for the new decade
Mistaken financial views, a different socio-economic context and an alarming new virus
By Jean-Luc Burlone
Let us start by getting rid of three falsehoods. First, the correlation between stock markets and economic growth. Financial performance is not a consequence of macroeconomics and it is not positively correlated with economic growth.
Stock markets perform well when companies generate a stable and reliable flow of earnings or when saving accounts are awash with money with no other outlet than the stock market. (It is uncommon when there is a lack of investments for the available savings.) In fact, going back one hundred years, financial performance and economic growth are negatively correlated if at all.¹
Japan is a convincing case: the Nikkei 225 grew by 22% in 2019 and the Japanese Yen is strong while the economy is hindered by deflation: falling prices, falling sales and falling profits – in the last quarter of 2019 the GDP grew by 0.4%.
Second, political leaders have a direct impact on the economy. To boast that politicians can foster economic growth only reveals ignorance of macroeconomic principles. The GDP is a function of spending (government, businesses and consumers), investments and exports minus imports.
Other than government spending (on infrastructure for instance), a large, fluid, and vast economy, like the American economy, is only slightly impacted by good or bad policies, particularly in the short term. On the long term, policies on education, for example, will affect the quality of the labour force and thus the economic productivity. On the other hand, emerging or small economies can be damaged within a few years by unwise political decisions, as were Argentina under Perón and Venezuela under Chavez.
To boast that politicians can foster economic growth only reveals ignorance of macroeconomic principles. The GDP is a function of spending (government, businesses and consumers), investments and exports minus imports.
Third, a tax cut will pay by itself because it will stimulate the economy. This statement is a recurrent figment of the imagination; it has been proven wrong again and again² but we cannot get rid of it. In fact, apart from the enthusiasm it arouses among wealthy investors, a tax cut mainly represents a loss of income for the state.
Since the 2008 financial crisis, the basic factors that sustain the recovery are low-interest rates, low oil prices and consumer spending. It is noteworthy that the US quarterly economic growth rates, for the past eleven years, have been quite similar under both the Obama and Trump administrations³. In Europe as well, the recovery has been and remains tepid regardless of the different governments that were elected.
Large economies are damaged by shocks to the demand or the supply curve. The oil shocks in the seventies affected the supply of the commodity while the current outbreak of a new coronavirus is a shock to the demand curve of China and may well be followed by a shock to the supply chain of the world economy.
This time is different… will it be?
“The Boom and Bust Cycles are over,” as the CIO,4 of a well-reputed hedge fund has argued. Economic cycles are driven by credit expansions and contractions, which, in turn, are caused by central banks’ monetary policies. Since interest rates are close to the zero bound and since any increase would jar financial markets, central banks are “in a box” so to speak. Hence, those cycles, as we knew them, are over and the financial environment should remain stable.
‘… since markets are highly leveraged, any argument that implies a lack of caution because “this time is different” increases the risk of financial losses and renders the expectation of good profits unwarranted.’
Most professionals agree that central banks have little room to manoeuvre but only time will tell whether or not the argument has merits. History, however, tells us that overconfidence is in human nature as are fear and greed. In addition, since markets are highly leveraged, any argument that implies a lack of caution because “this time is different” increases the risk of financial losses and renders the expectation of good profits unwarranted.
The Modern Monetary Theory (MMT) is another novelty for countries that can control (print) their currency. Its main protagonist is Stephanie Kelton, an economist at Stony Brook University and economic advisor to Bernie Sanders. The theory claims that government deficits are compensated by a surplus in the society, which helps finance productivity. Hence, persistent deficits are nothing to worry about.
MMT recognizes that deficits are unwarranted when there is a lack of production factors such as materials, labour or manufacturing facilities. Economic experts are skeptical when confronted with a theory that allows for perpetual borrowing. A deficit is much more than the record of a government’s spending; it is a financial weakness and the larger it gets, the more it thwarts the solution of an unexpected problem.
