The Economic Consequences of Covid-19, Part 2

Wednesday, 10th August 2022 10:30 - by Eric Chalker

Further Observations by Eric Chalker, July 25, 2022

Introduction

I belong to an investor organisation called SIGnet – Serious Investor Group network. At my group meeting on July 20, 2022, my persistent bearish stance was challenged: “To what level will the market need to fall further for me to describe it as a ‘screaming buy’?”. My answer was, “As much again as we have already experienced”.

Thinking that my position needed some justification, I wrote the article which follows. The last time I set out my thinking in detail was at the end of March 2020, just after the prime minister had locked the country down, the chancellor had opened the floodgates and the Bank of England had decided to finance the resulting debt. My title, The Economic Consequences of Covid-19, was of course a take-off of John Maynard Keynes’ book about the peace settlement following the end of WW1. As I hope everyone knows, Keynes was right. Despite writing in 1919, well before German hyperinflation in the Roaring Twenties, the stock market crash of 1929 and the rise of Hitler (all of which were related), these were among the consequences he feared, because of the reparations demanded from Germany.

In my previous article, published as a blog here on London South East, I railed against our government’s decisions of March 2020 and made a number of quite dire predictions. At the time, the paper encountered some scepticism, which was natural and to be expected: it is always difficult today to imagine things happening tomorrow which seem too extraordinary to believe. Even so, I do not think now, 28 months later, that I was wrong, even though share prices temporarily recovered from their March 2020 fall (because of QE, of course). Much that I wrote has already been seen, such as rising inflation and higher taxation. I am content to stand by what I wrote then and offer these further thoughts now, in The Economic Consequences of Covid-19, Part 2.

- The Economic Consequences of Covid-19

The swelling of debt

Global debt, a term covering borrowing by governments, businesses and households, has been growing exponentially for many years. I first became concerned by this some twenty years ago and began to imagine the eventual consequences for economic stability, ultimately affecting all forms of investment. This is why I became a bore on the subject of risks facing even ordinary investors.

According to the Institute of International Finance, global debt passed $300 trillion in 2021. The International Monetary Fund tells us what we should already know, that this is a dangerously high level. It had already reached $226 trillion before the pandemic burst upon us, but government and central bank actions since then have increased it by an astonishing 34 per cent.[1][2]

It is usual to relate such debt to GDP – ie the total value of a country’s ‘product’, or that of a region, or of the whole world. This is to measure debt to income. In 2021 global GDP was just under $100 trillion. The ratio of global debt to GDP in 2021 was more than 300%, but consider this: “Japan, with its population of 127mn, has the highest national debt in the world at 234% of its GDP.”[3] So global debt to GDP is even worse than Japan’s. The IMF can help a country which can no longer service its debt, but there is no third party to bail out the World.[4] The entire product of the whole world for three years would need to be devoted to the debt if it were to be cleared in that short time, but of course that is impossible. So how is global debt to be dealt with, when will it stop swelling and can an ultimate collapse be avoided?[5]

Debt is created by lending from those who have the money to do so, or can obtain it. Money is lent to those who think they can use it profitably, or those who are desperate to avoid bankruptcy, or even penury. Because so much debt has been created, one must wonder how many individuals, businesses, institutions and governments have the ability to sustain it. There have always been debts which go bad, but how much of this can economies endure before there are serious economic consequences?

We are currently witnessing, in Sri Lanka, what can happen when a country has essentially become totally bankrupt: it is no longer able to import fuel or food. If Sri Lanka can stabilise its government, which currently seems unlikely any time soon, it may be helped to recover, but there are not sufficient resources available to bail out all the countries that find themselves in a similar situation. It is not just developing countries that do or may need help – consider Italy, for example. In 1974 it was Britain.

