Step-change at the Fed – Reaching for the stars

Step-change at the Fed – Reaching for the stars

Macro Letter No 132 – 04-09-2020

Step-change at the Fed – Reaching for the stars

  • The Federal Reserve has changed the emphasis of their dual mandate
  • Inflation targeting will become more flexible in the long-run
  • Full employment has become the Bank’s priority
  • Asset markets will be the immediate beneficiaries

In a speech entitled – New Economic Challenges and the Fed’s Monetary Policy Review – given on August 27th, at the Jackson Hole, Kansas City Federal Reserve Economic Policy Symposium, Federal Reserve Chairman, Jerome Powell, announced a change in the emphasis of the dual mandate. The new focus is on promoting full-employment even at the expense of price stability.

The policy review was, of course, more nuanced. Past policy decisions were analysed and found wanting – especially the rate increases witnessed between 2015 and 2018. The extraordinary flatness of the Phillips Curve was noted; the lower trend rate of economic growth, contemplated; the stickiness of inflation expectations, contextualised: and the ever rising, pre-pandemic participation rate, considered. What the speech omitted was any discussion of forward guidance or expectations of the change in size, composition or direction of the Fed’s, already historically large, balance sheet.

For financial markets the key change is contained in this paragraph: –

Our statement emphasizes that our actions to achieve both sides of our dual mandate will be most effective if longer-term inflation expectations remain well anchored at 2 percent. However, if inflation runs below 2 percent following economic downturns but never moves above 2 percent even when the economy is strong, then, over time, inflation will average less than 2 percent. Households and businesses will come to expect this result, meaning that inflation expectations would tend to move below our inflation goal and pull realized inflation down. To prevent this outcome and the adverse dynamics that could ensue, our new statement indicates that we will seek to achieve inflation that averages 2 percent over time. Therefore, following periods when inflation has been running below 2 percent, appropriate monetary policy will likely aim to achieve inflation moderately above 2 percent for some time.

The initial market response saw stocks rally whilst 10yr T-bond yields rose – testing 0.79%. During the week which followed, 10yr yields slipped back to 0.62%. Equity markets subsequently switched focus and moved on, returning to their obsession with the ever rising tide of technology stock earnings expectations. Even the Dow Jones Industrials Average Index has been effected by the tech boom, as reported by S&P – Dow Jones Industrial Average: 124 Years and It Keeps Changing – the index changes, announced on August 31st included, (CRM) replacing Exxon Mobil (XOM), Amgen (AMGN) replacing Pfizer (PFE), and a tech switch with Honeywell International (HON) replacing Raytheon Technologies (RTX).

Returning to monetary policy, the Fed announcement was hardly a surprise, the August 10th, FRBSF Economic Letter – Average-Inflation Targeting and the Effective Lower Bound had already set the tone. The chart below reveals the Fed’s inflation targeting dilemma: –

Source: FRBSF

If the average for Total PCE over the last decade has been less than 1.5%, allowing it to rise above 3% for a few years is just what is needed for the Fed to get back on track.

Setting aside the vexed questions of whether an Inflation Target is appropriate or, deflation, a good or bad phenomenon, we need to investigate the structural cause of the decline in inflation. Here I will resort to the monetary equation of exchange: –


Where: –

M            is the total nominal amount of money supply in circulation on average in an economy.

V             is the velocity of money, or the average frequency with which a unit of money is spent.

P             is the price level.

Q             is an index of real expenditures for newly produced goods and services.

The basic problem for the Fed is that, despite their success in expanding money supply (see below): –

Source: Federal Reserve Bank of St Louis

The velocity of circulation has continued to plummet: –

Source: Federal Reserve Bank of St Louis

I discussed the rapid expansion of money supply in more detail in a June article for AIER – Global Money Supply Growth and the Great Inflation Getaway:

I suspect, fearful of repeating the mistakes made by the Bank of Japan, that once the inflation genie is finally out of the bottle, central bankers will forsake the hard-learned lessons of the 1970’s and 1980’s and allow inflation to conjure away the fiscal deficits of their governments at the expense of pensioners and other long-term investors.

Of course, consumer price inflation may not return, even with such egregious debasement as we have seen thus far, as Michel Santi suggests in Japan: a sleeping beauty: –

A global battle has thus been raging on pretty much since the deflationary episodes of the 2010s in an attempt to relaunch economies by dint of inflation. In this respect, the Japanese experiment, or rather multiple experiments, remains a case study to show that inflation is still proving a difficult spectre to revive.

Santi, points to demographic decline, a trend in which Japan is a world leader, together with, what he considers to be, an irrational fear of debt and deficits, which renders people unwilling to spend. In this scenario, government, corporate and consumer debt cannot be inflated away and sits like a giant toad atop all the animal spirits that might reignite economic growth. He also alludes to the profound changes in the nature of work – from permanent to temporary, from employed to self-employed, from office based to remote. These changes have rendered the Phillips Curve redundant.

The dual mandate of full employment and price stability has never been so easy for the Federal Reserve to achieve. That, at least, was the case until the global pandemic unknit the fabric of the global market economy. Now, the Federal Reserve – and central bankers in general – are faced with the prospect that printed money, whether it be sterilised or not, will either be invested or hoarded. In this scenario, the greater the debt the less likely prices are to rise as a result of demand-pull inflation. On the opposite side of the inflation equation, the shortening of global supply chains and the need for dual-redundancy, agin another unwelcome and unexpected lockdown, has created the classic bottlenecks which lead to product scarcity, personified in cost-push inflation.

Interest Rates, Global Value Chains and Bank Reserve Requirements– published in June of last year, notes that Global Value Chains have suffered and shortened since 2009; that, despite low interest rates, financing costs remain too high and yet, at the same time, bank profitability has not recovered from the damage caused by the great financial recession. Nonetheless, those same banks, which were supposed to have been broken up or dramatically deleveraged, remain still too big to fail. My conclusion looks dismally prescient: –

The logical solution to the problem of the collapse of global value chains is to create an environment in which the credit cycle fluctuates less violently. A gradual normalisation of interest rates is the first step towards redemption. This could be accompanied by the removal of the moral hazard of central bank and government intervention. The reality? The societal pain of such a gargantuan adjustment would be protracted. It would be political suicide for any democratically elected government to commit to such a meaningful rebalancing. The alternative? More of the same. Come the next crisis central banks will intervene, if they fail to avert disaster, governments’ will resort to the fiscal spigot.

US interest rates will converge towards those of Europe and Japan. Higher stock/earnings multiples will be sustainable, leverage will increase, share buy-backs will continue: and the trend rate of economic growth will decline. Economics maybe the dismal science, but this gloomy economic prognosis will be quite marvellous for assets.

Conclusion and Investment Opportunities

According to data from S&P, US share buybacks were lower for the second quarter in a row in Q2, 2020. They amounted to $166bln, versus $205bln in Q1 and $190bln in Q2, 2019 – this is still the seventh highest quarterly amount ever recorded. The chart below shows the evolution of buybacks over the last two decades: –

Source: S&P, FT

The consolidation of the US equity market continues – from a high of 7,562 on July 31, 1998, the Wilshire 5000 Index list of constituents has shrunk to just 3,473 names. This is a side effect of the fact that debt finance remains cheaper than equity finance. According to a recent article published by the Financial Times – US corporate bond issuance hits $1.919tn in 2020, beating full-year record corporate issuers have raised more capital in the first eight months of 2020 than in any previous full year. Low rates going to no rates, thanks to the actions of the Fed, is said to have driven this step-change in activity. The reticence of commercial banks to extend finance, despite the favourable interest rate and liquidity environment, is a contributing factor: –

Source: Refinitiv, FT

The Covid pandemic has accelerated many of the economic and financial market trends which have been in train since the end of the 2008/2009 financial crisis. Lower interest rates, more quantitative easing, further share buy-backs and greater debt issuance – by borrowers’ individual, corporate and national – look set to continue.

