Apart from COVID
My title alludes to the notorious question to Mrs Abrham Lincoln as to whether she had enjoyed the play at which she was suddenly widowed. Nevertheless, let me assure you that the general tenor of my comments is not of pessimism, rather of caution in the light of exceptional circumstances.
There are still very large numbers of COVID cases being reported from around the world but on (a rather fine) balance it does look like the worst is over for many of us. So, it is time to think about life apart from the pandemic. I personally am still finding this quite difficult but it is worth noting that it took US equity investors all of 6 weeks last year between mid-February and early April to decide that both business and the wider economy were fit and well, even if hundreds of thousands of people were falling ill and worse. True enough, some investors had a bit of a wobble in September/October but even for them it was game over by November with the news of successful vaccination trials, prompting a resurgence in FOMO, which is a somewhat different type of affliction..
I am not a futurologist or anthropologist or even an ethnographer and am unqualified to make profound predictions about the progress of humankind. However, I am humane enough to believe that something that has inflicted so much misery will surely impact the behaviour of not only those who have suffered most but also that of everyone who works, shops and votes. Perhaps, those likely to be most affected are those who are not yet quite old enough to work, shop and vote. Accordingly, I have adopted a practical approach to forecasting that starts with seeing COVID as a catalyst in developments that were underway before it struck.
Figure 1 US jobs: still a long way from recovery
Source: @isabelnet.com/@calculatedrisk
Growth: hold on to your hat
It is over one year since the lockdowns began and economic data has become positively exciting! The most spectacular so far has been April US Retail Sales, up over 51% year-on-year, but the corresponding UK number was scarcely dull at plus 42.4%. Other heady catch-ups have been in Industrial Production just about everywhere and in Q1 GDP in both the US and China. Also highly encouraging, albeit as very short-term indicators, are Purchasing Manager Surveys (PMIs) at record or multi-year high levels in US, UK, Germany, Netherlands and Italy. The good news is likely to continue in the coming months, notably in Q2 and Q3 GDP in the Euro Area and the UK. However, the picture is less clear on Employment and there some suggestion of a shake-out in those countries that incentivised employers (e.g. the UK’s furlong scheme) to retain workers while in the US, where payments were made to employees laid off, the job market still appears to be restarting rather than yet fully recovered, with millions not yet back at work.
As we cheer the current glad economic tidings, we ought to remember that most economies, including the US and China, were slowing in both 2018 and 2019, with the Euro Area and the UK struggling to manage much more than 1%. The main explanations offered by economists have been a melange of President Trump’s trade fights, Brexit uncertainties and various regional and domestic quarrels around the globe. It seems likely, however, that other longer-term factors were at work before the pandemic struck and which have been lost sight off during it. At least some of these long- term factors can be expected to re-manifest themselves once the global recovery has peaked.
Figure 2 World Output annualised growth rate: Q1 2018- Q4 2022
Source: OECD
Figure 2 is of World Output (i.e. the total of national GDPs). It shows flat-lining in 2018 at around 3.5% followed by a slide during 2019 to less than 1% by Q4. The dramatic slump in Q1 of last year and the eye-watering recovery in Q2 and Q3 speak for themselves. I chose the OECD data because of its quarterly breakdown but the numbers, including forecasts, are consistent with those of the IMF and World Bank. These august organisations are expecting growth to stay above 4% throughout 2022 and dip thereafter to around 3.5% (i.e. the run rate at the start of 2018). Should these forecasts turn out correct, the confidence of US equity investors since April last year would indeed be justified.
More consumers wanted
Consumption is the obvious place to start if the global economy is to build new momentum. We know that it is already on the mend, with people eager to spend at least some of the savings that they accumulated involuntarily during lockdown. However, pre-pandemic Consumption already accounted for around 70% of GDP in the US and 50- 60% in other advanced economies and there had been some signs that demand for consumer services was plateauing. Just as there are limits as to how many cars we can park in our drives and stuff we can pack into our houses, no matter how hard we try, we can only go to so many gyms, theatres, cinemas, restaurants and coffee bars. The housing sector could well provide a boost in the next few years, not just directly for the builders, estate agents, mortgage brokers and lenders but indirectly through the wealth effect. However, US house prices rising at the fastest rate for 8 years raises the spectre of excessive personal borrowing that was such a major factor in the Great Financial Crisis in the US, while many younger people may just give up trying to get on the housing ladder.
Among the major developing economies in which Consumption still accounts for 50% or less of GDP, China has been leading the way but even it is running into a number of inhibitors, not least demographics. What would really help the global economy would be an influx of new consumers on a similar scale to those from China and Eastern Europe in the 1990’s. India, ASEAN countries, Brazil and Mexico have also come a long way since then but it is not proving easy for them to break through the ‘middle income trap’ at the same time as export demand from advanced economies is stalling. Coming along behind them are countries, notably in Africa, with plenty of potential consumers but with political and institutional obstacles’ restricting economic progress. An ‘obvious’ way of adding new consumers would be to facilitate migration from Latin America into the US, from Africa into Europe, and from the Indian subcontinent into the UK, Canada and Australia but, of course, even this would not only be politically contentious but would take time to deliver.