As professors Reinhart and Rogoff have once stated: “A highly leveraged economy can unwittingly be sitting with its back at the edge of a financial cliff for many years before chance and circumstance provoke a crisis of confidence that pushes it off.” And the authors5 added: “The siren music of a rising market, combined with the ‘this time is different’ lyric, have proved a pied piper in the past, and it is unlikely to be resisted in the future.”
Low-interest rates and the fear of deflation
In the wake of the 2008 financial crisis, central banks have lowered their overnight rate close to or below the zero bound to prevent the collapse of the world economy. Cheap money was spread through the financial system to facilitate investments, stimulate demand and increase inflation to the level of about 2%.
‘In North America, negative rates and deflation are unlikely. Both Canada and the US have a decent economic growth rate and current conditions do not entice negative rates for now.’
Confronted by low rates, pension plans and insurance companies had to seek higher returns with riskier investments to meet their fiduciary obligations. But such a strategy has proven dangerous in the past. As James Grant6 would put it: when low-interest rates entice demand for high-yield (high risk) investments, it always turned out to be a time-tested source of trouble.
Inefficient at close to zero, interest rates went negative in several countries7: Japan (-0.20%), Germany (-0.59%), France (-0.32%), Switzerland (-0.99%) and the Netherlands (-0.48%). All to no avail as inflation remains unresponsive and worse since deflation now harms the economy of Japan and looms over Europe. The legacy of the financial crisis remains unsettled.
Deflation threatens the principles of the financial system. Time loses its value; retirees see their capital curtailed and their revenues truncated. Banks must pay to hold securities; companies with cash are penalized while those indebted are rewarded. The present value of future income is reduced, making it harder to meet the future instalments of a mortgage.
For now, negative rates are imposed only to banks and large financial institutions. With the exception of retail banking in Switzerland, depositors are not asked to pay a fee to their bank for holding their liquidity. But the possibility should not be discarded.
In North America, negative rates and deflation are unlikely. Both Canada and the US have a decent economic growth rate and current conditions do not entice negative rates for now. That said, if negative rates are not likely in North America, they are not ruled out. If confronted by an unexpected event (a pandemic?), the Bank of Canada (BOC) and the Federal Reserve Board (FED) in the United States have little room to manoeuvre.
In handling past recessions, the BOC and the FED had cut their overnight rate by an average of 5% to boost their respective economy. If it is needed again, negative rates will become a reality for both countries since the central bank rate currently stands at 1.5 – 1.75% in the US and at 1.75% in Canada.
Is the new coronavirus a Black Swan?
Corona viruses8 are common in many animals: camels, cattle, cats, and bats. They rarely infect people but two have recently appeared in South China. The SARS-CoV appeared in November 2002, spread to more than two dozens countries and by July 2003, had contaminated 8098 people and killed 774 of them – a mortality rate of 9.5%.
‘The impact on an integrated world economy could be highly disrupting because China’s economy represents 17% of the world GDP and the country is the world’s largest consumer of raw materials.’
The new coronavirus, called 2019-nCoV, was detected early last December in the province of Hubei and by February 7, it has contaminated 31,161 persons and caused 636 deaths – a mortality rate of 2.1%. China accounts for 99% of the cases but next to thirty countries, in Asia, Europe and in North America, are affected with one or more cases.
Tens of millions of people are now in quarantine. International efforts are coordinated to limit the spreading and to decrease the propagation rate. The human suffering of the affected families cannot be understated.
The impact on an integrated world economy could be highly disrupting because China’s economy represents 17% of the world’s GDP and the country is the world’s largest consumer of raw materials. As China closes its borders, its demand for commodities comes to a stop. Goldman Sachs has estimated that Chinese demand for oil fell by two to three million barrels per day. The drop in demand for copper is similar.
As long as the quarantine lasts, economic activities inside China are reduced or stopped: smelters are not operating, manufacturing plants are shut down, stores are closed and exports are falling. Little goes out and little comes in. Since most of the Chinese inputs and intermediary products are not produced, supply chains are disrupted, depriving Asian, European and North American economies of their needed supply. Only Africa is not affected, either by contamination nor through its economy.