A global economic depression is looming, yet the price of many assets continues to rise. In a similar manner to the Tech bubble of the late 1990’s, today’s valuations rely more on the willing suspension of disbelief than on any sober assessment of earnings potential. The US stock market has outperformed partly due to the high proportion of technology stocks, as the chart below (from May) shows: –

Source: FactSet, Goldman Sachs

The magnitude of this fiscal and monetary response has already reached far beyond the United States. The table below shows those national stock markets with a positive year to date performance exceeding 5%: –

Source: Trading Economics, Local Stock Exchanges

I have deliberately excluded the Nasdaq 100 which is currently up more than 57%. Other countries will catch up. The US$ has weakened, since February, on a trade weighted basis: –

Source: BIS, Federal Reserve Bank of St Louis

In a competitive race to the bottom, other central banks (and their governments) will expand monetary (and fiscal) policy to stop their currencies appreciating too fast.

Global bond yield convergence will continue, stock market strength will endure. Inflation will creep into consumer prices gradually and the central banks will turn a blind eye until it is too late. The world economy may be on its knees but, in general, asset prices will continue to reach for the stars.

When does a recession become a depression?

When does a recession become a depression?

Macro Letter – No 131 – 21-08-2020

When does a recession become a depression?

  • Defining a depression as opposed to a recession is open to wide interpretation
  • Recessions are a natural part of the credit cycle
  • Depressions are destroyers of a nation’s wealth
  • Fiscal policy can help ease the pain of ‘creative destruction’ but long-term planning is key

There is a tide in the affairs of men

Which, taken at the flood, leads on to fortune.

William Shakespeare (Julius Caesar)

When your neighbour loses their job, it’s a recession.

When you lose your job, that’s a depression!

Harry S. Truman (33rd President of the Unites States)

The common knowledge definition above is grim and highly specific, but its banality serves to highlight the fact that the recession/depression question is not that simple to answer. Back in 2007 The Federal Reserve Bank of San Francisco – What is the difference between a recession and a depression? – attempted to reach a conclusion. They embraced the NBER definition of a recession: –

A recession is a significant decline in economic activity spread across the economy, lasting more than a few months, normally visible in real GDP, real income, employment, industrial production, and wholesale-retail sales. A recession begins just after the economy reaches a peak of activity and ends as the economy reaches its trough. Between trough and peak, the economy is in an expansion. Expansion is the normal state of the economy; most recessions are brief and they have been rare in recent decades.

And turned to Gregory Mankiw to distinguish between the two states of economic contraction: –

There are repeated periods during which real GDP falls, the most dramatic instance being the early 1930s. Such periods are called recessions if they are mild and depressions if they are more severe.

Despite the Federal Reserve’s valiant efforts, the simpler and more commonly accepted definition of a recession is a consecutive two quarters of decline in GDP. When it comes to depressions, however, there is little consensus; the two most common descriptions are: –

  • A decline in GDP of more than 20%
  • A period of more than two years of declining GDP

Whilst the two definitions are not mutually exclusive, they are broadly different. I believe the difference between a recession and a depression is more nuanced. A recession is a natural part of the business (or perhaps we should say credit) cycle, a depression, by contrast, involves the physical destruction of the economy – businesses are irreparably broken, employment opportunities terminally destroyed, investment has to be totally written off.

An alternative approach is to examine previous great depressions. Alas, this method proves equally inconsistent, for example the Great Depression of the 1930’s is generally considered to have lasted from 1929 to 1941 and yet, as the chart below reveals, there were only two distinct periods of declining GDP growth between 1930 and 1933 and again between 1937 and 1938: –

Source: Federal Reserve Bank of St Louis

Notwithstanding my more prosaic definition above, I favour the two year plus definition over that of a sharp decline in GDP. A recession hurts some parts of an economy, a depression is more widespread.

Another factor often associated with recessions and depressions is a rise in the rate of unemployment. Historically, rising unemployment has preceded the onset of recessions and only once recessions have become protracted have they been dubbed depressions.

A further differentiator relates to the absolute level of inflation. In general, as inflation rises, central banks respond by raising short-term interest rates. This helps to cool overheating economies, however, if they tighten too aggressively they may prompt a recession as the credit cycle is forced into a sharp contraction. By contrast a depression is often accompanied by an absolute fall in the price level, caused by an excessive overhang of domestic or corporate debt.

As an investor, why does a depression definition matter? Because financial markets are forward looking. If investors believe the recovery from the Covid-19 pandemic will be ‘V’ Shaped, then, even a 20% decline in GDP, together with zero interest rates, price support for government bonds and a fiscal expansion on a scale not witnessed since the ‘New Deal’ of FDR, will rapidly translate inot a sharply rising stock market. If, by contrast, it becomes clear that a tsunami of creative destruction is sweeping away entire industries, then even the most lavish of New New Deals may be insufficient to hold back the tide of stock liquidation as market participates rush to the safety of cash.

So far the official policy response has been sufficient to convince investors that a depression will be avoided. Scratch the surface of the S&P 500, however, and a rather different picture appears. The chart below shows market performance up to the end of May. The same five technology stocks have continued to drive S&P 500 index performance since then: –

Source: FactSet, Goldman Sachs

Technology has been the top performing sector. One argument for such elevated valuations rests on the premise that the pandemic has accelerated a wide range of technology trends bringing with it the potential for much swifter profits. In finance parlance, the net present value of future technology cash-flows has been brought forward by, some analysts suggest, several years. No wonder, they argue, that these stocks have broken to new all-time highs: and will continue, higher.

Since May, the broader stock market has hung of tech coattails (at the time of writing – 19-8-2020 -the MSCI World Index is up 1.73% YTD). For the present, hope triumphs over fear, yet vaccines remain many months from being widely available, meanwhile, for the Northern hemisphere, autumn – and fears of a second wave of infections – draws imminently near.

For emerging markets the situation is worse still. As Carmen and Vincent Reinhart, writing in Foreign Affairs – The Pandemic Depression– put it: –

Although dubbed a “global financial crisis,” the downturn that began in 2008 was largely a banking crisis in 11 advanced economies. Supported by double-digit growth in China, high commodity prices, and lean balance sheets, emerging markets proved quite resilient to the turmoil of the last global crisis. The current economic slowdown is different. The shared nature of this shock—the novel coronavirus does not respect national borders—has put a larger proportion of the global community in recession than at any other time since the Great Depression. As a result, the recovery will not be as robust or rapid as the downturn. And ultimately, the fiscal and monetary policies used to combat the contraction will mitigate, rather than eliminate, the economic losses, leaving an extended stretch of time before the global economy claws back to where it was at the start of 2020.

The World Bank estimates globally more than 60mln people will be pushed into severe poverty. Meanwhile, in developed countries, bankruptcies, which have been postponed by government intervention, may meet their personal epiphanies as fiscal largesse is suddenly withdrawn. Unless the lockdown restrictions are lifted and people feel safe, both medically and financially, to venture out and spend, the destruction of large swathes of developed market economies has simply been deferred.

By next month we will have experienced two quarters of diminished growth – this is a deep recession already. Swathes of the economy have been permanently altered, making a depression highly likely. Millions of workers have been displaced, it will take more than a handful of months for them to be retrained. Without the consumption demand from these erstwhile workers, it will be difficult for new and existing companies to create the growth they need to hire new employees.