In conclusion, while Consumption will surely carry on as the principal component of the global economy it is far from certain that its rate of growth will kick on once it recovers fully from the pandemic. While there is no shortage of potential new consumers or of those who would like to raise their game, too many are in the wrong place (continent?) and/or the wrong jobs (gig workers?). Moreover, a huge set-back is in train according to the UN, which estimates that the pandemic has pushed more than 100 million more workers into poverty and not only in the poorest countries.
Figure 3 Corporate debt/GDP in the US before and after recessions 1985-2020
Source: Federal Reserve Bank of St Louis
Business Investment and debt: less of the same
While Business Investment (new plant and equipment, IT, AI and other R & D) is still widely regarded as both good and important, the experience of China (and earlier the former Soviet Union) has shown that too much of it can be unproductive, even if in the short-term it adds to GDP and creates jobs. For many years it has become standard for it to be funded substantially with debt, rising when higher growth coincided with lower interest rates and falling when slowdowns/recessions coincided with interest rate hikes. This may seem obvious but it was, and still is, actually quite tricky to work out what was prompted by what. Led by Fed perma-Chair Alan Greenspan, central bankers came to believe that they could regulate economic cycles. During the Great Financial Crisis Mr Greenspan’s successor Ben Bernanke displayed even more confidence in the role (largesse) of central banks and, sure enough, corporate debt rose faster than ever (Figure 3.) Also shown, is the subsequent fall in corporate debt in 2020-21 as the measures to combat COVID resulted in an unprecedentedly sharp recession. As in the aftermath of previous recessions (1990-91, 2001 and 2007-9), companies can now be generally expected to start borrowing again to fund new investment. However, an important difference with earlier cycles is that much of the increased debt since 2012 had not been applied to Business Investment but instead to debt service by weaker companies (including ‘Zombies’) and to share buy-backs and dividends by stronger companies. Moreover, relief in the form of official interest rate cuts will not be forthcoming as rates have been at historic lows for much of the last 12 years and in the US are already effectively at zero. Worse still, bond rates have moved sharply higher as investors have greeted impressive vaccination roll-out programmes and expectations are running high that official rates will have to do so too in response to surging inflation. Higher borrowing costs may well limit share buy-backs and dividends but they will also inhibit new business investment and inevitably will trigger the collapse of those Zombies that have been falling behind in servicing their debt.
Accordingly, although the Business Investment component of GDP can be expected to rally in the short-term as companies respond to a post-pandemic surge in demand, sustained growth will depend largely on consumer demand. Meanwhile, there are plenty companies that do not involve substantial fixed investment but still will contribute to the global company through hiring staff and buying services from other businesses. There may not be a spurt of new FANGs but small companies, including the rapidly expanding social enterprise sector, will surely carry on creating new jobs.
Figure 4 Dallas Fed Trimmed Mean PCE Inflation Rate: what the Fed focuses on now
Inflation and Monetary Policy: enough already?
Amid the crescendo of pontification on Business TV , the financial press and social media it is quite easy to forget that inflation before the pandemic was very subdued in advanced economies (the Euro Area even experienced 5 months of deflation in 2020). Also in train were the Fed’s preparations for a long and slow tightening of monetary policy.
The current outburst of cost-push inflation is due principally to severe supply chain disruptions during the pandemic in combination with the more recent renewal of the Russo-OPEC production pact. Also in play are trade and tariff fights and sudden food supply problems, which has meant that inflation never really fell by much in many developing economies (notably, India, Brazil, Mexico and South Africa). In fact, some economist prefer to use the term ‘price level adjustment’ that can always expected to arise when an economy reopens after widespread severe supply constraints. In fact, demand, specifically from consumers, feeding through to collective action for higher wages would be the necessary factor for inflation to take off as in the 1970s and 1980s. However, wages have since become less correlated to inflation and it would require a massive revival of militant union membership to really fire up cost-push inflation. Too many of us, however, have mortgages and worry about losing our jobs. Similarly, Russia and the OPEC countries are financially stretched and will always struggle to hold together on production quotas.
Nevertheless, there will be scary inflation numbers published in the coming months until the plunge in the first half of 2020 works its way through and some of the current price hikes by hard-pressed suppliers in response to the release of pent-up demand for domestic holiday accommodation, restaurants, dentists and hairdressers are unlikely to be fully reversed, if at all. This raises the rather dry but also controversial issue of which indices best reflect the rate of inflation. Suffice to say, there are several and their composition varies both between countries and over time (the EU has overhauled its CPI weightings this year). It is also general practice to supplement the headline index with a ‘core’ index that excludes food and energy prices on the grounds that they are both volatile and beyond the control of individual countries. In the US the Fed, instead of the CPI, prefers to use the Personal Consumption Expenditures Price Index (PCE) and has increasingly focussed on the PCE Core Index. More recently, however, the Federal Reserve Bank Dallas has been pioneering the ‘Trimmed-Mean PCE Inflation Rate Index’ (Figure 4), which does include food and energy prices and takes account of labour market conditions but ‘ filters out headline inflation’s transitory variation, leaving only cyclical and trend components’. It now seems clear that the national policy-making FOMC is attaching increasing importance to the Dallas index, which has perked up in recent months but only as far as 1.8% vs. the Core PCE of 3.2% and the headline US CPI of 4.2% in April.
