Growth In the Spring?

In the movie Being There Chauncey Gardner predicted “there will be growth in the spring”. Ephemeral cherry blossoms are a welcome harbinger of spring. Unfortunately, April showers of poor economic data are going to continue for months to come, though substantial economic support from financial authorities does provide a tailwind to economies and financial markets. The challenge for investors is to determine the unique characteristics of the current paradigm and what we might we learn from historical precedents.
COVID-19’s impact on the global economy compares best with a war economy like WWII and the future impact may resemble previous pandemics, and the 1930’s. Current consumption has been diverted; some of it will recover (e.g. pent-up demand for big ticket items), but much of service sector consumption will be lost for good as meals, cinema, and the like will only be recovered to a small extent. A study at UC Davis of pandemics going to back to the 14th century showed 40 years of after-effects and specifically notable declines in real rates of return following a pandemic. The forward risk faced today is a period like the 1930’s with a secular change in spending, rising savings rates, and higher taxes.

Unlike 2008, the current crisis is not starting as a financial crisis, but a self-engineered “repression” leading to a liquidity and possibly, a solvency crisis. Bank and consumer balance sheets are in much better condition than 2008, but the enormous expansion of debt issuance in areas like collateralized loan obligations make corporate balance sheets highly levered and ominously similar to that of consumers during the global financial crisis of 2008. Compounding current challenges is the fact that both businesses and governments have largely squandered the past decade as an opportunity to reduce deficits and improve productivity. The US is heading into recession with a 5% fiscal deficit to GDP ratio, large debt load, and central bank balance sheet larger than ever. Corporations have chosen a path of financial engineering through debt issuance and buying back stock rather than capital expenditures.

Substantial moves by policy makers have helped to ease financial conditions only by a small margin (as can be seen in the chart) as they face severe obstacles in the form of global fault lines. China’s GDP was growing at 8% or better until 2013 and provided a strong tailwind to commodity prices, emerging markets, and global growth. Now China is experiencing an epic credit and housing bust that will likely impair growth and capital flows for years. In emerging markets both private and public sector balance sheets have been on a downward trajectory for a few years. In Europe, Italy, the third largest single currency member, is in the midst of a recession of biblical proportions with estimates suggesting trillions of US dollars needed to fund debt rollovers, budget deficit, and growing banking sector needs.

Global financial markets are experiencing one of the largest supply and demand shocks in history. The first stage of market reaction was a sharp panic move lower. The second stage is ongoing now (and may continue for a while), a reflexive rebound as participants gauge valuation levels and the efficacy of policy measures. The key question is do we get a third stage and when will it begin? If we truly have seen a secular shift in markets and economies then we can expect further substantial market pricing adjustments and geopolitical fallout. We have tragically witnessed the virus having the most devastating effects on vulnerable individuals, similarly the crisis is most damaging to systems with inherent weakness.