Fiscal spending will need to be undertaken on a much larger scale, and for much longer, than has been envisaged so far. In all the major financial crises since 1850, the average time for per capita GDP to recover to the pre-crisis level was eight years. To date it is estimated that the G20 response to the pandemic has amounted to $11trln. Most of these measures have been ‘temporary’ or ‘short-term.’ It is quickly becoming clear, the disruption to employment, business and sectors of the economy will be protracted and, in many cases, permanent, The IMF estimate that for advanced economies the deficit-to-GDP ratio will rise from 3.3% in 2019 to 16.6% this year. For emerging economies, where the capacity for fiscal expansion is more limited, the ratio is expected to swell from 4.9% last year to 10.6% in 2020. Whilst for advanced economies the cost of borrowing has remained low in emerging markets financing costs have risen. The burden of fiscal stimulus will inevitably fall most heavily upon the treasuries of the advanced economies.


As Sir Winston Churchill once said: –

Now this is not the end. It is not even the beginning of the end. But it is, perhaps, the end of the beginning.

In the aging societies of the West (and elsewhere) the individual need for income remains key. Developed nation governments are fortunate in their ability to borrow more cheaply than at any time in economic history. Whilst it is at odds with my Austrian, free-market instincts, I am forced to admit that fiscal policy is the least panful weapon available to combat the economic catharsis created by the pandemic. Economically, there will be a heavy price to pay, but the alternative is a dangerous cocktail of political fragmentation and polarisation.

For investors the task of securing steady real income remains challenging. Private debt and asset backed lending, which offers high yield, comes with both default and liquidity risk. The chart below looks at some of the public market options, financial repression is rife across the credit spectrum: –

Source: Federal Reserve Bank of St Louis

High income stocks might be an alternative but they offer no guarantee, no matter how ‘blue-chip’ the name. An addition to the acceleration in technology trends, growth stocks in general are benefitting from the exceptionally low interest environment, but there will be a greater number of failures because the cost of speculative finance is also at an historical low. Active management has been unfashionable for at least a decade but looking ahead preservation of capital is going to be more important than capturing out-sized gains.

I wrote about value investing back in June in – A Brave New World for Value Investing – concluding that:

Stock and corporate bond markets have regained much of their composure since late March. Central banks and governments have acted to ameliorate the effects of the global economic slowdown. As the dust begins to settle, the financial markets will adjust to a new environment, one in which value-based stock and bond market analysis will provide an essential aid to navigation.

The geopolitics of trade policy, already a source of tension before the pandemic struck, has been turbo-charged by the simultaneous supply and demand shocks and their impact on global supply chains. Supply chains will shorten and diversify. Robustness rather than efficiency will be the watch-word in the months and years ahead. This sea-change in the functioning of the world economy will not be without cost. It will appear in increased prices or reduced corporate profits. Value-based investment analysis will be the best guide in this brave new world.

I would add an additional strategy to the investment armoury, a momentum overlay. With fiscal and monetary policy continuing to support economies as they transition to the new world order, capital flows will be a powerful arbiter of investment return. Technology stocks may look expensive by most normal metrics but the trend is patently clear. Do not emulate Cnut The Great, but do as Brutus advises in the opening quote, after all, financial market liquidity flows like tide.

After the flood – Beyond fiscal and monetary intervention

After the flood – Beyond fiscal and monetary intervention


Macro Letter – No 130 – 26-06-2020

After the flood – Beyond fiscal and monetary intervention

  • Monetary and fiscal stimulus to ameliorate the effect of the pandemic has exceeded $9trln
  • Stock markets have recovered, although most are below their February highs
  • The combined supply and demand shock of Covid-19 is structural
  • A value-based investment approach is critical to navigate the transition

In my last Macro Letter – A Brave New World for Value Investing – I anticipated the beginning of a new phase for equity investment. In this Letter I look at the existing business and economic trends which have been accelerated by the pandemic, together with the new trends ignited by this sea-change in human behaviour.

In economic terms, the Covid pandemic began with a supply-shock in China as they were forced to lockdown the Wuhan region. This exacerbated strains which had already become evident in trade negotiations between China and the US, but also revealed weaknesses in the global supply chains. A kind of ‘Mexican Wave’ has followed, with a variant on the initial supply-shock occurring in successive countries as the virus spreads from region to region and governments responded with lockdowns.

The supply-shock has gone hand in hand with a global demand-shock. The key difference between this recession and previous crises is the degree to which it has impacted the service sector. According to 2017 data, the service sector represents 65% of global GDP, whilst Industrial/Manufacturing accounts for 25%, Agriculture represents only 3.43%. Over time, Agriculture and Manufacturing has become more increasingly automated, the principle growth sector for employment is Services. The ILO Monitor: COVID-19 and the world of work. Fourth edition states:  –

As at 17 May 2020, 20 per cent of the world’s workers lived in countries with required workplace closures for all but essential workers. An additional 69 per cent lived in countries with required workplace closures for some sectors or categories of workers, and a further 5 per cent lived in countries with recommended workplace closures.

The latest ILO estimate for Q2, 2020 indicates a 10.7% decline in working hours – equivalent to 305mln lost jobs worldwide. 60% of these job losses have been in four industries, leisure, retail, education and, perhaps counter-intuitively, healthcare. The knock-on effects have been felt almost everywhere.

Governments and central banks have responded. The chart below shows the rapid expansion in central bank balance sheets: –

CB Balance Sheets - Yardeni

Source: Yardeni, Haver Analytics

The Federal Reserve began their latest round of quantitative easing in August 2019, well before the onset of the pandemic. They have added $3.3tlrn in nine months, seeing their balance sheet balloon to $7.1trln.

Around the world, governments have also reacted with vigour; on May 20th the IMF updated their estimate of the global fiscal response to $9trln, of which $8trln has emanated from G20 countries. The geographic breakdown as a percentage of GDP can be seen in the table below: –


Source: IMF

The majority of global stimulus has come from the richer developed nations. Assuming this pattern continues, emerging market equities are likely to lag. The table below ranks a selection of emerging economies by four measures of financial strength, public debt, foreign debt, cost of borrowing and reserve cover: –


Source: The Economist, IMF, JP Morgan, iShares

Overall, whilst the flood may subside, global expenditure should continue to rise as the pandemic sweeps on across the globe. Whilst loan forbearance and forgiveness, together with state guarantees, will help to maintain the solvency of many existing corporations, new spending will be aimed at stimulating employment. Infrastructure projects will be legion.

Impact on Industry Sectors

For investors, the abrupt changes in supply and demand, combined with the impact of the fiscal and monetary response, make navigating today’s stock markets especially challenging. To begin, here is a chart from 2019 showing a breakdown of industry sectors in the US by their contribution to GDP: –

Deloitte Fig 1 (1)

Source: Deloitte, BEA, Haver Analytics

This tells us that finance, insurance and real estate are the largest sector but it fails to tell us which sectors are thriving and which are not: –

Deloitte Fig 2 (1)

Source: Deloitte, BEA, Haver Analytics

Here we see the continued march of digital transformation, but also the ever increasing share of healthcare services in GDP; near to four decades of asset price appreciation has created an asset rich aging cohort in developed economies which, if not healthier then definitely wealthier. Looking ahead, developed nations are better equipped to weather the crisis better than their developing nation peers. Within developed nations, however, smaller businesses, especially those which cannot access capital markets, will fail, whilst larger firms will fare far better. Private Equity funds will also find rich pickings among the plethora of distressed private market opportunities.

Since the outbreak of Covid-19, several trends have accelerated, others have been truncated or reversed. Social behaviour has had a negative impact on travel, leisure and retail. Declining demand for travel has damaged a range of industries including airlines, autos, oil and gas. The leisure sector has been hit even harder with hotels, restaurants and bars closed, in many cases forever. The sports industry has been severely undermined. Meanwhile the decline in retail has accelerated into a downward spiral.

