I am increasingly being asked about how the governments enormous stimulus packages in response to the coronavirus pandemic can be paid for and what impact this might have on client investments. The following article (it’s a little long but well worth the read) by David Thorpe, special projects editor of Financial Adviser and FTAdviser, goes someway to answering these questions. The article is aimed at Financial Advisers but it is reasonably accessible.
“The response of governments across the world to the pandemic-induced collapse in economic activity has been to inject hundreds of billions of pounds of borrowed money into the system in an effort to plug the gaping holes wrought upon the economy by the virus.
Gilles Moec, group chief economist at AXA says a particular feature of this policy response is the extent to which policy makers and commentators around the world accepted the need for governments to borrow money and spend it at this time. Mr Moec adds that, while there are a range of potential consequences for advisers and their clients from the bigger debt pile, it would be wrong to focus in the short-term on repaying the debt.
He said that one of the negatives that typically arises from higher levels of government borrowing is much higher inflation in the short term. This can happen either because too much cash is pumped into the economy, so demand rises faster than supply, or because the extra currency entering the system leads to a fall in the value of the currency, making imports more expensive. The reduction in economic demand has been so severe that inflation will remain low for an extended Period.
Were either of these scenarios to play out in the UK, the resultant inflation would be magnified by the additional costs businesses face as a result of the pandemic, for example, from spending money on extra cleaning of premises, or buying masks. But Mr Moec does not believe inflation is something that advisers will need to worry about in the near term, as he believes the reduction in economic demand has been so severe that inflation will remain low
Government debt never really needs to be paid back; instead it needs to be refinanced, that is, as the bonds mature and investors get their capital back, the capital is repaid with newly issued bonds.
The ten-year bonds of the UK government currently have an interest rate of 0.1 per cent. So, while it is not the case that the UK government will in ten years have to find all of the money to repay bondholders then, the uncertainty comes from what interest rate the government will have to pay on the debt in ten years, if it is much higher than the current rate, that will create future funding problems. But, Mr Moec does not believe inflation is something that advisers will need to worry about in the near term, as he believes the reduction in economic demand has been so severe that inflation will remain low for an extended period.
He draws a parallel with the world in the years immediately following the second world war, when governments rapidly increased spending, but inflation did not rise to unhealthy levels in those years, as the extra spending was replacing demand lost in the war, rather than creating an excess of demand.
Mr Moec says this shows: “There is no need for austerity to be used this time to get the deficit down.”
Neil Williams, senior economic adviser at Hermes, says the debt level will not be a problem for the wider economy as long as central banks are happy to let inflation rise.
The only remit of the Bank of England in terms of economic management is to achieve inflation at or near 2 per cent annually; if this was happening, the central bank may stop buying government bonds, and make it harder for governments to refinance.
He says he does not expect central banks to act in this way, as inflation was considerably below target prior to Covid; he anticipates policymakers will tolerate it being above target for an extended period.
Stephen Bell, managing director of Global Macro at BMO Asset Management, says that he does not believe inflation will be a problem in the near term, because the unemployment rate may be relatively high for a prolonged period of time. This is deflationary in an economy as it means individuals have less money to spend.
Bill Dinning, chief investment officer at Waverton, is less sanguine. He says: “There will have to be a reckoning, from all of this borrowing, it may be that inflation is higher and clients have to deal with that, or it may be something else.”
The nature of the recession
While the definition of a recession as two consecutive quarters of negative growth is universal, there are a multitude of different types of recessions.
The downturn caused by Covid-19 is what economists call an exogenous shock, that is, caused by an event outside of the financial system.
Such recessions tend to be very sudden, very deep, and over very quickly. They end relatively quickly because if the shock is from outside the system, as the shock subsides, the system is intact and activity can return to previous levels.
This is the thinking behind those who believe the UK economy will recover in a V shape. But Fahad Kamal, strategist at BNY Mellon, says this is not a typical exogenous shock-induced recession, because the impact of the pandemic may have changed long-term societal trends. He says those factors, such as remote working, will lead to “permanent“ changes in the structure of the economy.
