12 June 2020
Economic & Financial Impact of COVID-19
This calendar year I have communicated with you much more than in previous years because of the extraordinary times we are living in. I will recap on some important points I have previously made because as you know the news cycle can be counted in hours which creates noise rather than helps investors.
If you look back at 2019, the global economy and in particular the US economic growth was primarily driven by debt because of the Trump tax cuts. Real US GDP growth was about 0.25% because most of the income was going to paying interest on the national debt. US unemployment was at record lows and the stock market was booming although much of this was driven by share buy backs as result of the corporate tax cuts. Global interest rates were low and in the Eurozone and Japan there was negative yielding interest rates. Also, you may recall during 2019, the US 10 year Treasury yield curve on a number of times inverted (long term interest rates are lower than short term interest rates) which is a historical signal of a recession is coming. Normally, long term interest rates are higher than short term rates because investors must be compensated for tying their money up for longer periods of time. Next time you are looking at a Term Deposit Rate you will see that the 1 month rate is less than the 6 month rate.
COVID-19 – Government Induced Recession
Even though Governments around the globe triggered the recession, as 2019 revisited shows the global economies were not travelling so well as it was a debt fuelled economic boom, so COVID-19 was the “straw that broke the camel’s back”.
Equity markets have re-bounded quickly led by the US from the March crash despite the massive unemployment which is being partially offset by fiscal policy, e.g. Job Keeper and Job Seeker. Governments are trying to bridge the gap between the natural capital investment by business and consumer consumption demand for goods and services. At the same time Central Banks, e.g. RBA and importantly the US Federal Reserve has been actively using monetary policy, e.g. printing money to support the markets. The steps they have taken have been unprecedented and have contributed to the bullish equity markets.
It is likely that aggregate demand for discretionary spending, e.g. overseas holidays will take some time to come back and once Job Keeper and Job Seeker stop, as they are masking the real impacts of the downturn. Of course, there are some folks that have kept their jobs, so they have not been impacted by COVID-19. In fact, they are better off as they are saving money because they are not paying bus, rail fares and are not driving as much so are using less petrol and incurring fewer tolls. They are not buying lunches or eating out as much or going out as they are working from home. So overall they are financially better off. Even some folks on Job Keeper are better off as they are earning more than when they work.
The flip side is there are some folks whose jobs are gone forever and they will need to re-skill and have become part of the long term unemployed.
Wall Street and Main Street
It is often said that Wall Street (or the stock market) bears no relationship to what happens in the real world (Main Street), and now is a time when this saying appears to be so true. This is in part because equity markets trade on future earnings 6-18 months away, i.e. what they see the world economy will look like and the earnings of companies then. Whereas, Main Street is about today and the pain and suffering folks are currently living through. Of course, Wall Street can get it wrong, because if the pain and suffering continues for a lot longer than expected then equity markets will adjust downwards.
Macro and Geo-Political Considerations
The US trade dispute with China is the most important Geo-political matter occurring at the moment. It impacts all economies, including Australia and to suggest that a country with a population of 1.4billion can be contained is ridiculous. Brexit is a side show.
US Debt - Sovereign Risk
The US is facing a sovereign debt crisis as their debt situation has deteriorated. National liabilities are about $23trillion (not billions) with assets of $5trillion. There is $100trillion in off balance sheet liabilities (promises) and then each state is either bankrupt or close to it and will be bailed out in the next package to pass Congress. There is also the unfunded pension liabilities for firefighters, etc. in the many billions of dollars. Not included in the above debt figures is personal debt which is also very high. Personal debt levels are also high, crossing over credit cards, mortgages and student debt.
All of these debts (excluding personal) are serviced by the national income (budget), but this is in a deficit of $1.4trillion and increasing. National income is adding to the National debt, not reducing it which is what it should be doing. America is broke and can’t service its debt. The US Federal Reserve cannot increase interest rates as it will make the servicing of the debt situation worse and it could cause the stock market to crash. Therefore, the debt will be serviced by printing money until the rest of the world says no more and we are starting to see this with the USD depreciating.
World Reserve Currency
There is no natural successor to the USD as the world’s reserve currency, as 60-70% of world trade and capital movement are in USD, despite the Chinese making no secret of their desires for the Renminbi to take up the mantle. Equally, calls to go back to the Gold standard do not represent progress and a more likely longer term outcome is there will be 2-3 reserve currencies or a weighted index. It is only 50 years since the Bretton Woods Agreement ended when the US Government defaulted bringing the Gold Standard to an end. It is likely with the rise of China and the coming of India this approaching a new world order will bring a new form of monetary system.
Rise in AUD
We have seen a rise in the AUD against the USD because of all this money printing by the US Fed more so than demand for commodity prices. This trend is likely to continue. In time this will make international equities cheaper.
Trends - Digitalisation, Unemployment and Coastal/Country Properties
As to the immediate future there are risks of a second wave of COVID-19 forcing a second lock down in some countries while others may choose to ignore the risks and continue to open up. Because of these different approaches international travel will be limited and companies will use the opportunity to restructure with middle management likely to lose their jobs and corporations will embrace digitisation. The demand for office space will reduce as working from home will become the norm and more folks will move to country/coastal areas as telecommuting works. Interest rates will remain low for the foreseeable future so mortgagees should look for better deals (speak to us) and for investors there are yield opportunities that we are pursuing.
In the longer term asset diversification including exposure to China/India as well as the US is important as the new world order unfolds.
If you wish to discuss the above or your circumstances, please feel free to contact us.