Nonetheless, several industries have benefitted. Within retail, online sales have hit new records, grocery sales have ballooned. Healthcare has gone digital, from consulting to dispensing productivity gains have been evident. The home improvements industry has benefitted even as commercial real estate has suffered. Working from home will be a permanent feature for many office workers. Every existing home owner will need to create a permanent office space, every new home buyer will need more space to incorporate an office. Longer, occasional, commutes will lead people to move further from the city. Some workers will move to more clement climes, requiring less energy. Structural changes in where we live and how we live present threats and opportunities in equal measure. For example, every house will require better communications infrastructure, high speed connectivity and broad, broadband will become the norm.

Changes in the delivery of goods (direct to homes rather than to retail outlets) means more inventory will held in out-of-town locations. Inner city retail and commercial property businesses will consolidate as out-of-town commercial thrives. New out-of-town property demand will also emerge from the manufacturing sector. The on-shoring of production was already in train, with robots replacing cheap labour from developing countries, now, concern about the robustness of supply chains, especially for critical manufactures such as pharmaceuticals, will encourage a wave of old industries in developing countries to be reborn. Whereas in retail, larger inventory may become more prevalent, in manufacturing, ‘just-in-time’ delivery and lower transportation costs will compensate for higher fixed production costs.

The energy sector has suffered a medium-term setback, for example, 28% of all US gasoline is consumed in the daily commute. After the lockdown, some commuters will choose to travel alone rather than by public transport, many more will now work permanently from home. Yet whilst gasoline demand falls, demand for diesel, to fuel the home delivery revolution, will rise. Home heating (and cooling) is also set to rise and, with it, demand for heating oil and natural gas. Overall demand may be lower but there will be many investment opportunities.

In healthcare, aside from tele-medicine, which is forecast to capture between one third and half of consultation demand, there is also increased appetite for bio-sensors to measure multiple aspects of health. Hospital consolidation will continue in an attempt to drive efficiency. On-shoring of drug manufacture may well be mandated, online delivery is likely to become the new normal, especially to the elderly and infirm who are advised to shelter-in-place. On-shoring creates domestic jobs, government favour will focus on these companies.

Airlines will be forced to diversify or merge; I envisage a mixture of both strategies. A diversification into car hire, travel insurance and hotels seems likely. Many airlines are national carriers, they possess an implicit government guarantee, their financing costs will remain lower, their low-budget competitors will diminish, fare discounts will become fewer and, thereby, their fortunes may conceivably rebound.

The automobile industry remains in a state of turmoil, but new technology will continue to determine its fortune. If de-urbanisation continues, whilst commuting will decline, there will be an increased demand for individual car ownership, especially electric vehicles. In the fullness of time, the industry will transform again with the adoption of driverless transportation.

Technology will, of course, be ubiquitous. The fortunes of the cybersecurity sector have been ascendant since the crisis began, but even relatively ‘non-tech’ businesses will benefit. Commercial real estate will gain as tech firms seek out ever larger data centres to support their cloud computing needs. The auto industry will benefit from improvements in battery storage and charging times. This will also change the economics of electricity for homes and factories. Green energy will come of age.

Tourism will recover, the human race has not lost the desire to travel. In Europe tourism is down between 30% and 40% – it accounts for 10% of GDP. The rebound will be gradual but the travellers will return. More consumers will buy on-line.

Banking and finance will evolve to meet the challenges and needs of the industrial and services sector. Certain trends will continue, bricks and mortar will give way to on-line solutions, branch networks will consolidate. With government support, or threat, existing loans will be extended, new loans made. As household savings rise, new credit will be granted to new and existing entities, few questions will be asked.

Insurance companies will consolidate, once claims are paid, premiums will rise and competition lessened. As with banking more consumers will move on-line.


Looking beyond the business potential of different industry sectors and the technological advances which will support them, we should remember that governments around the globe will direct fiscal policy to alleviate unemployment, the initial flood of fiscal aid may moderate but if the tide goes out the ebb will be gradual, this is one of the benefits of a fiat currency system. According to the ILO, in 2019, employment in services accounted for 50%, Industry 23% and Agriculture 27%. The chart below shows how employment by sector has evolved over the last 28 years: –

Global Employment by Sector – Services – Agriculture - Industry (1)

Source: World Bank, ILO

The services sector has embraced employees leaving agriculture, whilst industry has grown without significant employment growth. The leisure industry, including hotels, restaurants and bars, is one of the largest employers of low-skilled, part-time employment. Consolidation within the hotels sector is inevitable. Larger, better capitalised groups will benefit as smaller enterprises fail. Corporations from beyond the leisure sector will diversify and private equity will fill the gaps which public companies step aside.

Conclusions and Investment Opportunities

In my previous Macro Letter I concluded that value-based analysis would be the best approach to equity investment. On closer examination, one can find risk and opportunity in almost every industry sector. In the last three month, stock markets have risen, but stock return dispersion remains heightened. A prudent, value-oriented, framework should yield the best results in the next few years.

A Brave New World for Value Investing

A Brave New World for Value Investing

In the Long Run - small colour logo

Macro Letter – No 129 – 05-06-2020

A Brave New World for Value Investing

  • Stock markets have rebounded from their March lows on fiscal and monetary stimulus
  • Corporate bond spreads have narrowed in their wake
  • The prospect of further fiscal spending and broader quantitative easing remains
  • The global economy has changed forever and value analysis is back in demand

Perhaps the most frequently used adjective during the Covid pandemic is ‘unprecedented.’ On the 14th February, when I published – Macro Letter – No 126 – 14-02-2020 – When the facts change – I wrote: –

My title is the first part of JM Keynes famous remark, ‘When the facts change, I change my mind.’ This phrase has been nagging at my conscience ever since the Coronavirus epidemic began to engulf China and send shockwaves around the world. From an investment perspective, have the facts changed? Financial markets have certainly behaved in a predictable manner. Government bonds rallied and stocks declined. Then the market caught its breath and stocks recovered. There have, of course been exceptions, while the S&P 500 has made new highs, those companies and sectors most likely to be effected by the viral outbreak have been hardest hit.

Much has happened since, yet, in my conclusion, I stated: –

…the facts always change but, unless the Covid-19 pandemic should escalate dramatically, the broad investment themes appear largely unchanged. Central banks still weld awesome power to drive asset prices, although this increasingly fails to feed through to the real economy.

… Like an addictive drug, the more the monetary stimulus, the more the patient needs in order to achieve the same high. The direct financial effect of lower interest rates is a lowering of bond yields; lower yields spur capital flows into higher yielding credit instruments and equities. However, low rates also signal an official fear of recession, this in turn prompts a reticence to lend on the part of banking intermediaries, the real-economy remains cut off from the credit fix it needs. Asset prices keep rising, economic growth keeps stalling; the rich get richer and the poor get deeper into debt. Breaking the market addiction to cheap credit is key to unravelling this colossal misallocation of resources, a trend which has been in train since the 1980’s, if not before. The prospect of reserving course on subsidised credit is politically unpalatable, asset owners, especially indebted ones, will suffer greatly if interest rates should rise, they will vote accordingly. The alternative is more of the same profligate policy mix which has suspended reality for the past decade. From an investment perspective, the facts have not yet changed and I have yet to change my mind.

To judge by the current level of the Nasdaq 100 (current level 9,683 as at COB 03-06-2020, just 1.6% below its all-time high) the unprecedented crisis has been met by an equally unprecedented policy response. The S&P 500 has lagged the Nasdaq somewhat and the MSCI World Index still more: –

Nasdaq 100 v SPX v MSCI - Yahoo Finance (1)

Source: Yahoo Finance

Returning to my letter from February, the facts have changed, governments and central bankers have responded to a crisis, a crisis which proved far worse than anticipated. The stock market collapsed, but has now regained composure, nevertheless, the main driver of stock market performance for more than a decade – ability of central banks to lower interest rates – has been exhausted. The central bankers’ armoury is not quiet empty, however, they still have the QE bazooka which can be aimed at corporate bonds and even common stocks, but, not wishing to exceed their mandates they have turned to their respective governments’ for guidance and succour.