Exogenous shocks do not typically leave permanent changes, but Mr Kamal says the combination of the Covid crisis and the changes to society are creating “lost growth” which will not be recovered by the economy.
The multiplier effect
The rationale for government’s increasing spending in a downturn was first created by the UK economist John Maynard Keynes, who described a “multiplier effect”. This is the idea that, if the government stimulus is spent properly, it can generate more activity and wealth in the economy than the cost of the original debt.
Some economic activities have a larger, and faster acting, multiplier than others. For example, a pound spent by the government on a construction project tends to move quickly through the economy as such a project employs many people in different trades and requires the purchase of raw materials.
If the multiplier in an economy works, then the pace and rate of GDP growth should increase rapidly.
Using borrowed money to increase the salaries of already relatively highly paid people may not have the same effect, as the extra salary may not be spent quickly.
But Hugh Gimber, chief market strategist at JP Morgan Asset Management says that despite the vast sums pumped into the economy, investors should not expect the multiplier to be high in the UK.
Mr Gimber says: “While a lot of money has been pumped into the economy, it has not delivered the traditional benefits of a stimulus. This is because while the money went in, we were told to not go out, we couldn’t spend it, so it didn’t multiply. I also think there are factors in the UK such as the ageing population that were already present and not really conducive to growth.
Mr Dinning says the borrowing and spending now may actually reduce the multiplier of future government spending. He says: “The cash that has been spent now is to sort out an emergency. It is absolutely the right thing to do, but it also is likely to mean that there is less ability to borrow in future, so there would be less cash for spending on long-term projects in areas such as infrastructure that contribute positively to economic growth.
"So it may be the borrowing now, lowers the longer-term growth rate in a way that is almost permanent.”
Mr Williams says other policy decisions taken over the past decade probably mean any multiplier effect will be much slower. He said the policy of quantitative easing, whereby the Bank of England buys government debt and other bonds helps to keep borrowing costs low, but also reduces the multiplier achieved on that debt. This is because the bond buying programme causes asset prices to rise.
So, for example, in the decade after the global financial crisis, house prices in the UK rose much more quickly than did incomes. This meant people seeking to get onto the housing ladder had to save more of their income and for longer to do this, and that reduces the amount they can spend in the economy.
With central banks continuing to buy bonds as part of the Covid response, Mr Williams says the rise in asset prices is likely to continue, meaning those that have to save to buy assets will need to save more.
In this way, “even if the policy succeeds in getting money into people’s pockets, which is not something that happened after the global financial crisis, higher asset prices will have an impact on spending levels and growth.”
Portfolio impact
Gero Jung, chief economist at Mirabaud says it is a central tenet of investment theory that if interest rates are low, then equities will rise in value.
This is because many equities are priced relative to the return available on cash on bonds. Low bond yields and low interest rates therefore make equities relatively more attractive. He says it is unlikely that interest rates will rise for many years into the future, and this will be supportive of equities.
Mr Gimber says the yield on government bonds is now so low that they are an unattractive income investment. He says: “The rationale historically for owning government bonds in a portfolio is that they are a diversifier and they pay an income. "But now they don’t pay an income and the diversification effects may not be as strong as in the past. I think real assets are more interesting, as they offer income and can offer inflation protection.”
Mr Moec says in the short-term the profits achieved by companies will be lower, as they deal with the higher costs of restrictions, but will not be able to pass the costs onto consumers due to the pressure on wages and higher unemployment. For this reason, he believes that investors will just have to accept lower equity returns for the foreseeable future.
Mr Bell agrees that returns to equity investors will be lower in the years ahead, but he believes the returns will be more attractive than those available from other asset classes.”
I hope you have found this information of interest but if you have any questions, please do not hesitate to contact me at any time.
With best regards,
Yours sincerely