Although countries (like local authorities) do not actually go bankrupt, because governments have the power of taxation, there are practical limits to taxation and much of what is raised is sometimes needed to pay off creditors. This behaviour can starve a country’s population, leading to unrest; this may not be limited to a single country, thus potentially leading to mass migration (as we see now) and even war. Meanwhile, the original creditors of a country in such a situation will have suffered losses. What happens if many countries find themselves in this situation at the same time?[6]

The matter of liquidity

This is not the place to go in detail into the world of finance, but I have read enough to know that some of the infrastructure which supports it is, shall we say, pretty dicky. This is the matter of liquidity, which has several aspects. Liquidity matters to investors, when they want to sell: this is the risk so enjoyably portrayed in the film Trading Places, which I assume we have all seen (and it’s worth seeing more than once, as a reminder of what investors do when they panic). I have long shuddered at the risk posed by ETFs, so easy to sell, whereas selling individual investments needs more thought and so can take time; this doesn’t mean that shares can’t be dumped en masse, as has happened in the past, but it seems to me incontrovertible that mass dumping of ETFs, if it were to happen, would be more destructive because of the potential scale and speed of it. But liquidity means more than what may be required to facilitate the sale of assets.

Liquidity is also necessary to purchase assets, as Walgreens the owner of Boots has found, as its potential buyers cannot raise enough cash. Suddenly, after years of never ending liquidity, it is beginning to disappear. While Boots’ owner’s non-sale disappointment is one thing, a company’s need to replace a maturing bond or other loan is quite another. The cost of borrowing is rising and lending to companies is becoming more risky: those with the cash to lend are becoming less likely to put it at risk, especially if it has been borrowed in the first place. When governments can no longer borrow, to increase debt or replace maturing bonds, it is very serious indeed. The 2020 film The Kindness of Strangers did not score highly in audience reviews, but “the kindness of strangers” as mentioned by Mark Carney, the immediate past governor of the Bank of England, was in his opinion crucial for the UK government to continue borrowing, even though he made light of it.

I return to the question of where the money that has been lent to drive debt to such monumental heights has come from. Some money counts more than once of course, as it is lent by its originator to one borrower, who then lends it to another and then another and so on. Recognising this tells us, again as we already know, that this can finish up like a row of standing dominoes and behave like one when the first domino falls. This is why banks must keep reserves, but banks long ago ceased to be the only source of finance, which has already become a matter of concern to the Federal Reserve Board of the USA, the ‘Fed’. We know how banks get money to lend (mainly from depositors), but where does the other cash come from and how resilient is it to extreme market stress?

There are funds created out of saved profits from commercial enterprises and other funds which represent accumulated savings held by institutions and those held by individuals, which is all good stuff. But other funds will have been created by borrowing, that is money borrowed for the purpose of investing. All types of funds suffer when investments go sour, but the borrowed type stand to suffer twice, once from their loss of value and then from potential difficulties in repaying their borrowings. There is also the matter of fraud.

In September 2003, the Securities & Exchange Commission of the USA (the SEC), instituted a fact-finding mission by its staff, to review the operations and practices of hedge funds, the results of which produced a 130 page report[5]. SEC staff found an “inability to detect fraud and other misconduct at early stages” and a “lack of meaningful information about hedge funds and hedge fund advisers”.[7] Despite this, hedge funds in the USA are still unregulated, except by a law passed in 1933. UK regulation appears to be tighter, but it is applied by the Financial Conduct Authority which does not have a starring role in this or any other form of regulation.

However, this still doesn’t uncover the source of the money which goes into hedge funds or other funds (such as private equity) which invest on behalf of individuals or other institutional investors. By this, I mean the ultimate source. This brings me to quantitative easing (QE), the creation of money by central banks. It should be given its true description, namely money printing (MP, one might say, rather than QE). Astonishingly, this has been going on since 2009 in the USA and UK, since 2014 in the Eurozone and since 2001 in Japan.[8]

The Bank of England has printed £895 billion, roughly equivalent to $1.1 trillion. The European Central Bank has printed 2.6 trillion euros, roughly equivalent to $3 trillion. The Fed in the USA has printed more than $8.5 trillion. These three sources have produced more than $12 trillion of new money. The Central Bank of Japan has created (ie printed) 18 trillion yen, equivalent to more than $126tn. This brings the total of these four major economies to more than $138 trillion, which is almost half the global debt of $303 trillion.