Governments’ can and have responded to the pandemic in a manner which is both broader and more direct in its impact on the economy and businesses. Going forward the effect of government largesse will be felt in a less consistent manner than the largesse of central banks. For governments’ employment will take precedence over corporate profits, corporate executives would be wise to recognise the profound change in the terms of engagement. Stock performance can no longer be assured by increasing debt to repurchase stock. Mergers which rely on rationalisation will be thwarted from above. Wages are unlikely to rise given the increase in unemployment, but the cost of making incumbent employees redundant will have adverse consequences both seen and unseen. Firms that hire will find favour, those that trim payrolls will not.

We will witness the return of the Value Investor, an endangered species who underperformed the Index Trackers during the decade since the great financial crisis. The great rotation away from index tracking or hugging is about to begin. Technology will continue to provide new employment opportunities even as more roles in the wider economy become automated. The public sector will create opportunities. Infrastructure spending is set to bring a ‘New, new deal’ to those in need of work. Healthcare will continue to expand as the population of developed countries age and life expectancy increases.

Other changes are also afoot. Working from home is about to become the norm for many people. Video conferencing, now widely adopted, brings into question the need for excessive travel. Demand for office space is already in retreat. Many firms are reporting unexpected productivity gains from the enforced ‘work from home edict,’ and have cancelled leases in favour of smaller, more flexible office space. Meanwhile, those eponymous start-ups, for whom flexible office space was the norm, have made a virtue of necessity, slowing their cash-burn – and mollifying investors in the process – by closing their offices altogether.

As economies recover from the effects of the lockdown, companies will fall into three categories based on their prospects for recovery from the dual supply and demand shock – ‘L,’ ‘U’ and ‘V’. The Tech giants (V) have rebounded and their prospects remain strong, even at these exalted valuations. Investment Grade Corporates (U) will take longer to recover, but even before interest rates were lowered by the Federal Reserve (Fed) these corporations were preparing for an economic slowdown. Q1 corporate debt issuance surged to the highest since records began in 1980: –

1-US-debt-issuance-20-05-2020 refinitiv

Source: Refinitiv

The High-Yield bond market followed in the wake of Investment Grade issuers, although the sudden widening of credit spreads in March dampened their ardour. Issuance returned with renewed urgency as soon the Federal Reserve announced that ‘Junk bonds’ where to be included in its expanded asset purchase program: –


Source: Refinitiv

This chart from the St Louis Fed tracks yield changes year-to-date for the High Yield bond index: –

fredgraph (1) HY YTD

Source: Ice Data Indices, Federal Reserve

High yield bond yields remain elevated despite the interest rate cuts and Fed asset purchase promises. On 3rd June they averaged 5.8% up from 3.56% in mid-February, but far below their 23rd March high of 10.87%.

Many of the firms in the high yield sector (L) are involved in the Oil and Gas industry. As oil and gas prices rebound, they will regain some composure and, being high profile employers, they should receive government support. Other firms may fare less well, these are those destined to follow an ‘L-shaped’ recovery. Their survival will be dependent on their ability to provide employment, some will be saved, others will fail.


Stock and corporate bond markets have regained much of their composure since late March. Central banks and governments have acted to ameliorate the effects of the global economic slowdown. As the dust begins to settle, the financial markets will adjust to a new environment, one in which value-based stock and bond market analysis will provide an essential aid to navigation.

The geopolitics of trade policy, already a source of tension before the pandemic struck, has been turbo-charged by the simultaneous supply and demand shocks and their impact on global supply chains. Supply chains will shorten and diversify. Robustness rather than efficiency will be the watch-word in the months and years ahead. This sea-change in the functioning of the world economy will not be without cost. It will appear in increased prices or reduced corporate profits. Value-based investment analysis will be the best guide in this brave new world.

Epidemics, Economic Growth and Stock-market Performance – An Historical Perspective

Epidemics, Economic Growth and Stock-market Performance – An Historical Perspective

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Macro Letter – No 127 – 13-03-2020

Epidemics, Economic Growth and Stock-market Performance – An Historical Perspective

  • As the COVID-19 pandemic gathers momentum, history offers too few data points
  • The Spanish Flu is the nearest comparison – similarities are matched by differences
  • Clinical trials have started, but the rise in new cases is slowing in China already
  • Global economic growth will suffer, but monetary and fiscal stimulus should support stocks

As I write this article I am conscious that the Coronavirus is a very real and global tragedy. In all that follows I do not wish to detract from the dreadful human cost of this disaster in any way.

Putting the current pandemic in perspective, according to a 2017 estimate from the US Center for Disease Control, in a normal year, seasonal flu kills 291,000 to 646,000 globally. By contrast, the fatality rate for coronavirus seems to have stabilised at around 3.6% of those diagnosed. Of course, a more heartening figure of 0.79% can be found in South Korea which has tested almost 10 times more of its population than other country:-

Testing for COVID-19 - 9-3-2020 -


Suffice to say the current statistics are still confusing at best, but they are all we have to work with.

In a recent interview Dr Soumaya Swaminathan of the World Health Organisation (WHO) provided some insights (emphasis is mine): –

Of 44,000 Wuhan patients 80% had very mild symptoms, 15% of cases are severe and 5% critical. In terms of transmission rates, the R0 is still just an estimate of between 2 and 3 – in other words for every carrier between two and three people are infected.

…Two drugs, an antiretroviral called Lopinavir-ritonavir and an experimental drug used in the treatment of Ebola – Remdesivir, manufactured by Gilead (GILD) – are being tested in China where more than 80 clinical trials are already underway. The development of an effective vaccine it several months away. 

It was reported today (11-3-2020) that Gilead has begun trails with US nationals and signed a deal with the US military.

Market Impact

Given the continued lack of clarity about COVID-19 in terms of numbers infected and numbers suffering, it may seem futile to attempt to gauge the potential economic impact of the current Coronavirus outbreak. History, however, may be able to provide some guidance to investors who might otherwise be tempted to liquidate and hibernate, especially after the dramatic decline this week in the wake of Saudi Arabia’s decision to turn its back on the OPEC cartel.

In order to begin this assessment, there are a vast array of factors which need to be considered. Here are just a few: –

  1. Speed of spread – higher in urban areas due to population density
  2. Urban versus rural population – generally a function of GDP per capita
  3. Likelihood of a cure or vaccine – the majority of estimates range from three months to a year (hopefully it was be sooner)
  4. Health of demographic cohorts by country – a function of average age and GDP per capita
  5. Average income – also a function of GDP per capita
  6. Extent of healthcare coverage – generally a function of GDP (although European welfare arrangements are more developed than those of the US)

Each of these factors are complex and warrant an essay to themselves. Suffice to say, the economic impact is already becoming evident. Schools, factories and offices are closing. Those workers that can are beginning to work remotely. At the extreme, entire cities, towns and countries are being subjected to lock-downs. In these conditions, economic activity inevitably suffers, this is a supply and demand shock combined. The price of crude oil has already responded, encouraged by the actions of Saudi Arabia, it has collapsed. Transportation activity has been substantially reduced. Economic indicators from China point to a pronounced contraction in 2020 GDP growth. Will the pattern seen in China be repeated elsewhere? Are the nascent indications of a resumption of economic activity now evident in China a reliable indication of the speed of recovery to be expected elsewhere? The jury is still out.

For G20 countries the effect of the 2008/2009 financial crisis still lingers. According to a BIS report more than 12% of developed nation firms generate too little income to cover their interest payments. Meanwhile, at the individual level, the Federal Reserve estimates that more than 10% of American adults would be unable to meet a $400 unexpected expense, equivalent to around two days’ work at average earnings. There is concern among governments that people may start to hoard cash if the crisis deepens.

