This Time is Utterly Different

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What Lies on the Other Side of the Valley?

Many financial market participants miss the forest swaying in the wind before them. Instead, they count the number of cedars, interspersed amongst the oak and the elm, and the forest eludes them.

The detail obsessed will want to know the depth of the downturn, how long it will last and how quickly the economy will recover. Will the recovery be shaped like a V a U or an L? None of us knows, but we should not assume a sudden recovery to follow a sudden stop. 

Looking to China is likely to be misleading. The apparent post lock-down rebound in Asian economic activity is not a useful guide for North America and Europe, especially since the shut down in those areas will bounce back to Asia.  The shape of the rebound will not soon be answered, but a lengthy period of rebuilding is likely with fiscal and monetary policy working in tandem to rebuild an economic base.

We need to consider strategic rather than tactical questions, and look beyond the immediate journey to what lies on the other side of the economic rift valley. It is important to ask what forest we will see on the other side of the valley before we start counting its trees and moving to harvest them.

Much of the coming economic loss is in social consumption, and lost output will be gone forever. Bankruptcies will be large in number, and colossal in dollar value. Small and medium sized businesses will disappear and never return. And the apparently more stable businesses that serve them will suffer. 

Large corporations that have both a large market share and cash reserves to carry them through will make it to the other side of the valley; battered and bruised, but still standing. This is why (former) investment grade cruise lines have been able to tap the market for cash, but must pay high yield coupons in what looks like a “market” downgrade.   

The potential damage looming on the other side of the valley is why monetary and fiscal policy makers are pulling out all the stops: this is not stimulus but damage limitation. This is why we are using money finance through the back door of QE. The line between monetary and fiscal policy is much finer than many behold, and we have surely crossed it. 

What monetary policy will be doing tomorrow will be very different from what it has been doing for the past forty years, and how we organize our production is going to change. Both forces matter for expected inflation, expected returns, and investment strategy.

All Change at the Central Bank & Losing a Helping Hand

Monetary policy’s chief job looking forward will be to facilitate the provision of fiscal resources at bargain-basement interest rates, and hoping for the best on inflation. This is a quite radical proposition and if correct has radical implications. 

Nations must make sure the provision of state financial resources is sufficient to lay a solid financial foundation on which to rebuild. Long global supply chains that both concentrated and dispersed production offshore have left us vulnerable, so we must look for the re-emergence of industrial policy and potential re-shoring of key strategic industrial capacity. 

Nations will need to add surge capacity in health care as pandemics will not go a way in a crowded world, and government presence in resource allocation and location will be intrusive. The Thatcher-Regan libertarian revolution is over, make no mistake about it.

The inability to quickly increase domestic production of key medical supplies and pharmaceuticals speaks to the constraints to separating economic space from sovereign space. The wholesale offshoring by large corporations of antibiotic production to China and India, and the offshoring of API (active pharmaceutical ingredients) to India have been truly eye-opening.

Given a large proportion of state crisis aid will go to the same corporations that felt no responsibility to the countries they left behind, suggests this model is broken in key sectors including pharmaceuticals, medical equipment and textiles, and precursor chemicals.  

The coercive power of the state will be brought to bear to secure good health and economic security as the two are inextricably linked. Corporate efficiency will likely give way to surge production capacity even if costly. 

Fundamental changes to industrial organization are on the way that will upend the financial model of the last forty years. The prolonged diversion of labour income and free cash flow to share buy-backs is likely over, and the financial engineers are on the way out, and the “NASA” engineers are on the way in. Goodbye Wharton and hello MIT.

The proliferation of supply chains lent more than a helping hand to central banks in their achievement of inflation control. The potential reshoring of high skill, high value added, production for strategic objectives has non-trivial implications that will likely complicate future inflation control. 

So, there are two major policy changes to welcome us on the other side of the valley. Central banks will now target interest rates, and inflation may well be left to fend for itself. Second, the reshoring and reorganization of supply chains will weaken a major force constraining inflation.

A look back at what happens when monetary policy shifts from inflation targeting to interest rate targeting is illuminating.

The Federal Reserve During World War II

National emergencies of this scale demand big resources be transferred to where they are needed quickly. Immediate needs take precedence, but we will also need to clean up the mess afterwards. Reconstruction demands more investment, and this will come at the cost of lower personal consumption, changing the underlying economic structure. 

