initiated during Trump's Trade Wars as a consensus emerged in Washington across both sides of politics that the US needed to economically decouple from China because of the national security threat posed by the latter. The GVC will substantially accelerate this dynamic by encouraging companies and nation states to look to domestic production capacity to supply key inputs and reduce their reliance on one specific source (eg, for emergency medical equipment, amongst many other things). This could ultimately be quite inflationary.
- As central banks debase the value of money through printing vast quantities of it to fund their domestic budget deficits we will eventually see the value of currency as a medium of exchange decline, which could ultimately drive an inflationary shock. But my best guess is that this is a long way off. We were heading in this direction as output gaps closed following the GFC and wage pressures started to reemerge in key markets like the US. That dynamic has, however, been reversed by the disruption wrought by the GVC. Having said that, we are now seeing central banks and treasuries unleash an unprecedented combination of money printing and fiscal stimulus that could generate a speculative melt-up once the crises passes.
- The GVC will result in a lot of permanent economic damage akin to a form of creative destruction where the virus is killing off both weak companies and unproductive employees. Many businesses will come back looking different, shedding low quality workers and closing unprofitable activities/subsidiaries. Some industries will be permanently changed in both positive and negative ways. For example, entire communities are being forced to get much more comfortable with online shopping and the associated delivery process, reducing at the margin the demand for traditional retailing. The cinema industry will be irreversibly damaged as consumption shifts away from theatres to on-demand digital platforms like Apple and Netflix, which will turn allow these distributors to capture more of the value-chain in the same way Amazon did with bricks and mortar retailing.
- Another example is the commercial property sector. It is entirely possible that there is a permanent global decrease in the demand for both office and retail space. The GVC has forced the global labour market to experiment with working remotely. There will be many companies that conclude they can save huge amounts of overhead by remaining disaggregated (ie, not renting office space). This means the value of commercial properties will decline, and the risk associated with commercial property debt could increase sharply. Commercial property lenders' LVRs might suddenly jump as a consequence of this. Indeed, one would expect a lot of distress in commercial property debt portfolios over the next 12 months.
- With the advent of cheap video-conference technology (eg, the Zoom craze), the value of face-to-face meetings may fundamentally dissipate. This could result in a permanent decrease in the demand for expensive business-related travel and accommodation, adversely impacting airlines and hotels, as companies seek to enhance their operating efficiencies. Video-conferencing is also a superior way to share live on-screen content (eg, our real-time COVID-19 tracking systems) where each participant has their own dedicated image via their personal computer/device.
- This creative destruction will mean that unemployment rates may not quickly return to their pre-GVC levels, which will amplify the short-term downward pressure on wages. There is likely to be a sustained increase in long-term unemployment as weak businesses fail and surviving businesses revisit cost structures. The deep 1991 recession demonstrated that it takes a long time to retrain this excess labour supply, which will be eventually diverted to the winners that thrive in the post-GVC environment.
- Across the economy, the corporate mid-market may be especially vulnerable. The public policy focus is on supporting: (1) systematically important banks/businesses; and (2) workers and mass-market SMEs. There is a mid-market in between these two cohorts that is neither too big to fail nor too small to matter. Within this mid-market, there are unproductive zombie companies with too much debt and insufficient revenue, which could be wiped out by the GVC.
- The GVC could also perpetuate a fundamental rewiring of global geo-political relations. The balance of power is likely to shift away from its recent North Asian centre of gravity back towards open liberal democracies or hybrid states like Singapore that have managed to effectively mitigate the crisis. (A counter-argument is obviously that Trump's ineptitude in acknowledging the crisis in the first place calls into question American hegemony.) There will be blame laid on the source of the outbreak, which also happens to represent the key economic and national security supply chain risk. This will likely increase global geo-political tensions and unfortunately boost the otherwise low probability of kinetic conflicts between the major powers.
- The manifestation of this black/white swan, depending on your vantage (ie, whether you have actively prepared for pandemics), is likely to result in an increase in global risk-aversion and adversely impact confident/sentiment for a period of time. This will be a battle between the shock of the new (ie, a global pathogen that derails life as we know it) and the gigantic stimulus afforded by fiscal and monetary policy.
- The net result could be heterogeneity in asset-class outcomes. For example, one might expect that more liquid and high-quality assets that benefit from central bank QE operations will perform relatively well compared to asset-classes that are not directly or indirectly touched by QE. As discussed above, the mid-market may struggle for some time. This is in turn likely to mean that leveraged loans and high yield bonds underperform, as we have long warned, alongside other directly impacted areas like commercial real estate. We will probably also see credit rating agencies with itchy trigger fingers downgrade many "cuspy" BBB rated issuers into the high-yield, or junk, rating bands, which could amplify stress in this domain. And, finally, we may see a shift away from assets that were once assumed to be liquid, but proved to be less during this time of need.
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Chris co-founded Coolabah in 2011, which today runs over $8 billion with a team of 26 executives focussed on generating credit alpha from mispricings across fixed-income markets. In 2019, Chris was selected as one of FE fundinfo’s Top 10 “Alpha...