Where the viral epidemic began, in China, the Purchasing Managers Index for February was the lowest since the series began in 2004. According to China Beige Book’s flash survey for February, 31% of companies were still closed and many of those that have reopened lacked staff or materials. Other estimates suggest that between 40% and 50% of the China’s truck fleet remains idle – those essential materials are unlikely to be delivered anytime soon. This supply-shock slowdown has inevitably fuelled expectations of an actual contraction in the size of the Chinese economy, the first shrinkage since the death of Mao Zedong in 1976: –

China PMI

Source: Trading Economics

Everywhere GDP forecasts are being revised lower: –

Economist GDP revisions from Q4 2019 to Q1 2020 OECD

Source: Economist

Policy Response

For the world’s governments there are essentially three policy responses: –

  1. Provision of credit via banks and money markets – central banks are doing what they can
  2. Aid to corporates to meet fixed costs, such as rent and tax bills
  3. Protection of workers by subsidising wage costs

Central banks are limited in their ability to lend directly to firms, meanwhile the banking system, petrified by the recent widening of credit spreads for sub-investment grade debt, is likely to become a bottleneck. It will take more than gentle persuasion to force banks to lend new funds and reschedule existing non-performing loans. Other aid to corporates and individuals requires varying degrees of fiscal stimulus. Governments need to act quickly (today’s UK budget is an indication of the largesse to follow) it would also help if there were a coordinated global policy response.

The Peterson Institute – Designing an effective US policy response to coronavirus make the following suggestions: –

A first step is to lock in adequate public funding. In 2014, emergency funding of about $5.4 billion was provided to fight the Ebola outbreak. Much more than that should be provided today, given the apparently greater transmissibility of COVID-19 and the fact that it has already appeared in many locations around the United States and more than 60 countries around the globe.

…A classic recession involves a shortfall of demand relative to supply. In that more ordinary situation, economic policymakers know how to help fill in the missing demand. But this case is more complicated because it involves negative hits to both supply and demand.

No one knows how serious the economic damage from COVID-19 will be, so a key challenge is to design a fiscal countermeasure that clicks on when it’s needed and clicks off when it’s not. One approach that would fit that description would be to move immediately to pre-position a temporary cut in the payroll taxes that fund the Social Security and Medicare programs…

The final suggestion is a US-centric proposal, it is different from the income tax cut alluded to by President Trump and will directly benefit lower-income families, since healthcare costs will be a larger proportion of their after tax income. The authors’ propose a similar mechanism to click in when the unemployment rates rises and click off when re-employment kicks back in.

The table below shows actions taken by 4th March: –

Government response to COVID-19

Source: Economist

It is worth mentioning that Hong Kong, still reeling from the civil unrest of last year, has pressed ahead with ‘helicopter money’ sending cheques to every tax payer. This approach may be more widely adopted elsewhere over the coming weeks.

The Spanish Flu

In an attempt to find an historical parallel for the current Corona outbreak, there are only two episodes which are broadly similar, the Black Death of 1347 to 1351 and the Spanish Flu of 1918 to 1919. Data from the middle ages is difficult to extrapolate but it is thought that the Plague wiped out between 20% and 40% of Europe’s population. The world population is estimated to have fallen from 475mnl to between 350mln and 375mln. The world economy shrank, but, if data for England is any guide, per capita economic activity increased and the economic wellbeing of the average individual improved. For more on this topic I would recommend a working paper from the Federal Trade Commission – The English Economy Following the Black Death by Judith R. Gelman -1982.

The Spanish Flu of 1918 was the next global pandemic. It began in August of 1918, three month prior to the end of the First World War, and, by the time it had ended, in March of 1919, it had infected 500mln out of a global population of 1.8bln. The fatality rate was high, 40mln people lost their lives. Following the war, which cost almost 20mln lives, the combined loss of life was similar in absolute terms to the Black Death although in percentage terms the fatality rate was only 2%.

An excellent assessment of the Spanish epidemic can be found in the Economic Effects of the 1918 Influenza Pandemic – Thomas A. Garrett – Federal Reserve Bank of St Louis – 2007 – here are some key findings: –

The possibility of a worldwide influenza pandemic… is of growing concern for many countries around the globe. The World Bank estimates that a global influenza pandemic would cost the world economy $800 billion and kill tens-of-millions of people. Researchers at the U.S. Centers for Disease Control and Prevention calculate that deaths in the United States could reach 207,000 and the initial cost to the economy could approach $166 billion, or roughly 1.5 percent of the GDP. Longrun costs are expected to be much greater. The U.S. Department of Health and Human Services paints a more dire picture—up to 1.9 million dead in the United States and initial economic costs near $200 billion.

Despite technological advances in medicine and greater health coverage throughout the 20th century, deaths from a modern-day influenza pandemic are also likely to be related to race, income and place of residence.

The Spanish-flu was different from COVID-19 in that the highest mortality was among those aged 18 to 40 years and was often found among those with the strongest immune systems.

Garrett goes on to assess the economic impact with the aid stories from newspapers and the limited amount of previously published (and some unpublished) research. National statistics on unemployment and economic activity had yet to be compiled, but the simultaneous supply and demand shocks were broadly similar to the patterns we are witnessing today.

…One research paper examines the immediate (short-run) effect of influenza mortalities on manufacturing wages in U.S. cities and states for the period 1914 to 1919. The testable hypothesis of the paper is that

influenza mortalities had a direct impact on wage rates in the manufacturing sector in U.S. cities and states during and immediately after the 1918 influenza. The hypothesis is based on a simple economic model of the labor market: A decrease in the supply of manufacturing workers that resulted from influenza mortalities would have had the initial effect of reducing manufacturing labor supply, increasing the marginal product of labor and capital per worker, and thus increasing real wages. In the short term, labor immobility across cities and states is likely to have prevented wage equalization across the states, and a substitution away from relatively more expensive labor to capital is unlikely to have occurred.

The empirical results support the hypothesis: Cities and states having greater influenza mortalities experienced a greater increase in manufacturing wage growth over the period 1914 to 1919.

Another study explored state income growth for the decade after the influenza pandemic using a similar methodology. In their unpublished manuscript, the authors argue that states that experienced larger numbers of influenza deaths per capita would have experienced higher rates of growth in per capita income after the pandemic. Essentially, states with higher influenza mortality rates would have had a greater increase in capital per worker, and thus output per worker and higher incomes after the pandemic. Using state-level personal income estimates for 1919-1921 and 1930, the authors do find a positive and statistically significant relationship between state-wide influenza mortality rates and subsequent state per capita income growth.

Aside from wages, however the author concludes: –

…Most of the evidence indicates that the economic effects of the 1918 influenza pandemic were short-term. Many businesses, especially those in the service and entertainment industries, suffered double-digit losses in revenue. Other businesses that specialized in health care products experienced an increase in revenues.

How did financial markets react? The chart below shows the Dow Jones Industrial Average over the period from 1918 to 1923. The shaded areas indicate recessions: –

dow-jones- 1918 to 1923 Macrotrends

Source: Macrotrends

When reinvested dividends are included, the total return of the Dow Jones Industrial Average in 1918 was 10.5%, despite influenza wiping out 0.4% of the US population. Fears about a slowdown in economic activity, resulting from the end of WWI, were the underlying cause of the brief recession which coincided with the pandemic, the stock market had already reacted, dipping around 10% earlier in the year. The subsequent recession of 1920 had other causes.

As is evident from the chart below, the newly created (1913) Federal Reserve felt no compunction to cut interest rates: –


Source: Federal Reserve Bank of St Louis

US 10 year Treasury Bonds simply reflected the actions of the Federal Reserve: –

US Bonds Jan 1918 to Dec 1919

Source: ECB

One is forced to concede, financial markets behaved in a very different manner 100 years ago, but they may yet have something to teach us about the global impact of a pandemic – that it is an economic interruption rather than a permanent impediment to progress.

