This email to clients updated our earlier information on 21st March on the impacts of coronavirus on our modelling of real spending outcomes for their spending plans. This takes into account the extraordinary scale of governments’ intervention in economies, potentially challenging our model assumptions. Our conclusions are that our modelling remains valid and that the longer-term impacts mainly affect inflation and therefore investment processes exposed (unlike ours) to bonds.
An update on the impacts of coronavirus on financial plans
Chris Ling’s email of 21st March, before the lockdown was extended, implied the impact of coronavirus on equity markets was within the parameters of our equity-return model:
‘If the market situation worsens before it gets better, we urge you to take comfort from knowing that your plans assumed incidents of extreme market stress so that whilst the potential for higher spending may now have been reduced, the bottom end of the forecast range remains valid.’
What we now know about the extraordinary scale and nature of the UK Government’s intervention invites a fresh considered opinion. And then there are the responses other governments are making that will be felt on national and regional indices we invest in. Some of these will be far more influential on global trade and capital markets than the UK’s, although I would like to think we are showing the way.
The first thing to acknowledge is the scale and also reach of governments’ intervention, which makes it legitimate to wonder whether we can really comprehend its impacts. ‘Where is all the money going to come from’, we hear. The key insight, in our view, is that the economic impacts of containing coronavirus are likely to be similar to those resulting from the measures to contain the banking crisis of 2008/9. Indeed, were it not for recent shared memory of coping with the global banking crisis, which itself ‘broke all the rules’, governments’ response would probably have been far less bold.
This insight is important because it implies it is not quite as untried as we might otherwise fear. It is tempting, because of how the containment measures feel, to view it as more akin to war, catastrophic climate change or a nuclear accident. But whereas these imagined analogies may permanently damaging physical assets and productive capacity, this need not be the case now.
What the banking crisis and coronavirus have in common with each other is governments intervening in the economy to perform a function that can no longer be carried out by the normal participants, to keep money flowing as much as possible through the economy. They are effectively printing this money, as central banks buy the debt created by governments’ intervention. Printing money is not outside the equity market real-return histories. Far from it, in fact.
In common with wars, government is taking over a significant proportion of employment earnings but, unlike in war, it does not require production to be maintained. In this instance, keeping production up is not feasible. What is necessary and feasible is to pay wages. If governments do not take on this role, the banking system would be exposed to possibly unsustainable losses via its exposures to both individuals and companies. We are being warned to expect to see falls in countries’ GDP this year of between 10 and 20%, even with intervention to cushion employment incomes. The degree is clearly sensitive to the unknown duration of the restrictions on activity as well as the nature of the restriction. But this is mostly output postponed. It can be postponed without necessarily seriously damaging future productive capacity. The value of banking collateral, particularly residential and commercial property, may be impaired but that too may be mainly temporary.
The UK Government’s bold and practical intervention to date fits this general description very well, in both form and scale. So, we note, does Switzerland’s.
Less certain is whether the individual members of the EU, or the EU institutions themselves, will be willing or able to intervene on the same scale and with the same speed. This is not possible from an EU budgetary point of view, because the EU budget is tiny, but individual members’ response is constrained by EU rules governing their own fiscal and monetary behaviour. An interesting speculation in relation to this is whether the virus will trigger the fiscal union that is already marked out as the key battle ground for the future of the EU. Will we see EU-guaranteed Corona Eurobonds? Indeed, what is the point of the EU, if not risk sharing and mutualisation, considering free trade can be organised well enough without such a vision?
The US response is arguably much more important. This is still evolving, initially from stimulus to more of a ‘substitution’ model like the UK. Just as a week makes a big difference to the spread of Covid-19 and the resulting containment policy, so also will a lag of just a week in terms of the scale and form of the government intervention in money flows. So far, the response appears fortunately not to be handicapped by a presidential vision habitually distorted by the prism of imagined enemies of the state, amongst which none looms larger than science.
The more the policy response to coronavirus is, in most countries, similar to the banking crisis, the more the eventual, and perhaps enduring, impacts on private wealth depend on the exit from unorthodox monetary policy. That impact is likely to be mainly via inflation. This was always the case with Quantitative Easing. The question mark just got even bigger.
As a client of Fowler Drew, you do not need to know the answer to the question because you do not hold conventional, inflation-exposed debt instruments, whether issued by governments or any lesser credit. Risk free assets are either cash for short-horizon liabilities or index linked gilts for longer horizons. But this is not true of most private wealth management, which relies on mixing debt instruments (not cash) with equities in order to target some level of combined portfolio volatility. The same short-term effect on portfolio volatility could be achieved by investors holding more cash and less exposure to equity volatility. As it is, reliance on bonds effectively trades off short-term volatility effects against long-term exposure to inflation and (possibly) credit risk. This is not a good trade off to make at the best of times and certainly not when investing in a time of unorthodox monetary policies.
In conclusion, we are confident restating our earlier views.
The trend real returns for equities will not be noticeably affected by coronavirus as the productive capacity of the world’s economies should not be seriously affected. There is always uncertainty about the growth trend but the reasons for any specific or generalised shift up or down are not usually evident until after the event and arise much less often than they are predicted before the event. The equity return model’s contribution to our estimates of worse-case plan outcomes is not invalidated by coronavirus. As Chris pointed out, not only are we assuming anything that has happened anywhere in an equity market can happen again, but we also assume it can happen in all markets at the same time, and that it can persist. The persistence effect even ignores the model’s presumption of mean reversion, by making the time slice outcomes independent of each other (which is not entirely logical but builds in another level of prudence). The longer-term effects, determined by the exit from unorthodox monetary policy combining both episodes, the credit crisis and now coronavirus, will be felt mainly on inflation, not output or equity returns. Inflation risk is allowed for in the equity return model: the data histories contain a wide range of price regimes from deflation to high and volatile inflation. Only hyperinflation in Europe and Japan has been excluded, by starting the data series after those episodes. Inflation is specifically excluded as a source of risk in the bond portion of portfolios by holding only inflation-linked bonds and it is minimised when rolling over cash deposits held against short-term liabilities.
We can only make these claims because we chose to adopt a text-book solution that we decided was best suited to managing a spending plan: matching assets to real cash-flow liabilities at every horizon, with the range of outcomes for each cash flow controlled by dynamically altering, through time, a high-level mix of equities and real, risk free assets.
We will add to these comments as events unfold.
With all good wishes,