Many nations faced the same challenge at the start of WWII, and also looked beyond the conflict to resolution. To transfer resources from domestic consumption to armaments, the Federal Reserve was pressed into service to help finance the war and keep interest rates down. 

The US moved to full employment virtually overnight, putting upward pressure on wages and income heightening Fed concern that inflation would surge.   

The Fed was tasked by the Treasury with keeping government securities prices up and yields down, pegging short rates at 3/8th of one percent on bills and a 2.5% yield on bonds. Inflation control was turned-over to wage and price controls, helped by constant war bond issuance that drained excess income from the system. 

 The Fed slowly lost control of its balance sheet, and the money stock grew by 149% between August 1939 and August 1948.  Eventually inflation came through, peaking at 18% in 1948 followed in 1949 at about 9% a far cry from the -0.7% prevailing in 1940.   

Central banks have one instrument at their disposal, the overnight rate of interest, and they can target only one variable at a time. If the central bank changes its balance sheet to target a government financing interest rate directly, that interest rate will likely be inconsistent with achieving the desired inflation rate. 

The coming price path is likely to be unusual: first we will encounter a near-term collapse in inflation given the scale of the economic hit, and then as the recovery is spread-out over years the potential money financing of recovery flows raises the potential for more inflation that is assumed. Once the central bank has been captured to control interest rates and provide emergency financing, WWII history shows it cannot quickly revert to inflation control even if it wants to.[1]

Wither globalization?

The proliferation of global supply chains in the past 30+ years delivered a large positive productivity shock to advanced economies, and a negative relative price shock. By severing the link between domestic wages and prices, globalization de-fanged organized labour, vanquished cost-push inflation, and stabilized inflation expectations by reducing inflation persistence[i]. 

Prior to globalization, a positive production shock would normally force wages and prices up. However, following globalization the price persistence coefficient related to a 2.0% production surge fell from 0.6 to 0.4[ii]. Meaning that there was a smaller inflation memory from an upward production shock. This may not seem like much, but through time it had a powerful cumulative effect. 

Lower price persistence checked inflation expectations. Current low inflation expectations are hard to break, especially given the big negative shock we are currently facing. They keep our assumptions about inflation and its control grounded. However, once expectations break higher, they can have a devastating impact on inflation control, and the expectation Genie is difficult to put back in the lamp without incurring enormous cost.

In the United States, globalization dragged down goods prices even as domestic service prices were quite buoyant. Goods prices were an average of 0.7% lower than service prices since 1992, and inflation remained very low since the early 1990s. The reason is simple: service prices are mostly determined by domestic wages; offshoring haircuts to low wage developing countries is not possible. The persistent trend in lower goods prices inflation left more income to spend on services, making social consumption an ever-larger share of the economy. 

The scatter plot shows those industries that were most open to trade, and that they contributed most to relative price declines. This is what one would expect given a large productivity shock. 

However, this may now be reversed. Moreover, many of the industries that restrained prices the most are among those most likely to be ordered home: medical supplies, pharmaceuticals, medical equipment, API chemicals. It doesn’t take a leap of imagination to see this helping hand to inflation withdrawn.  

The emergence of such sweeping policy changes means we must challenge our prevailing economic and inflation assumptions. Economic policy matters, and the previously unimaginable transformation of our economies and the state’s role in them is clear to those who are looking beyond the valley.

The potential re-emergence of intrusive states, financed by central banks, means investors need to re-examine the validity and usefulness of their investment beliefs. If we don’t have the right investment beliefs, then we are unlikely to make the right investment decisions, and nor will we have the right investment infrastructure. 

Time to Take Stock

Merging tactical and strategic decisions suggest that in the near-term equity markets have discounted that the policy support so far puts a floor under the worst economic outcome, but that rebuilding will be slow, long in duration, and accompanied by a change in underlying structure. History also suggests that, beyond the immediate downturn, inflation will be a secondary policy concern relative to reconstruction. Investors must consider that real assets will need to play a more prominent role in asset allocation, but this time positioned to protect against inflation rather than to smooth returns. 

While this time is utterly different, we have been here before – eighty years ago. Those who don’t know their history are bound to repeat it. Let us learn from the past so that we don’t repeat our failures. 

[1] It took until 1951 for the Fed to establish sufficient independence from the Treasury and revert to inflation control, marked by the Treasury Federal Reserve Accord on March 1951. 

[i] How Has Globalization Affected Inflation, Chapter 3, IMF World Economic Outlook, April 2006

[ii] IMF op cit.