Figure 5 Bank of Canada leads the way with a ‘new mandate’
The Fed’s insistence that US inflation is ‘transitory’ is troubling some in Wall Street, who in a masochistic way feel that the official interest rates ought to be hiked, even though that would hit both bond and equity prices. All the public discussion adds to the tension, especially for those who have never worked at a time of rising inflation, as to why the Fed appears to place so much weight on its employment mandate and the plight of the low-paid and unskilled workers vs. the inflation mandate. Even worse, is the growing conviction that the Fed has accepted a ‘third mandate’ of ensuring the Federal Government can fund its burgeoning deficit. This seems very probable despite (because of) official denials but is unlikely ever to be formally adopted. The Bank of England has got close to a similar approach in providing a temporary ‘overdraft’ to HMT. More dramatic are new figures from Canada that show that its central bank has been funding the federal deficit almost on its own (Figure 5). Nevertheless, the BoC has been the first to announce its intention of cutting back on its asset purchase programme......but not until next year. It is hard not to believe that the major central banks, who confer all the time, have concluded that monetary policy is no longer the essential stimulus that it was and really do want governments to do more on the fiscal front. Further evidence for this came last weekend with Janet Yellen’s allegedly ‘off the cuff’ musing that higher interest rates might be a good thing. Dr Yellen thought the opposite when she was Fed Chair but now, as Treasury Secretary, she needs investors to step up and buy a lot more US Treasuries!
Figure 6 The US does ‘big and bigger’
Government Spending: beyond stimulus
Figure 6 shows all the major US spending programmes all the way back to President Roosevelt’s New Deal. The $2.2tn Cares Act was passed in March 2020 and the $1.9tn American Rescue Plan in March this year. Both had the goal of keeping the US economy ticking over and included sending weekly checks to laid off workers: in other words, classic Keynesian fiscal stabilisers. Not shown in Figure 5 are two more jumbo proposals: the $2tn American Jobs Plan (infrastructure, climate change and housing) and the $1.8tn American Families Plan (education and health). Secretary Yellen describes the Jobs and Families Plan as multi-year investments rather than stimulus at the rate of about $400bn per annum. They are unlikely to be approved in full by Congress but will still represent the best chance of stimulating both the US and global economies. This at last is where sustained long-term growth could be generated with a knock-on effect on both Consumption and Business Investment. It will depend, however, on the Democrats’ keeping control of Congress beyond 2022..
Figure 7 Not in front of the children! Net wealth of wealthiest households
President Biden and Secretary Yellen are two septuagenarians in a hurry and their Plans represent a defiant break with the ‘Reaganite’ orthodoxy that has allowed US infrastructure to decay and inhibited the development of a welfare state on a par with other advanced economies. Having lagged many other countries for many years before the pandemic, not just during the Trump presidency, the US appears to be facing up at last to the two principal global challenges: inequality, which the pandemic has exacerbated, and climate change, from which the pandemic has been a deadly distraction. Sooner rather than later other countries will have to try harder to keep up, whether out of shame or conviction, or face rejection by the new generation of voters.
Figure 7 is both shocking and informative. Perhaps the most relevant aspect is the impact of a combination of the push-back against trade union over-reach in the 1970s, the vast increase in the global workforce from China and Eastern Europe in the 1990s, the rise of Tech since 2000 and monetary easing pushing asset prices ever higher since 2009. Tackling the resulting inequality is not just about prudence to avoid an uprising by the peasants armed with their metaphorical pitchforks or about morality to appease the tender-hearted, it makes sense economically. Climate change is about economics too: half-hearted efforts will cost more in the end than spending serious money on it now. As it happens. The two challenges already have in common a blurring between the public and private sectors and will contribute to economic output in many ways. Happily and almost certainly not coincidentally, occurring already is the formation of new businesses and the creation of new jobs that most appeal to Millennials and Generation Z.
Apart from the pandemic, it is possible to think the world will become a better place but not necessarily one where we shall be better off and where Wall Street can make easy money.
Figure 8 Wall Street no longer easy street?
Disclaimer: This report is compiled from sources the author believes to have been reliable but it may not be complete or accurate on any particular subject. All opinions, estimates, and analyses are or were those of the author at the date of issue and are subject to change without notice. Accordingly, the author makes no representation or warranty on any subject discussed in the report; nor does he accept responsibility or liability for any claim, loss, damage, expense or cost arising from reliance upon its contents.