If the coronavirus turns out to be a Black Swan, the damage will be negative and significant for the world economy. As mentioned above, the BOC and the Fed have little to spare before entering into negative territory while Japan and Europe are left with no other tool than quantitative easing, whose effect is doubtful.
In the meantime, some investors on Bloomberg TV consider that the pandemic will be under control and that the expected damage represents a fairly low risk to financial stability.
In addition to the troublesome virus, the new decade carries the resurgence of social fear, i.e., the uprising of the masses against the status quo. Dissatisfied by the lack of social mobility and apprehending a bleak future, people are economically motivated to challenge their establishments.
‘Be that as it may, inequalities not only create a material discomfort for the have-nots but it destroys the notion on which a democracy is built and by which it survives, i.e., that all men are equal.’
At the World Economic Forum (WEF), an executive report9 on inequality concluded that governments have no other choice but to act rapidly to close the wealth gap. Moreover, the report has strongly highlighted the importance of nurturing people’s optimism for their future as a necessary condition to answer their grievance.
It should be mentioned that recent empirical studies10 have concluded that inequalities have increased but not as much as claimants pretend. One main argument is that relocations of funds to social services should be correctly accounted for as a distribution of wealth.
Be that as it may, inequalities not only create a material discomfort for the have-nots but it destroys the notion on which a democracy is built and by which it survives, i.e., that all men are equal. Without equality between all citizens in basic living conditions and in opportunities for the future, social cohesion can hardly be maintained and the fractured society can only shamble ahead.
The welfare state that was instated after WW2, must now be adapted to meet today’s social issues. In addition to the traditional and essential betterment of healthcare and education, an efficient social system would offer lifelong insurance that protects those in need against disruption from technology and climate change.
For its part, over and above paying its taxes, the private sector must facilitate the adaptation of the workforce to today’s economy. Businesses should give as much care to their stakeholders than they do to their shareholders, e.g., decent wages, support, training, education and good working conditions that favour social mobility.
Investors should be aware that Larry Fink – the boss of BlackRock, the fund that controls $7 billion – has threatened to vote against board members that neglect to serve the interest of their company’s stakeholders. Their first warning was directed to Siemens in Germany. Happily, when financial interest goes along virtue, the latter gains some influence.
Each year it is sadly remarkable how the WEF in Davos makes clear and strong statements defending social values, battling inequalities and defending environmental issues, while business panels keep discussing about how to make money regardless of those issues so loudly heralded.
This year, it was reported11 that business leaders at Davos were taken aback by Trump’s impeachment trial while the economy is doing well. Since the impeachment was not related to the US economy but to the ethics of Donald Trump, it is appalling and worrisome that the business elite would ignore macroeconomic principles and judge the situation strictly from the financial point of view.
In a bottle at sea
Maybe there is time for us money makers to hold our horses, to revisit our priorities and to act accordingly. The way we invest reflects who we are; being prudent with our money and considerate with our environment can only be beneficial. Let us be change-makers while we can.
- Jeremy Grantham, Chief Investment Officer, Grantham, GMO, July 2017
- Paul Krugman, Arguing with Zombies: Economics, Politics and the Fight for a Better Future, 2020
- Jason Kirby, Globe and Mail ROB, September 20, 2019
- Bob Prince, co-CIO, Bridgewater Associates, Bloomberg, January 22, 2020
- Carmen M. Reinhart and Kenneth S. Rogoff, This Time Is Different: Eight Centuries of Financial Folly, 2009
- Grant Interest Rate Observer, September 2018
- 10 year government bond yield, Bloomberg iShares, August 2019
- Centers for Disease Control and Prevention (cdc.gov)
- Saadia Zachidi, Managing Director, World Economic Forum, 2020
- The Economist, Volume 433 Number 9171, December 2019
- David Rubenstein, Carlyle Group co-founder, Bloomberg, January 22, 2020
Feature image: pxhereRead also: other articles by Jean-Luc Burlone