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The inescapable truths investors face now

Covid-19 reality: What the combination of higher savings rates and lower capital investment means for global growth.
Investors will need to be more agile than ever, particularly in the face of increasing government intervention. Image: David Weaver

A little over a year ago global asset manager Schroders highlighted several ‘Inescapable Truths’; the economic and disruptive forces it thought would shape the investment landscape in the decade ahead, to help guide investors through a time of ‘unprecedented disruption’.

Before Covid-19, we argued that demographics and trends in productivity pointed to an outlook for the world economy of subdued growth and low inflation, against a backdrop of disruption from populist politics, technology and climate change.

Such a prospect meant that real interest rates should remain low, and investors would have to navigate an environment of considerable change, where stock market index returns alone were unlikely to excite.

The effect of pandemics on economies

Studies of the economic effects of pandemics point to significant long run effects.

Growth and returns on assets are depressed for a considerable period of time, up to 40 years after the pandemic has passed.

Those studies cover outbreaks stretching back to the Black Death of the 14th Century up to the H1N1 (swine flu) pandemic of 2009.

Source: Schroders

Covid-19 is most frequently compared with the Spanish flu of 1918-19, an outbreak that claimed 40 million lives, or 2% of the world population, implying 150 million deaths when applied to today’s population.

Fortunately, better health systems and government action to suppress the virus mean the current outbreak shouldn’t be anywhere near as fatal. Nonetheless, although governments may ultimately succeed in curtailing the health impact, the economic effects and debt costs are significant.

Pandemics and people

Pandemics leave deep scars in terms of their impact on those who survive and how they behave in the future. In economic terms they alter the balance of saving and investment in the economy.

After the initial shock has faded and the illness has been contained, the natural response of households and business is to be more cautious. Countries that have already lifted lockdowns in the current pandemic are finding that consumer spending is slow to recover and history suggests this is likely to persist.

Previous experience finds that the shock of a pandemic means that savings rise as households build up their precautionary balances.

Having survived the outbreak, people are more aware of the vulnerability of their employment and income to ill health, causing them to save more for bad times. This means weaker consumer spending growth, the mainstay of economic demand and activity.

Pandemics and companies

On the corporate side, studies show that business investment is also weaker. In most cases this reflects in the fall in labour supply as a consequence of the illness, which increases wages in the economy. The drop in profitability then weakens capital investment. Today, the impact on the working population should be significantly less due to preventative measures and the fact that it’s the elderly who are primarily affected.

We therefore would not expect to see rising wages as a consequence of Covid-19.

Nonetheless, for many firms the near-death experience of the lockdown where cash flows have simply dried up, will have a long-run effect on their willingness to take risks and invest. As with households, the lockdown and fall in activity has brought a greater awareness of the risks to business. While fiscal and monetary policy is working to offset the adverse effects, these scars from the crisis will weigh on future risk-taking and the willingness to invest.

Here we look at four themes from our original ‘truths’ that the coronavirus crisis is likely to reinforce or accelerate.

Truth #1: Low interest rates

The combination of higher savings rates and lower capital investment would point to slower growth and a lower equilibrium interest rate; that is, the interest rate when unemployment is at its natural rate and inflation is stable.

Weaker investment will also hamper a recovery in productivity and reinforce the outcome of slower GDP growth. Consequently, the Covid-19 outbreak strengthens our conclusion from the ‘inescapable truths’ that interest rates will remain low in real terms for a considerable period.

The long-anticipated normalisation of rates, which was briefly achieved in the US in late 2018, has been pushed out even further.

Truth #2: Rising healthcare spending

In our original Inescapable Truths paper, we pointed to increasing healthcare spending within the context of ageing populations. This theme has been super-charged by Covid-19.

It will form part of a broader trend whereby governments are likely to play a more permanent role in supporting aggregate demand in the economy through fiscal policy. Government spending will be higher to offset slower private demand. In particular, we would expect spending on health to rise as governments build more resilience into their health systems.

Just as the banking sector had to increase buffers against risk after the global financial crisis more than a decade ago, the health sector will be expected to do the same after the pandemic.

Health spending as a share of GDP has already been rising significantly, largely as a consequence of demographic pressures. In the US spending on health has risen from 13% to 17% of GDP since 2000, the highest level in the OECD (Organisation for Economic Co-operation and Development). In Europe, where it accounts for 11% of GDP, there have also been significant gains over the last 20 years (see Chart 1). The private sector will play a role, but public spending will bear the burden in the OECD. In 2018, the average OECD country spent $4 000 per head on health of which three quarters was public spending.