Conclusions and investment opportunities

Whilst there are similarities between the Spanish Flu of 1918 and the COVID-19 pandemic of today, there are also profound differences. Urban areas, for example, are expected to suffer higher fatalities than rural areas today. In 1919 only 51% of the population of the US was urban, today it is above 80%. Population density has also increased three-fold over the last century, if 500mln were infected in 2018/2019 then the comparable figure today would be 1.5bln. Changes in the ease of transportation mean that the spread of a pandemic will be much more rapid today than in the first quarter of the 20th century. Tempering this gloom, for many people, communications have transformed the nature of work. Many aspect of business can now be transacted remotely. Unlike in 1918 self-isolation will not bring commerce to a standstill.

The economic impact will also be felt more rapidly. Supply chains have been optimised for efficiency, they lack resilience. Central banks have already begun to cut interest rates (where they can) and provide liquidity. Governments have picked up the gauntlet with a range of fiscal measures including tax cuts and benefit payments.

Many commentators are calling the COVID-19 pandemic a Black Swan event, yet SARS (2003), H1N1 (2009), and MERS (2012) preceded this outbreak. Predictions that just such an event would occur have been circulating for more than a decade.

Financial markets have behaved predictably. The oil price has collapsed as Saudi Arabia has broken with the OPEC cartel, stocks have fallen (especially those related to oil) and government bonds have rallied. Gold, which saw significant inflows during the last few years, has vacillated as holders have liquidated to meet commitments elsewhere even as new buyers have embraced the time-honoured ‘safe haven.’ Looking ahead, we do not know how long this pandemic will last nor how widespread it will become. The two prior pandemics of a similar stature provide little useful guidance, the Spanish Flu lasted seven months, the Black Death, by contrast, spread over more than four years and was still flaring up into the 17th century.

Expectations of a cure and a vaccine remain a matter of conjecture, but epidemiologists suggest that within a year we will have a viable solution. At the time of writing (Wednesday 11th March) the total number of infections has reached 120,588, there have been 4,365 deaths while 66,894 patients have recovered – a 55.47% recovery rate, although the Chinese recovery rate has been steadily rising and now stands at 76.22%. The global fatality rate is 3.62%, whilst individual country fatality rates range from Italy at 6.22% to South Korea (where 210,000 people have been tested – ten times the per capita global average) at a heartening 0.79%. The WHO still expect the fatality rate to stabilise at around 1% which implies that 99% should eventually recover.

Whilst a larger correction in stocks should not be ruled out, the relative lack of selling pressure suggests that investors are prepared to reappraise their estimates of what price to earnings they will accept – remember interest rates have been cut and will probably be cut again. Where rates can be lowered no further, quantitative easing (including the purchase of stocks) and fiscal stimulus will aim to preserve value.

The historical evidence of the Spanish Flu suggests this pandemic will be short-lived. The recent market correction may prove sufficient but, with only two data points in more than 600 years, it is unwise to assume that it will not be different this time. Defensive equity strategies which focus on long-term value have been out of favour for more than a decade. Good companies with strong balance sheets and low levels of debt are well placed to weather any protracted disruption. They may also benefit from rotation out of index funds. When markets stabilise, the reduced level of interest rates will see a renewed wave of capital pouring into stocks. The only question today is whether there will be another correction or whether now is the time to buy.

When the facts change

When the facts change

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Macro Letter – No 126 – 14-02-2020

When the facts change

  • The coronavirus is a human tragedy, but the markets remain sanguine
  • A slowing of global growth is already factored into market expectations
  • Further central bank easing is expected to calm any market fears
  • A pick up in import price inflation has been discounted before it arrives

My title is the first part of JM Keynes famous remark, ‘When the facts change, I change my mind.’ This phrase has been nagging at my conscience ever since the Coronavirus epidemic began to engulf China and send shockwaves around the world. From an investment perspective, have the facts changed? Financial markets have certainly behaved in a predictable manner. Government bonds rallied and stocks declined. Then the market caught its breath and stocks recovered. There have, of course been exceptions, while the S&P 500 has made new highs, those companies and sectors most likely to be effected by the viral outbreak have been hardest hit.

Is the impact of Covid-19 going to be seen in economic data? Absolutely. Will economic growth slow? Yes, though it will be felt most in Wuhan and the Hubei region, a region estimated to account for 4.5% in Chinese GDP and 7% of autopart manufacture. The impact will be less pronounced in other parts of the world, although Korea’s Hyundai has already ceased vehicle production at its factories due to a lack of Chinese car parts.

Will there be a longer-term impact on the global supply chain and will this affect stock and bond prices? These are more difficult questions to answer. Global supply chains have been shortening ever since the financial crisis, the Sino-US trade war has merely added fresh impetus to the process. As for financial markets, stock prices around the world declined in January but those markets farthest from the epicentre of the outbreak have since recovered in some cases making new all-time highs. The longer-term impact remains unclear. Why? Because the performance of the stock market over the last decade has been driven almost entirely by the direction of interest rates, whilst economic growth, since the financial crisis, has been anaemic at best. As rates have fallen and central banks have purchased bonds, so bond yields have declined making stocks look relatively more attractive. Some central banks have even bought stocks to add to their cache of bonds, but I digress.

Returning to my title, from an investment perspective, have the facts changed? Global economic growth will undoubtedly take a hit, estimates of 0.1% to 0.2% fall in 2020 already abound. In order to mitigate this downturn, central banks will cut rates – where they can – and buy progressively longer-dated and less desirable bonds as they work their way along the maturity spectrum and down the credit-structure. Eventually they will emulate the policy of the Japanese and the Swiss, by purchasing common stocks. In China, where the purse strings have been kept tight during the past year, the PBoC has already ridden to the rescue, flooding the domestic banking system with $173bln of additional liquidity; it seems, the process of saving the stock market from the dismal vicissitudes of a global economic slow-down has already begun.

Growth down, profits down, stocks up? It sounds absurd but that is the gerrymandered nature of the current marketplace. It is comforting to know, the central banks will not have to face the music alone, they can rely upon the usual allies, as they endeavour to keep the everything bubble aloft. Which allies? The corporate executives of publically listed companies. Faced with the dilemma of expanding capital expenditure in the teeth of an economic slowdown – which might turn into a recession – the leaders of publically listed corporations can be relied upon to do the honourable thing, pay themselves in stock options and buyback more stock.

At some point this global Ponzi scheme will inflect, exhaust, implode, but until that moment arrives, it would be unwise to step off the gravy-train. The difficulty of staying aboard, of course, is the same one as always, the markets climb a wall of fear. If there is any good news amid the tragic Covid-19 pandemic, it is that the January correction has prompted some of the weaker hands in the stock market to fold. When markets consolidate on a high plateau, should they then turn down, the patient investor may be afforded time to exit. This price action is vastly preferable to the hyperbolic rise, followed by the sharp decline, an altogether more cathartic and less agreeable dénouement.

Other Themes and Menes

As those of you who have been reading my letters for a while will know, I have been bullish on the US equity market for several years. That has worked well. I have also been bullish on emerging markets in general – and Asia in particular – over a similar number of years. A less rewarding investment. With the benefit of hindsight, I should have been more tactical.

Looking ahead, Asian economies will continue to grow, but their stock markets may disappoint due to the uncertainty of the US administrations trade agenda. The US will continue to benefit from low interest rates and technological investment, together with buy-backs, mergers and privatisations. Elsewhere, I see opportunity within Europe, as governments spend on green infrastructure and other climate conscious projects. ESG investing gains more advocates daily. Socially responsible institutions will garner assets from socially responsible investors, while socially responsible governments will award contracts to those companies whose behaviour is ethically sound. It is a virtuous circle of morally commendable, albeit not necessarily economically logical, behaviour.

