What next for our slow-moving economic train wreck?

Roger Montgomery

Montgomery Investment Management

Government support programs have helped to soften – and postpone – the financial blows from the disruptions caused by COVID-19. In so doing, they’ve also bolstered share markets. But, I doubt this can go on forever; looking ahead, we could experience an extended period of lower equity market returns.

In the absence of a demonstrated sustainably-superior model, we have adopted capitalism, with some government regulation of the private sector, as our economic and political framework.

If we accept capitalism and its many benefits, we must also accept that entrenched in this capitalist model is an element of natural selection. Some business will fail and some of the those will recover. Others will grow into the gaps left by those that failed. Lessons are learned through the experience and new practices and legislations emerge to improve and create a new brand of capitalism with superior resource allocation.

The process elements of renewal, improvement and growth, however, cannot occur unless failure is first allowed to occur. That failure of course is painful for some and often it is painful for many. It is natural to fear pain. Raised in West Brunswick in the seventies with a single mother on the widow’s pension, loss and financial pain has left an indelible mark on me. Pain hurts.

The fear of uncertainty

It has struck me that the economic calamity we are presently experiencing is the result of a fear of the pain associated with recession. It is also the result of a fear of uncertainty and a failure to believe in the mechanics of capitalism. The fear of course is valid. The absence of fiscal and monetary support in 2008 and 2009 would have resulted in a deep and protracted recession and possibly a depression.

Instead, the very many global central bank liquidity measures resulted in an economic recovery of sorts. And as is now well-documented, it also resulted in a more than decade-long boom in asset prices that has only been recently and briefly interrupted by the outbreak of the coronavirus pandemic.

Also uninterrupted, has been the fiscal and monetary measures adopted by governments and central banks in the late 2000s. They commenced in 2008/09 to prevent or defer the proper recession that might otherwise have begun 2009 and they continue today to prevent the same consequences. Kicking the can down the road is a very apt metaphor for the actions our governments and central bankers have undertaken.

I am not sure the co-ordinated measures that commenced at the time of the collapse of Lehman Brothers permanently ended the possibility of a deep and protracted recession. It remains to be seen whether the measures central banks have embarked on have done anything more than deferred the inevitable. In that case one wonders whether a short sharp recession in the late 2000’s was traded for a deeper and more painful one. One that we now be on the brink of.

Different threats this time

And it’s not just the economy on the precipice. Today the threats to our financial system are different to those of the late 2000s but there are threats nevertheless. The risks to banks today do not hide in structured financial products. Today they are broader-based and macro-economic in nature.

In the US for example, it is not Collateralised Loan Obligations that put bank balance sheets at risk. It is corporate loans extended to small and medium-sized businesses that are likely to experience non-performance first.

But most importantly, we should acknowledge that the banking system in the US is not suffering from a liquidity crisis and when this is combined with the many relaxation measures being offered to borrowers by banks encouraged by their regulators it suggests this train wreck will be slow moving.

And this view is reinforced by the fact that current predicament is not grounded in the misbehaviour or financial mismanagement of our banks. It is the result of a broad economic slowdown, itself the consequence of a hard and synthesised economic stop. And importantly the economic slowdown has produced a disastrous collapse in aggregate incomes and therefore, without government support programs, spending.

And while these government support programs are a welcome part of the capitalist system we have adopted they don’t justify the euphoria in financial markets and particularly in equities.

What happens after JobKeeper?

From our own channel checks we have discovered a significant number of people on JobKeeper are unwilling to work extra shifts. Inertia and comfort are contributing to a lower desire to work and according to some reports a fifth of those on JobKeeper are earning more than they were originally.

A bearish interpretation of this is that an unwillingness to work hard means lower productivity is becoming entrenched in the workforce, and the ending of JobKeeper will produce adverse aggregate income consequences. If lower productivity does eventuate, lower rates of job growth is likely, as is a previously unacceptable level of structural unemployment.

In that case, the economic growth rate is also likely to be lower for a longer period of time. Then add the fact that interest rate cuts are off the table and unlikely to be stimulatory even if they were cut.

So, the fear of recession and the failure to take the required medicine early appears to have placed us at the cusp of an extended period of lower aggregate equity market returns, not only because high prices generate lower returns but because the fundamental driver of value creation, which is a return on capital above a rational measure of the cost of capital, is frustrated.

Acknowledging the very many personal tragedies, the real economic losses from this crisis have yet to be felt. And the deferral of those losses is quite possibly due to the failure to allow an earlier bust to fully play out.

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Chief Investment Officer
Montgomery Investment Management

Roger Montgomery founded Montgomery Investment Management, www.montinvest.com in 2010. Roger brings more than two decades of investment, financial market experience and knowledge. Roger also authored the best-selling investment book, Value.able.

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