Covid-19, and the Long-Term Impact on Globalization
With the 10-year Treasury yield breaking 1% last week and more than $14 trillion of negative-yielding sovereign debt worldwide, it seems almost axiomatic that the least held view among market participants is the potential for a return of inflation. There is a certain irony in this given the fact that the world’s central banks have so eagerly attempted to create it since the Global Financial Crisis. The never-ending cycle of creative destruction is the main reason why deflation rather than inflation is the natural order of things over the long arc of history. Good deflation, rather than inflation, is the rule rather than the exception. Our sad experiences with persistent and rapid increases in the aggregate prices of goods and services generally tend to evidence themselves only after periods of extraordinary monetary and fiscal profligacy. Weimar Germany’s money printing after World War I and America’s guns and butter policies of the ‘60s and ‘70s stand as examples, although far different in degree.
One wonders whether the outbreak of the coronavirus will change the world’s perception of the global economic system as much as 9/11 changed the world’s geopolitical landscape. In the final analysis, our collective experience during 9/11 appeared to be a sad coda to the heady, relatively carefree speculative days of the 1990s. The tragedy was sufficiently horrific, shocking, and visible that it permanently changed the way people thought about their own security in the West after nearly six decades of peace from hostile actors, at least on home soil. Time will tell whether the outbreak of the coronavirus will serve as a similar historical marker with regard to the generally accepted principal that globalization is always and everywhere good and that sophisticated mathematical models can make just-in-time inventory systems forever reliable. At any rate, it is undeniable that globalization has been a major contributor to the decline in inflation over time, accelerating markedly when China joined the WTO in 2001. It is also undeniable that the status quo ante of China’s relationship with the rest of the world has been inalterably changed since President Trump was elected. While it seems clear that the coronavirus is deflationary in the short-term, investors should now wonder whether a slowing in the pace of globalization will correspond to a concomitant increase in inflation over the long-term.
With the exception of the President, few policymakers were willing to question what the real meaning of free trade meant when it came to dealing with a country that fixed its currency and had different conceptions about private property and liberty. Trump was also the first with political power to openly question what the costs of near-cost flat panel television screens and tube socks might be to the typical middle class American. Like it or not, the President has permanently changed both public and elite opinion about just what constitutes free trade in America among both Republicans and Democrats. Similarly, permissive immigration policies in the U.S. and Europe have led many to wonder where the lines limiting the march toward globalization should be drawn. What is clear, as the Brexit movement indicated, is that there are limits, even among culturally similar populations. If your typical C-suite executive in the West wasn’t already wondering about the potential risks of over-concentrating its supply chains in one country during the trade war between China and the U.S. last year, he or she must be reconsidering the wisdom of such policies now as productive capacity is shuttered and the freedom of movement is curtailed.
Upon President Trump’s ascendancy to the Oval Office, we viewed the proposed policy mix of the new Administration as manifestly inflationary. The prospects of easier financial regulation, greater spending on defense and infrastructure, a tax cut, and a tightening of trade policies in an environment of already accommodative monetary policy all seemed to suggest to us that inflation was inevitable. So far, our concerns have been misplaced. In the last three years, the emergence of negative interest rates appears to have contributed far more to massive inflation in financial assets while simultaneously leading to disinflation of goods and services. A dearth of attractively yielding securities has rendered the cost of capital so low that all but the very weakest companies get to survive. Each successive round of interest rate cuts leads to an appreciation in the securities of weak companies and a greater inability to achieve pricing power for everyone else. Companies seeking to be profitable find it difficult to compete with companies merely seeking to generate cash flow. Ironically, this benefits the wealthy far more than it does the poor or the middle class. Those with financial assets prosper while those with merely “savings” see yields dwindle to zero. It could be credibly claimed, in this regard, that central bankers have been among the biggest contributors to the condition of income inequality they so often bemoan.
After nearly 10 years of waiting for rate normalization, it is quite easy to claim that inflation is dead and that we have killed it. So many of the things we point out to our clients in meetings about the current state of the global economy and the markets – that equity valuations are reasonable at current interest rates, that 50% of America’s $23 trillion in debt matures in the next three years, that low rates and TINA favor both high-valuation growth stocks and defensive stocks at the same time, and that flows into private equity as a silver bullet asset class for those with unrealistic investment return assumptions continue unabated – are based on the now-consensus belief that inflation will remain quiescent and long-term interest rates stay low indefinitely. In essence, the investment community is betting on the continued “Japanification” of the global economy.
Given the tolerance of most developed economies to accept this state of affairs since the Global Financial Crisis, it isn’t a bad bet. Still, we think it’s important to note that Japan is very different culturally than other developed countries in the West. In Japan, the nail that sticks up gets batted down. In Europe, despite the best efforts of the political class to enforce a certain shared interest among disparate countries, each with their own culture and language, cracks are evident as England’s experience with the Brexit vote demonstrated. Secular stagnation may be tolerable for Germany, which runs both a trade and budget surplus of 7.3% and 1.5% respectively while enjoying near full employment. But it might no longer be so tolerable for a country like Italy which, in contrast, has suffered an unemployment rate above 9% since 2011. Despite this disparity, the panjandrums in Brussels blanched when Italy proposed spending last year that would have led to a slight increase in its budget deficit to 2.2% of GDP. Greater intransigence on the part of the EU in light of the outbreak of the coronavirus in Italy will only serve to strengthen the power of Euro skeptics like the League’s Matteo Salvini. Recently, the leader of a party that represents more than 30% of the electorate wrote, “Either we change the rules of this Europe from inside or, as a fisherman from Bagnara Calabra told me, we do the same as the British. Either the rules change or it is useless to stay in a cage where they prevent you from being a fisherman, a doctor, a researcher.”
For its part, the American economy is holding up well. This is due in no small part to a concurrent easing of monetary, fiscal, and regulatory policies. While America’s reserve currency status allows it to run twin deficits without much of a problem, it is just a matter of time, in our estimation, before political forces lead to a similar policy mix among the G7. Although it appears as if the Phillips Curve is broken, it is not difficult to imagine that a refinancing boom coupled with what will likely be further Fed easing and the potential for coordinated fiscal stimulus in the context of near full employment will lead to a V-shaped bottom and upward pressure on prices. Sadly, the outbreak of the coronavirus is likely to lead to a greater atomization of national politics and economic policies rather than a greater embrace of globalization. It will only be then that we will be able to determine whether inflation is indeed dead or has been merely dormant. To paraphrase Yeats, we will learn - as things fall apart - whether the center can hold.