The UK lags behind Europe on environmental issues, but support for business and three years of deferred capital investment makes it an appealing destination for investment, as I explained last December in The Beginning of the End of Uncertainty for the UK.


Returning once more to my title, the facts always change but, unless the Covid-19 pandemic should escalate dramatically, the broad investment themes appear largely unchanged. Central banks still weld awesome power to drive asset prices, although this increasingly fails to feed through to the real economy. The chart below shows the diminishing power of the credit multiplier effect – Japan began their monetary experiment roughly a decade earlier than the rest of the developed world: –

Credit Multiplier

Source: Allianz/Refinitiv

Like an addictive drug, the more the monetary stimulus, the more the patient needs in order to achieve the same high. The direct financial effect of lower interest rates is a lowering of bond yields; lower yields spur capital flows into higher yielding credit instruments and equities. However, low rates also signal an official fear of recession, this in turn prompts a reticence to lend on the part of banking intermediaries, the real-economy remains cut off from the credit fix it needs. Asset prices keep rising, economic growth keeps stalling; the rich get richer and the poor get deeper into debt. Breaking the market addiction to cheap credit is key to unravelling this colossal misallocation of resources, a trend which has been in train since the 1980’s, if not before. The prospect of reserving course on subsidised credit is politically unpalatable, asset owners, especially indebted ones, will suffer greatly if interest rates should rise, they will vote accordingly. The alternative is more of the same profligate policy mix which has suspended reality for the past decade. From an investment perspective, the facts have not yet changed and I have yet to change my mind.

The Beginning of the End of Uncertainty for the UK

The Beginning of the End of Uncertainty for the UK

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Macro Letter – No 124 – 20-12-2019

The Beginning of the End of Uncertainty for the UK

  • The UK election result was a clear mandate for Brexit
  • A UK/EU free-trade agreement may not be ready by December 2020
  • Uncertainty remains but real economic progress can now begin

For traders and investors in financial markets, risk and reward are two sides of a single coin. There are, of course, exceptions and geopolitical risk is one of them. The difficulty with geopolitical risk is that it is really geopolitical uncertainty. As Frank Knight observed back in 1921 in Risk, Uncertainty and Profitrisk is can be measured and forecast, uncertainty, cannot: –

Uncertainty must be taken in a sense radically distinct from the familiar notion of Risk, from which it has never been properly separated…. The essential fact is that ‘risk’ means in some cases a quantity susceptible of measurement, while at other times it is something distinctly not of this character; and there are far-reaching and crucial differences in the bearings of the phenomena depending on which of the two is really present and operating…. It will appear that a measurable uncertainty, or ‘risk’ proper, as we shall use the term, is so far different from an unmeasurable one that it is not in effect an uncertainty at all.

I have kept this in mind throughout my investing career and it is for this reason that I have avoided investing in the UK stock market since the Brexit referendum. The uncertainty surrounding Brexit has not disappeared, but I now have sufficient confidence in the decisiveness of the incumbent administration to believe that progress can at last be made. To judge by the immediate reaction of financial markets in the wake of the UK election result, I am not alone in my optimism.

To begin, here is a chart of G7 GDP since Q2 2016: –

GDP comparison since 2016

Source: OECD

The UK has fared better than Japan and Italy but its momentum has diminished relative to the remainder of G7.

A more nuanced view of the relative underperformance of the UK is revealed by comparison with Eurozone growth. The chart below, which starts in 2014, shows the switch from UK outperformance to underperformance which began even before the Brexit referendum in mid-2016: –


Source: Eurostat, Full Fact

Whilst there are many factors which have contributed to this change in the UK growth rate, the principal factor has been uncertainty relating to Brexit.

Of course, the direct impact of the Brexit referendum was felt by Sterling. The chart below shows the (Trade-weighted) Sterling Effective Exchange Rate since 2016: –

Sterling Effective Exchange Rate since 2016

Source: Bank of England

The rise since August 2019 appears to predict the outcome of the election, but the currency still has far to rise if it is to return to pre-financial crisis levels, as this 20 year chart reveals: –

Sterling Effective Exchange Rate since 2000

Source: Bank of England

The strong upward momentum which began in 2012 was swiftly terminated by the political morass which culminated in the UK referendum. The unexpected outcome of the 2016 Brexit vote only served to exacerbate the malaise.

The weakness of Sterling merely accelerated the deterioration in the UK terms of trade. The UK has run a continuous trade deficit since 1998 but, as the chart below reveals, the deficit has become structural: –

UK Trade Balance

Source: ONS

Any significant imbalance in trade makes an economy sensitive to changes in the value of its currency. The fall in Sterling since 2016 has had a knock on effect on the rate of UK inflation: –

united-kingdom-inflation-cpi since 2016

Source: ONS, Trading Economics

Viewed from a 10 year perspective, the reversal is even more pronounced. UK interest rates would probably have been substantially lower during the last four years had it not been for the uncertainty surrounding Brexit: –

united-kingdom-inflation-cpi since 2010

Source: ONS, Trading Economics

Is optimism now justified?

Aside from the trade balance, the charts above are a reflection of the discount financial markets have imposed on the UK. This month’s election justifies a rerating. Whilst the markets have not been overly enamoured with the latest Tory Brexit deal they have been craving certainty. A working majority of 80 allows room for any Conservative dissenters to be quashed. Then there is the ‘Corbyn Factor.’ Promises of widespread nationalisation, without clarity about the price with which private investors would be compensated, did not sit well. Neither did the proposed tax increases required to fuel the £80bln increase in fiscal spending. That threat has now passed.

Finally there was clarification of the nation’s opinion on Brexit itself. Labour lost ground almost everywhere; to Tories and the Brexit party in England and Wales, whilst in Scotland they ceded ground to the SNP.

This summation of the UK situation is an over-simplification, but from a financial market perspective the UK political landscape has improved. Suffice to say, there remain many challenges ahead, not least the Brexit transition period (end 2020) during which a free-trade agreement (FTA) needs to be agreed to avert unnecessary trade disruption. After four years, one might hope there has been behind the scenes preparation and that much of the deal will be a slight amendment to current access arrangements. In reality to complete a deal by year-end 2020 it will have to be an ‘FTA-lite’ affair, which may prove less than satisfactory. A swift trade deal should, nonetheless, reduce uncertainty which is also in the interests of the EU. I remain sceptical, there may be many a slip twixt cup and lip.

Conclusions and Investment Opportunities

Four years of deferred investment and consumption will now gradually be unleashed. This should bolster Sterling. As the Pound rises inflation should fall. Assuming they do not give up on their inflation target, currency strength should prompt the Bank of England to ease monetary conditions. Gilt yields will decline, forcing investors to seek longer duration bonds or higher credit risk to compensate for the shortfall in returns. Companies will find it easier to issue debt in order to fuel capital expenditure: although I expect it may lead to more share buybacks too. UK equity markets will rise, driven by an improved outlook for inflation, a lowering of interest rates and expectations of stronger economic growth.

For equity investors, this rising tide will float most ships, but not all companies will benefit equally. Those firms which were at risk of nationalisation have been immediate beneficiaries. The chart below tracks their relative underperformance: –

UK Nationalisation Tragets v FTSE 350

Source: Bloomberg, The Economist

A longer term investment opportunity should be found in the FTSE 250. The four year picture is found below (FTSE 100 in blue, FTSE 250 in red): –

FTSE 100 vs 250 - 4yr

Source: AJ Bell

It might appear as if the FTSE 250 has already caught up with the FTSE 100, but this next chart reveals a rather different picture: –

FTSE 100 vs 250 10yr

Source: AJ Bell

The FTSE 250 is much more closely entwined with the fortunes of the domestic UK economy. For the past four years many business plans in the UK have been on hold, awaiting clarity on Brexit. Now that a deal will be done and an FTA with the EU will follow, we may have finally reached the beginning of the end of uncertainty.