Broadly speaking, QE has been used by central banks to buy government bonds and, to a lesser extent, corporate bonds. The money has therefore in practice been used principally to finance governments and, to a lesser extent, lend money to commercial enterprises. But money is like water, it flows to the lowest level possible, so it cannot be the case that the money created by QE stayed with its recipients; it must be assumed to have gone everywhere. This is especially so because it has been accompanied by ultra low interest rates (sometimes negative), but as I wrote in my earlier paper, reducing the cost of money reduces its value. There are countless instances of where money has been wasted because it has been so cheap (easy come, easy go), or invested in hugely unprofitable enterprises, or has financed corruption.[9] Governments splashed out money (from the ‘Magic Money Tree’) during the pandemic, without thought of the consequences, in what always seemed to me to be blind panic; that they all did it doesn’t make it right, but rather a form of herd behaviour. The UK government almost certainly spent more than £400bn, which included waste on a vast scale as is almost daily still being revealed.[9]

QE is the principal cause of today’s inflation

The ostensible purpose of QE was to create liquidity and so avoid recession or worse, but whether recession has been avoided we will only know as time goes by; personally, I very much doubt it. Implementing QE was an economists’ triumph, but the trouble with economics is that it is ever-changing in order to explain what has gone wrong. It is not a science, but a form of history, tracking events in order to understand and explain them to non-economists. It is no more a science than opinion polling, which likes to think that, from its research, it can make predictions. As the sub-title of a recent article in Investors Chronicle puts it, “Economics is evolving, so what shape will it take next?” I am reminded of an old joke: an economics examination paper was found to have the same questions as the previous year’s, but the answers had been changed.

I privately questioned QE when the Fed announced it in 2008, but increasingly came to condemn it, most fiercely in my previous paper. Since then, it has become apparent that, in the UK at least, QE has been used to finance government exenditure, previously considered verboten. Now QE is being questioned by professional commentators, just as the pandemic lockdowns are being questioned, which I also condemned at the time. These decisions, together with years of ultra low interest rates, were to deal with the problems of the day, but they were introduced without sensible consideration of the ultimate consequences. These are with us now and they are manifold.

Not least, they have seriously increased social inequality, inflating asset prices, boosting incomes at the top stratum of society, while at the bottom, real incomes have hardly changed. This is unquestionably bad for societal harmony and the consequences may be turbulent, something already seen with the election of Donald Trump.

In the beginning, commentators argued that QE would not create inflation. This is despite the fact that, throughout history, pumping money into an economy has caused inflation. Indeed, right from the start, QE did create inflation…… but only in asset prices. This was very much enjoyed by all those who owned assets, but it was laying up problems for the future among those who did not. By 2019, the World was seemingly coping with the after effects of QE while beginning its withdrawal, but then came the pandemic and governments went mad. The QE created after 2019 has gone into countries’ ordinary economies, where it had already taken inflation to a relatively high level before Russia invaded Ukraine. Naturally the invasion, with its impact on oil, gas, fertiliser and food, has seriously added to cost inflation, but it was not its initial cause despite what Bank officials and government ministers would (in their defence, we should note) like us to believe.

Meanwhile China, driven by an autocrat who, like Putin, has no regard for human life, instituted a draconian regime of whole city closures in a bid to eradicate Covid-19. This and Russia’s invasion have seriously impeded international trade, which hasn’t helped the inflationary picture but, more importantly, is bringing the whole world closer to recession. Some very important ingredients of a productive economy have become harder to obtain.

Gloom for investors

With dawning realisation of the state of things, stock markets and bond markets have already fallen – historically an unusual combination. The fall of equities erodes the value of those assets. The fall of bond prices drives up interest rates everywhere. Central banks have only just began to catch up, while until recently describing inflation as “transitory” and declining to do very much about it. But while rising interest rates are damaging asset values, rising inflation is at last having a very serious impact on ordinary people. Now we are truly “all in it together”, but of comfort there is none. The question is, where do things – and particularly asset prices – go from here?

This question is what this paper intends to answer, but it is of course just a personal opinion. One thing should certainly be borne in mind, which is that major events in human lives do not pan out quickly. As I am fond of saying, the Titanic took 2 hours and 40 minutes to sink, which of course should have allowed all lives to be saved, but it didn’t. More practicably, we should consider previous market falls.

Wikipedia tells us that, “between 1995 and March 2000, the Nasdaq Composite stock market index rose 400%, only to fall 78% from its peak by October 2002, giving up all its gains during the bubble. During the dot-com crash, many online shopping companies, as well as several communication companies, failed and shut down. Some companies that survived, such as Amazon.com, lost large portions of their market capitalization, with Cisco Systems alone losing 80% of its stock value.”