Chart 1: Healthcare spending as % of GDP – an inexorable rise

Source: Schroders

Healthcare spending already accounts for nearly a fifth of OECD public expenditure.

This will present a challenge to finance ministries at a time when the International Monetary Fund (IMF) forecasts that total government debt will rise to 150% of GDP for the G20 by the end of 2021 (see Chart 2 below), largely as a result of Covid-19.

Governments will face the unpalatable choice of raising taxes or cutting public spending to contain budget deficits.

Chart 2: Government debt as % GDP

Source: Schroders

In our view, it is increasingly likely that governments will rely on financial repression (keeping interest rates well below nominal GDP growth) to erode their debt-to-income ratios. Such a policy would be implemented through a combination of central bank purchases of government bonds (quantitative easing), direct yield curve control (as seen in Japan) and regulation that forces investors to hold government bonds.

Truth #3: Rising populism

Financial repression as a means to reduce debt ratios has been used before, particularly after World War II and since the global financial crisis. However, it takes time and may be undermined in a world of free capital movement.

Consequently, many see the current economic orthodoxy being challenged by a swing toward populism and believe that debt will be reduced not through financial repression, but inflation.

Populism, one of the disruptive forces we highlighted in the Inescapable Truths, in this context would mean governments undermining the independence of central banks, moving away from inflation targets and ultimately adopting policies such as Modern Monetary Theory, or printing money and directly spending it in the economy.

The outcome would then be higher inflation and possibly hyperinflation if pushed far enough.

Debt to GDP ratios would fall, but as those who remember the 1970s may recall, such policies do not make governments popular.

Indeed, given the demographic shift toward an older population, high inflation would be even more of an electoral liability for any government, as it would hit a key part of the electorate hardest by eroding the real value of their savings and pensions.

Truth #4: Accelerated technological change

Nonetheless, the more difficult environment we expect for the post-Covid-19 economy is likely to provide ripe conditions for populism.

Real wage growth will remain weak and income inequality could increase further. The latter is likely to be driven by the acceleration in technology after the crisis.

Two forces are at work here.

First, there is the ‘crisis as the mother of invention’ effect, where being forced to stay at home has provided a boost to online retailers, video conferencing and all aspects of remote working.

Covid-19 has accelerated the demise of the high street retailer in this respect and offices may be next. The lockdown has forced companies to innovate and make remote working viable.

It is not surprising that tech firms (as represented by the Nadsaq in Chart 3 below) have led the recent rally in US equity markets.

Chart 3: Covid-19 puts tech ahead

Source: Schroders

Past performance is not a guide to future performance and may not be repeated

Second, there is a longer-term effect as the experience of Covid-19 forces companies to rethink their supply chains. Difficulties in travel and the need to make supply chains more resilient is likely to lead to greater diversity in suppliers. In some cases, there may well be a preference to move more production closer to home. To the extent that wage differentials between developed and emerging markets remain significant, this would mean more automation rather than a rise in demand for local labour. Artificial intelligence (AI) and robotics are likely to be the winners, accelerating the fourth industrial revolution.

Greater domestic – rather than international – production is a further blow to globalisation, which has already been hit by the trade wars between the US and China. It will, however, take some time for this to play out. In the near-term the greater threat is a deterioration in relations between the two super powers, who are currently engaged in a blame game over the origin and spread of the virus.

In the longer term, accelerated technological change will probably raise productivity as it will reduce many of the inputs associated with business such as travel costs and the maintenance of office space. More immediately though, it means job losses for those sectors of the economy that facilitate business such as travel companies, airlines and office management firms.

AI and robotics are likely to hit employment in the emerging markets if driven by a desire to reduce supply chains.

While the economy may eventually be able to move to a new level of higher productivity, the immediate effect is to displace workers who will then need to reskill or relocate to gain work in the new economy.

This will only add to the sense of dissatisfaction felt toward the economy and cause people to seek populist solutions.

The winner-takes-all feature of technology means that widening inequality trends will persist during this phase, again heightening the search for populist solutions. Governments will find themselves in an increasingly difficult bind; as we have seen, they are unlikely to have the spare fiscal leeway to head off some of this pressure through increased expenditure.

