The Economic Consequences of Covid-19

Monday, 30th March 2020 11:45 - by Eric Chalker

To begin with full disclosure, I think the government has made a catastrophic mistake with its economic handling of Covid-19. It is painfully apparent to me that it has also handled the epidemic badly. That itself is not the subject of this paper. However, because it allowed its actions to be dictated by the appalling lack of preparedness by the NHS for such an eventuality, instead of demanding urgent and imperative action to correct this, the economic price to be paid is colossal. Based on its seemingly unquestioning acceptance of dire consequences forecast by a computer model which others in the field have questioned, it has initiated what The Daily Telegraph has called, “the biggest direct state intervention in the economy since the Second World War.”

This surely has profound consequences for private investors. In summary, the government:

• disrupting economic life instead of finding ways to keep it operating safely;
• destroying multiple, otherwise viable businesses and, in the process, entrepreneurial spirit;
• is triggering huge unemployment and all the misery that goes with it;
• is making life more difficult for those businesses that do survive, while squeezing their ability to make money;
• is frightening those workers who still have jobs so that they refuse to work, thus causing more businesses to close, or substantially reduce their operations;
• is dumping ever-increasing costs onto future taxpayers, seemingly without limit;
• is making us all much more dependent on and subject to the state than was previously imaginable under a nominally Conservative government.

It is not at all surprising that share prices have collapsed. This is partly because they were so high, not because the global economy was powering ahead but because of the malign combination of perpetual quantitative easing, ultra low and negative interest rates, plus debt without end. Covid-19 was the final straw on the camel’s back. I am not alone in thinking there is more to come – even if, along the way, there is a rebound. Except for very short-term investors, we should not be thinking that shares are cheap, but whether they are worth their current prices, in a country and a world in which so much has changed.

How will people behave, when they have no money and cannot repay their debts? What will those who still have employment do with their income, which may of course be smaller: spend it or save? How will companies adjust to the post-virus world, when people’s appetite for what previously attracted them may have totally changed, when previous markets may no longer exist? How will companies handle their own debts when cash flow has been stopped for an as yet unknowable length of time, particularly bearing in mind that the virus may return? What will be the impact on businesses and individuals of what must surely be an escalating tax burden? What restrictions and demands will the government impose on us and on businesses, now that we have all become indebted to the state? Will we not find ourselves in what is normally called a command economy, even if the election of an avowedly socialist government has yet to take place?

It may be common knowledge that the 1929 Wall Street crash was followed by others, but it is worth recalling what J.K. Galbraith actually told us, in his book, ‘The Great Crash 1929’.

“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. Nothing could have been more ingeniously designed to maximise the suffering, and also to ensure that as few people as possible escaped the common misfortune. 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.”

Could this happen again?
Disregarding that possibility, “Equities are no longer expensive,” wrote Merryn Somerset Webb in the Financial Times this weekend, basing her assurance on falling price-to-earnings ratios. This is an extraordinary conclusion, because it assumes that earnings will simply resume where they left off, once the virus is no longer a threat. It may also be because Ms Webb is looking at the PER of 12.25 shown in the FTSE 350 index, but my research has repeatedly shown that this is a dangerously misleading figure, as it appears to use as the divisor all companies in the index including those with no PER.

At the beginning of this month I circulated a note which showed that the average PER for the 171 companies in the top 200 by market value was 24.0. The market had fallen quite a lot by then, but the average company PER did not seem to reflect this, causing me to warn that shares were not cheap. Now the FTSE 350 index has fallen another 18 per cent and, for the first time when I have measured it (perhaps because I wrote to FTSE Russell about the previous discrepancy), this drop is matched by the average top company PERs. Even so – and this is the point – the average still stands higher than I would consider cheap. The average today of the 173 top companies with a PER, as measured by Morningstar, is 19.7, which is considerably different from the index figure of 12.25.

Given the factors mentioned in the second paragraph above, a PER which is virtually 20 is certainly not what I would consider cheap.
This weekend, the value of my 50 odd ISA stocks has fallen, since the start of the year, by 35 per cent. I record the values in five categories and it is interesting to see that the fall in four of these is virtually the same (33% to 37%), thus confirming that this is a widespread market drop, not related to particular companies. The exception is my resource stocks category, which has dropped by 41 per cent, but a special factor is at play there, so no surprise. All of them now, at least nominally, have wonderful dividend yields, even those which have deferred or suspended them, but are these now a realistic expectation in such a changed environment? How can anyone yet know?

My ISA stocks are held solely for income and it is of course highly probable that this will be substantially down this year. Dividends are paid out of cash generated by profits and, although not all profitable companies pay dividends, all listed companies must aim to make profits which can be turned into cash, in the forseeable future if not now, in order to justify their listings. In this respect, dividend payers are not different from non-dividend payers, so the question before buying any company share is, will the company be profitable and able to turn profits into cash, if not this year at least soon enough to justify the investment? To my mind, this is the great question at the moment which, for the reasons mentioned above, cannot be answered with any certainty for any but a tiny minority of companies.

It is worth adding to the above, I think, some thoughts on interest rates, inflation and tax. Despite central bank efforts to reduce interest rates and increase money availability, I read that rates are moving up. This makes sense to me, because impending loan defaults should make what remains become more expensive; the fact that money was so cheap was a mistake, because the debt mountain has grown beyond reason. If those who borrowed money had had to pay more for it, better judgements would have been made, as with any other ‘shopping’. I do note, though, that some clever people are arguing that the amount of debt doesn’t matter, because central banks can always create money to buy it up (along with company shares) or even – we are now being told – print money to finance government expenditure directly without equating us with Zimbabwe or Weimar Germany: it’s called Modern Monetary Theory.

When money grows without producing commensurate value, the value of what exists is depreciated. This creates inflation, which in turn leads to higher interest rates. Under MMT this won’t trouble the government directly, but the impact on domestic finances is likely to be painful and an additional cause of recession. New money flowing continually into the economy, without creating real value, strikes me as a recipe for high inflation. The fact that it hasn’t hit family finances after several rounds of QE is a puzzle to some, but it has of course made a huge impact on asset values, which is painful for those buying homes but gives asset investors a nice, warm feeling. If daily living cost inflation takes off, that will surely have a detrimental effect on people’s lives and attitudes, further weakening the UK economy.

The final element of concern is tax. Even if the government chooses not to reduce its indebtedness, the cost of what it has to provide will inevitably go up. At the very least, the public – which expects the NHS to be an open-ended service for all, without regard for how people choose to live their lives – will now demand a huge increase in expenditure on it. This is not to mention all the other pressing demands for the UK to catch up with those areas neglected by previous governments, such as social care, education (500,000 more secondary pupils expected in the next six years, apparently), housing, transport infrastrucure and, not least in my book, defence.

Despite low tax advocates (including Boris), public expectations of ‘entitlement’ have not been challenged since the early Thatcher years. They have grown exponentially. Our politicians seem likely to bend with the wind, so the only possible response is to raise taxes. On what, one wonders? Let us not assume that wealth will be exempt. After the virus, the division between those who have assets and those who do not seems likely to be a lot wider. Envy may stalk the land, fuelled by continuing resentment of banks. One possibility is a general wealth tax, but easier to introduce, it seems to me, would be some form of tax on ISAs; it strikes me as the height of folly for Lord Lee to allow himself to be quoted, as he is this weekend, as enjoying a six-figure, tax-free income from his ISAs.

I do not think the future looks bright, but it’s not the fault of the virus, nor of China. It’s years of poor government by the Conservative party.

Eric Chalker, UK Shareholders’ Association Policy Co-ordinator & Director, 2012-2016

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.