New article from Tatton Investment Management: Government ordered recession

23 March 2020

Just like the spread of the COVID-19 coronavirus itself, the rate of policy change over the last few weeks has been astounding. A week ago, Boris Johnson and co. were content to isolate the sick, have the public wash their hands and provide £30bn to fight the virus – but otherwise go about business more or less as usual. Since then, the country has been told to stay at home, schools and universities have closed, 20,000 military personnel have been put on standby and the government has increased its fiscal support against the virus fallout to £350bn. In London, heavy travel, shopping and socialising restrictions are to be imposed and – despite the government’s claims otherwise – rumours abound that the capital is to be sealed off and put into lockdown. Given how fast things are now changing, this could be out of date news by the time of reading.

It has also become rapidly and abundantly clear that we are plunging into a global recession of potentially unknown proportion and duration. Under government orders, economic activity for this quarter, the next and possibly beyond, will be substantially lower than before. Consequently, risk assets have nosedived as analysts continuously adjust their corporate profit expectations downwards while faced with unprecedented levels of uncertainty over the parameters of their estimates. Every day, as the virus restrictions affect more people, the capital market rollercoaster begins the moment trading opens.

This week we have seen equity markets still experiencing huge gyrations. However, it has been violent swings rather than constant falls. However, assets hitherto regarded as safe havens, like gold and government bonds, have had a much tougher time amidst a frenzied cash grab. Some have argued that prices for all types of assets this week became detached from any form of economic reality, bar global Armageddon. Indeed, some central banks and others have given up even trying to forecast what that economic reality might be.

This has raised the fear that capital markets trading very close to the borderline of ‘disorderly’ may trigger another global financial crisis akin to 2008/2009. We think there are crucial differences. Back in 2008/09, the problem was a systemic financial one. Investors bought debt that looked safe because it was ‘secured’ with assets. But those assets were themselves debt; and often they were also secured by more debt. When trust ‘left the room’, that circularity meant the whole system came crashing down around us. Because the borrowing spiral started with real peoples’ mortgages, the feedback loop with the real economy paralysed global activity. But the problems began in markets and spread from there.

This time, it is the other way around. A huge, natural, external shock has caused an economic downturn, one that has been ordered by governments as a trade-off against mass loss of life amongst the elderly and infirm. In turn, this has dampened market expectations and also raised fears over mass defaults by companies and private individuals. True, market dynamics have now picked up their own steam – which could cause problems of their own later. But the problem is, first and foremost, a natural shock.

That has important implications for how we get over and out of it. Back in 2008, there was no clear consensus on what the right policy response should be. In the public’s eyes, a small group of irresponsible gamblers lost everyone’s money and then asked for huge taxpayer handouts so they could continue their lives of luxury. Bank bailouts were therefore harder to come by, and politically were hugely unpopular when they did occur. What’s more, when the economic fallout from the banking collapse hit home, many governments around the world eschewed fiscal support programs through public funds in favour of the popular ‘tightening our belts’ soundbite.
None of that seems at all likely now. When it is an overarching societal interest and consensus that human activity has to be temporarily suppressed, then it is just as acceptable to bridge the financial chasm this action opens for businesses and individuals through unprecedented fiscal heavy lifting. That is why no one seemed to be particularly objecting to the government committing vast amounts of money, not only to containment measures or healthcare but also as a way of supporting those suffering under unprecedented activity restrictions that are no fault of their own.

Chancellor Rishi Sunak announced on Tuesday the £350bn support and rescue package for UK firms struggling with the impact of coronavirus. This comes on top of the already-guaranteed access to statutory sick pay and other benefits for individuals, as well as promises on tax exemptions. Across Europe – where budget rules have long prevented highly desirable public investment to overcome the slow growth malaise of the past decade – a consensus is building that the state has to act boldly. Indeed, expectations are that states must use every measure at their disposal to ensure that the global economy can as suddenly be switched back on as it has been switched off. This will only be possible if the collateral damage suffered in the meantime is limited to the absolutely unavoidable.

Crucially, unlike over the last decade, the dissenting voices of ‘how do we pay for this?’ are almost nowhere to be heard. This has nothing to do with government or central bank balance sheets suddenly being in a better position around the world – far from it. Rather, the agreed upon strategy is just that governments will borrow heavily via bond issuance. Interest rate costs will remain around the current historic lows nearing 0%, because central banks will buy existing government bonds with money they just printed.  

In short, the plan is: central banks print money for governments, who give it to their citizens to see them through the crisis. If that seems extreme, that’s because it is. But the growing consensus among policymakers – and the public – is that the world simply has no choice.

That kind of approach of course can bring its own challenges later down the line. Once the world opens up for business again, depending how ‘de-mob happy’ consumers will greet that event, these measures will likely result in a recovery boom that will push both bond yields and inflation substantially higher than we have been used to since the financial crisis (We cover this point more in a separate article in the downloadable document).

We would note that this might not necessarily be a bad thing, at least for the economy. In these extraordinary times, extraordinary measured are required to mothball the status quo before the virus outbreak to keep things in working order until we emerge on the other side. If we manage to get it right, then our economy’s productive capacity will still be there and more or less ready to be used once things return to normal. There are of course many complications along the way, but there is light at the end of the tunnel.

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