The world economy is still in the midst of the “full stop” described by Daniel Defoe some 300 years ago. However, investors are looking beyond the immediate downturn to anticipate the shape of the post-Covid economy.

In our view the virus is likely to reinforce the trends that were driving activity before the outbreak struck, by challenging the growth path, creating greater pressure on government finances and increasing inequality as technology becomes ever more pervasive.

Government intervention and the threat of populism will grow and investors will need to be more agile than ever to achieve their objectives in the face of these Inescapable Truths.

Keith Wade is chief economist and strategist at Schroders.

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The virus itself poses no threat to the world economy. It is man’s reaction to the virus that threatens to destroy the economic system. The errors and incompetence of Central Planning authorities pose a real threat to society. During the Spanish Flue epidemic, no Central Planning authority had the powers to order a shutdown of the economy. The system was anti-fragile back then because the system allowed individuals to accept the responsibility for their health. The system has progressed to a point where it is extremely fragile and unstable because the important trial-and-error mechanism of free-market capitalism and individualism has been replaced by the Central Planning authoritarianism of the WHO and all national governments except for Sweden and South Korea.

South Africa has 12 000 cases of diabetes per 100 000 of the population while the USA has 11 000 cases per 100 000 citizens. Compare the diabetes cases to the COVID deaths which stand at 5 people per 100 000 for the world on average at this stage. Diabetes is a pandemic while COVID is a flash in the pan. The COVID virus is no more dangerous than the Asian Flue, Hong Kong Flue and normal flue. People with serious pre-existing conditions are at risk. This implies that they were already waiting for any reason to get seriously ill, and if COVID did not kill them, the flue, TB, AIDS, bronchitis or hepatitis would.

The point is that lockdown serves no purpose at all for normal people of average body mass index. Obese individuals who are pre-diabetic or diabetic are at risk. Therefore, the risk is obesity and not COVID. If the WHO decided to declare a war on sugar and refined starch, now that would make total sense. To declare war on the economy because some extremely unhealthy people may die at some stage is simply irresponsible and destructive.
We need to make the system anti-fragile again. We need the trial and error mechanism to make the system robust and to protect society against the disastrous consequences of authoritarian Central Planning.

https://ourworldindata.org/grapher/total-daily-covid-deaths-per-million
https://www.indexmundi.com/facts/indicators/SH.STA.DIAB.ZS/rankings

Well said,should send this comment to cyril

i still get the feeling that banktrupting most of the world is a deliberate act,but by whom i dont know.Like the above article states: not everyone who contracts it will die,so why lock up the world and sink the economy?

Black Tin, it makes as much sense as the Xhosa cattle-killings that was motivated by prophetess Nongqawuse in 1856 to fight the invasion of the European settlers.

I am convinced that the level of sophistication of the decision-making process was similar in both cases. The prophetess and the “scientists” punched unreliable data into unproven models that were based on preconceived ideas to come to biased conclusions, based on hocus-pocus, that will lead directly to the deaths of large parts of the population. In both cases, the damage was not caused by the predictions and guesswork of the prophets per se, but rather by the naive and ignorant followers of the prophecies. We had millions of ignorant individuals worldwide who excitedly jumped on the “Contagion” bandwagon. They watched a movie once, and now they believe that they are health professionals and economists who can shut all economic activity. The threat is not a virus. Like with the starvation of 80% of the Xhosa population in 1857, the real killer was the ignorance of economic matters.

It is true. The average voter’s ignorance of economic matters can be very bad for your health.

Exactly. The government should have restricted/banned sugar, chocolates and sweets if they want to argue about cigarettes ( I do not smoke) and alcohol ( only some wine for me ). Obesity is the biggest killer – effects all systems in the body

The lockdown is not sustainable especially as over 90% of people who get sick will recover fine at home. Those in the high risk brackets should be protected and take extra precautions. However shutting down the world economy is not a solution. It will only lead to economic depression. Millions of unemployed people will lead to discontent and unrest. How many more people will die of starvation, caused by the lockdown, than of Covid-19?

Sensei, a well argued, -researched, factually based, sensible and rational explanation as response – as usual – and therefor valued.
Keep at it – a high level of intelligence coupled with a sound and rational evaluation- and creative solution ability brings about a higher duty of responsibility towards fellow citizens.

I appreciate your kind opinion. It serves as a strong motivation to seek the truth.

End of comments.

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