The dot-com bubble took two years to completely collapse.

In Wikipedia, I also found this. “In the 694 days between 11 January 1973 and 6 December 1974, the New York Stock Exchange's Dow Jones Industrial Average benchmark suffered the seventh-worst bear market in its history, losing over 45% of its value. 1972 had been a good year….., with gains of 15%...... 1973 had been expected to be even better, with Time magazine reporting just 3 days before the crash began that it was 'shaping up as a gilt-edged year'. In two years, from 1972 to 1974, the American economy slowed from 7.2% real GDP growth to −2.1% contraction, while inflation jumped from 3.4% in 1972 to 12.3% in 1974. The effect was worse in the United Kingdom, particularly on the London Stock Exchange's FT 30, which lost 73% of its value during the crash.” This was another two year episode.

As quoted in my previous paper, J.K. Galbraith’s seminal work on the 1929 crash tells us it did not finish that year. “The singular feature of the great crash of 1929 was that the worst continued to worsen. What looked one day like the end proved on the next day to have been only the beginning. The fortunate speculator who had funds to answer the first margin call presently got another and equally urgent one, and if he met that there would still be another. In the end all the money he had was extracted from him and he lost. The man with the smart money, who was safely out of the market when the first crash came, naturally went back in to pick up bargains. The bargains then suffered a ruinous fall. Even the man who waited out all of October and all of November [1929], who saw the volume of trading return to normal and saw Wall Street become as placid as a produce market, and who then bought common stocks would see their value drop to a third or fourth of the purchase price in the next 24 months.”

More detail on the 1929 crash can be found on the internet [10], including Wikipedia. The latter tells us that the crash lasted 987 days, from October 24, 1929 (‘Black Thursday’, the day of the largest sell-off of shares in US history) to July 8, 1932. Britannica tells us, “Another 20 years would pass before Dow regained enough momentum to surpass the 200-point level” – only the level it had already fallen to by October 29, 1929, ‘Black Tuesday’.

These market crashes were associated with deep and long lasting recessions. It was ten years in the 1930s. For the 1970s, Wikipedia tells us this. “From a rate of 5.1% real GDP growth in 1972, the UK went into recession in 1974, with GDP falling by 1.1%. At the time, the UK's property market was going through a major crisis, and a secondary banking crisis forced the Bank of England to bail out a number of lenders. In the UK, the crash ended after the rent freeze was lifted on 19 December 1974, allowing a readjustment of property prices; over the following year, stock prices rose by 150%. The definitive market low for the FT30 Index (a forerunner of the FTSE100 today) came on 6 January 1975, when the index closed at 146 (having reached a nadir of 145.8 intra-day). The market then practically doubled in just over 3 months. However, unlike in the United States, inflation continued to rise, to 25% in 1975, giving way to the era of stagflation.” We should note, I suggest, that a 150% rise after a 73% fall gives a figure just 55.5% of the starting point.

What has yet to happen?

These events remind us that, sometimes, really bad things do happen. Is this what we face now? Nobody knows for sure, but consider this. As set out above:

a. global debt is astronomical,
b. liquidity is at risk,
c. inflation is rampant,
d. interest rates are rising
e. stock markets have fallen, but only by 20 per cent.

In my opinion, whatever governments choose to do (in which I include central banks), to remedy (a), (b) and (c), which surely they must, the impact on stock markets will be profound. This is why I think they are still over-valued. But that is not all.

Some businesses are struggling to recruit the staff they need just to keep going – of which a major cause must be how easy it is to get universal benefit, coupled with the lingering effects of compulsory lockdowns. They will have to cope with falling sales, caused not least by falling net incomes as a result of inflation, tax rises and, for those buying on credit, rising interest rates. Businesses themselves will have to cope with rising taxation, rising wages and other cost increases, including interest on their borrowings.

Even if the corporation tax increase due next year is cancelled and the recent NI increase with it, there is still the matter of business rates, which as reported in the Mail on Sunday are due to increase next year by this September’s CPI; I well remember the pain of paying this tax when my company was making a loss and money was extremely tight (I had to go without income that year). Profits must fall, whether or not prices increase, while an increasing number may fail to survive.

