February 2021 Insights
What Next? Three Reasons for Optimism and Three Causes for Caution in These Uncertain Times
This newsletter is a new service we are offering clients, with the goal of reviewing some of the most important developments and trends taking place in the global economy and financial markets. Given the climate of acute uncertainty, we thought it would be fitting to kick off this series by exploring reasons for optimism at this current juncture as well as causes for caution. We came up with three of each to consider.
Three Reasons for Optimism
1) Stimulus has worked (so far).
The unprecedented stimulus launched by governments and central banks across the globe, even in many emerging economies, has, to a great extent, helped to stabilise international markets. Government support to individuals and businesses has prevented economies from imploding although certain sectors will, of course, only be in a position to recover once social distancing measures can be relaxed.
In many ways, this success is testament to the sheer power of government & central bank intervention. Before March, many thought that with interest rates languishing at their lowest levels in history, the world’s biggest central banks had painted themselves into a corner. With no scope remaining to cut interest rates meaningfully, they appeared to have run out of means to defend the economy against crises. However, the central banks pulled out all stops in response to the pandemic, hugely expanding the scale and scope of their money printing programs and enabling governments to fund enormous support programs.
The indications are that Governments are willing, increasingly, to adopt policies that are more ‘direct’ in nature, creating money on an almost unlimited basis to pay for support programs and investment in projects such as infrastructure. There are also signs that central banks are considering adopting even more extreme measures in future, such as handing out newly created digital money.
2) Vaccines offer a ray of hope against Covid.
It is easy to forget that Pfizer & BioNTech only announced the results of initial vaccine studies in November. Before that many experts had questioned whether it would even be possible to develop effective vaccines. Since then other vaccines, from the U.S., the UK, China, and Russia, have been introduced and approved in record time. The early signs are promising. If they are as effective as their developers claim and are rolled out in sufficient number, they have the potential to help bring Covid-19 under some semblance of control.
If so, governments may finally be able to relax lockdowns, social distancing and travel restrictions and reopen borders, which will give a much needed fillip to largely dormant industries such as tourism. For countries that depend on tourism, such as Spain, France Italy and Greece, this is a vital first step toward recovery. If the vaccines work, they will also give a lease of life to leisure, hospitality and cultural industries.
3) Brexit has finally happened and the sky hasn’t fallen.
After four years of acute uncertainty, we have finally received a degree of clarity on Brexit and the future relationship between the UK & EU, which markets have broadly viewed positively. The pound sterling has not crashed, as some had predicted. On the contrary, it hit a seven-month high against the euro in January.
Obviously uncertainties remain, such as the impact of border controls and tariffs on trade generally as well as the future role of the UK’s all-important financial services industry and the impact that could have on the City.
Three Causes for Caution
1) The crisis is by no means over.
The vaccines may have offered a ray of hope, which was enough to goose markets in the final quarter of 2020, but they have yet to offer much more in the way of certainty. We still don’t know how effective or safe the vaccines will be once they are delivered at scale, especially as new strains of the virus have begun to emerge. Whether the vaccines are the panacea we’ve been waiting for, only time will tell.
Meanwhile, the impact of the virus on the economy continues to grow. Many heavily indebted businesses can hold out no longer. Their collapse is likely to trigger a surge in defaults on loans, which will put many already-weak banks under serious pressure. Unemployment is rising in Europe despite all the hundreds of billions spent on furlough programs. And for all the trillions of dollars, euros, pounds, yen and renminbi conjured up by the central banks, the markets remain volatile, as recently shown by the market gyrations around the Gamestop stock.
The wider narrative on Gamestop is that complacent hedge funds betting on a share price fall were completely wrong-footed by an internet-based community of millennials, who turned the tables on the professionals using speculative techniques that were assumed to be the preserve of hedge funds themselves.
A good result for the little guys, perhaps, but our key ‘takeaway’ is that the episode was primarily a reflection of market psychology and crowd behavior – two forces that have always shaped, and from time to time rocked, financial markets. Sharp price movements, widespread use of debt to fund investment purchases, unrealistic market valuations and crowd euphoria… all of these are symptomatic of ‘late cycle’ market behaviour. How late we are in the cycle, though, will only be known with the benefit of hindsight.
2) The markets are now completely hooked on central bank intervention.
From the current vantage point, it’s easy to forget just how quickly financial assets collapsed in value at the beginning of this crisis, almost a year ago. The only thing that stopped the rout was massive, unprecedented central bank printing and intervention in the markets. But as we saw in the aftermath of the Global Financial Crisis, these emergency policies, while supposedly temporary in nature, will probably be impossible to unwind.
Central banks all over the planet have pushed the outer limits of monetary policy and expanded their balance sheets more than at any other time in history, including in the wake of the Global Financial Crisis. The Federal Reserve alone has doubled the size of its “balance sheet” – a statement of the condition of its financial position, consisting of assets, liabilities and equity – from around $3.7 trillion in March to over €7 trillion in December. This newly printed money is the equivalent of $10,600 for each man, woman and child in the U.S.
On the positive side, this unwavering central-bank support has curbed bond market volatility and capped government borrowing costs, allowing governments to keep paying the interest on their rapidly growing debt. But it has also raised serious questions about the sustainability of central bank policy as well as central banks’ treasured independence. The latter is key to ensuring that short-term political considerations do not influence monetary policy. Analysts fear that this particular Rubicon has already been crossed, as some central banks, including the Bank of England, now appear to be directly financing government debt.
3) The disconnect between financial markets and the real economy has never been greater.
Thanks to all of this central bank money printing, the financial markets are awash in liquidity and are completely out of kilter with the economic pain being experienced by a large proportion of the population. For many years the disparity in wealth has widened as financial assets have soared in value while many on middle and lower incomes have seen their earnings shrink and jobs disappear. This is further fuelling political instability, as recent events in the U.S. have amply shown.
In the meantime, bubbles seem to be forming in financial assets, particularly bitcoin, certain tech stocks and commodities. As the bubbles grow, financial risks rise. Margin debt – the amount of money that individuals and institutions borrow against their stock holdings – is already surging in the US. How long these bubbles ultimately last and how destructive their eventual collapse will be is anyone’s guess. But given the unprecedented amount of new money being created and released into the economy, investors would be wise to be looking for a store of value as a hedge against uncertainty, currency depreciation and possible inflation risks.
Conventional wisdom is that the creation of money on such a grand scale and its injection into people’s pockets will eventually stoke inflation. Because central banks will not be in a position to raise interest rates to counter this, since governments would then be unable to continue servicing their debts, there is clearly a risk that inflation will be hard to control.
With this in mind, we’ll be reviewing your portfolio to consider what, if any, changes might be advantageous in a more inflationary world. In such circumstances, ‘hard assets’ such as commodities, natural resources, precious & industrial metals and related equities are often considered to be useful inflation hedges. Yields on the latter remain attractive as many related sectors have been out of favour during the recent decades of falling inflation.
For the moment, though, the economic consequences of the pandemic appear largely deflationary. But as the old adage goes, ’best to buy an umbrella before it starts to rain’.