Individuals, as taxpayers, mortgage payers, tenants and credit card holders, face a painful year or more ahead. The government is under pressure to ease that pain and perhaps there will be tax reductions, but the cost of heating and food is unlikely to reduce in the foreseeable future. In any event, the government has a large number of other calls upon the income from taxation, not least the rising cost of financing its own debt (£19.4 billion last month alone). In my opinion the NHS does not deserve more money, but our elected representatives have yet to grasp that nettle. On the other hand, it must now be evident to all that we have been spending woefully too little on defence. If taxes are increased, this surely will in some way impact business profitability and the scope for dividends.

A recent ‘Market Insight’ article in the Financial Times (22.7.22) was headed, “The big collateral call facing UK pension funds”. The Investment Association has reported that UK pension funds hold £1.5 trillion of liabilities which are in hock to “so-called Liability Driven Investment trades”, taken out as a form of hedging to provide stability of their assets. This has left them, “as counterparties to enormous quantities of leverage in the financial system.” These funds are now “facing calls from counterparties to put up collateral to fund those trades.” The author, Toby Nangle, concludes, “[Pension] scheme collateral buffers have been markedly depleted across the board and require rebuilding: this can only realistically happen by selling growth assets like corporate debt, equities and property. So while rising yields are good news for pension scheme funding levels, they look a likely catalyst for a further liquidation of risky assets.” In other words, they’ll be selling what we invest in.

Future equity returns come from investment. In another recent FT article, Martin Sandbu tells us that there has been an “investment drought” spread over two decades. “France and the US have invested nearly two percentage points less this century than in the 1970s and 1980s, Germany and Italy 4.5 points less; the UK six points less and Japan ten points less.” He attributes this to “lack of demand and cheap labour……. (plus) cheap energy in Europe.” In so far as the USA is concerned, another author, Andrew Smithers, published books in 2013 and 2019, linking poor productivity to lack of investment and “the bonus culture”; it is a subject he has long been concerned about.

Other perhaps than in the UK, investors are readily able to borrow from their brokers to maximise potential profits, known as trading on margin. The FT’s ‘Big Read’ on July 21 reported that, “Despite the increasingly hostile investing environment….. high-risk speculation” is continuing, even though leverage is costing more. “In May, the amount of money borrowed to trade on margin was 25 per cent above pre-pandemic levels.” This will presumably exaggerate any further markets’ fall to come. Buying the dip is alive and well, I gather, which brings me to my final observation.

It is nearly always the preponderant inclination of investors to be optimistic, a tendency which can be seen even during market crashes. The last twenty years or so have indeed encouraged the belief that markets would always go up, with only temporary ‘dips’ in between. This has been the mindset, hugely influenced by the ‘generosity’ of central banks. Investment funds have traded on this belief. Recently, optimism has particularly driven youthful investors, which is understandable but potentially tragic.

Now it appears to me we have entered a new era, a new normal, when a great many chickens seem likely to come home to roost. As the saying goes, while history doesn’t repeat itself, it tends to rhyme. Certainly, in my opinion, from where we are to where we are going won’t be an easy ride. As to what individual investors should do, that does of course depend on individual circumstances.

Eric Chalker, July 25, 2022. Contact Eric here.

The links

1. https://www.reuters.com/article/us-eurozone-ecb-qe-idUSKBN1OB1SM
2. https://www.managementstudyguide.com/quantitative-easing-instances.htm
3. https://www.bis.org/publ/bppdf/bispap66g.pdf
4. https://worldpopulationreview.com/countries/countries-by-national-debt
5. https://americandeposits.com/history-quantitative-easing-united-states/
6. https://blogs.worldbank.org/voices/are-we-ready-coming-spate-debt-crises
7. https://www.sec.gov/files/implications-growth-hedge-funds-09292003.pdf
8. https://www.investopedia.com/articles/markets/052516/japans-case-study-diminished-effects-qe.asp
9. https://commonslibrary.parliament.uk/research-briefings/cbp-9309/#:~:text=The%20Covid%2D19%20pandemic%20has,per%20person%20in%20the%20UK
10. https://www.britannica.com/print/article/566754

The Writer's views are their own, not a representation of London South East's. No advice is inferred or given. If you require financial advice, please seek an Independent Financial Adviser.