Thoughts through the cycle: W3 November ’20

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Enter the vaccine, exit the bubble

  • On the 9th November, Pfizer and BioNTech announced they had a vaccine that was 90% successful against Covid-19. While further trials and peer-reviews are needed, it is nonetheless a huge step forward in the fight against the pandemic. Using new ‘messenger RNA’ gene technology, the vaccine promises immunity levels previously unimaginable for coronaviruses and will likely stand as one of the great triumphs of science and of human ingenuity under duress.
  • If the Pfizer vaccine and others like it prove to be decisive weapons in the war on Covid-19, then one would imagine that the war will come to an end. As countless historical examples show though, winning the peace is often harder than winning the war, and even for the victors, the world changes and the status quo ante bellum proves elusive. The question here is how normal will the new normal be, and behind this is the real question of whether the price of victory was worth paying.
  • With government largesse in the form of furloughs, 2020 has been a year where for many if not for all, the financial and economic blow of lockdown has been softened. For many in white-collar jobs, the WFH phenomenon has been a paradise of sorts, with the expandable waistband of tracksuit bottoms proving to be the perfect partner to a new-found proximity to the biscuit tin.
  • For many, the end of the household bubble and the return to office life may therefore seem like being cast out of this easy-fitting paradise. As the painting below by Thomas Cole (‘Expulsion from the Garden of Eden’, 1828, courtesy of the Boston Museum of Fine Arts) illustrates, the harshness of the coming reality is foreboding. For markets too, happy to rally over the summer on endless headlines of vaccine hopes, perhaps there are also questions of bubbles ending, and with them some home truths about the cost of all this pandemic-related spending.

Reality – do not pass go, do not collect £200?

  • In the US Presidential election of 1920, Warren G. Harding’s campaign slogan was ‘back to normalcy’. Winning 60% of the vote, he promised to take America back to where it was before the Great War. 1920-’21 was marked by a severe global recession and deflationary episode as war-time spending ceased. This is exactly the sort of slump that central banks want to avoid today, and that governments in developed countries are unwilling to countenance. If the welfare state as an idea can be described as a ‘war on want’, then luckily for governments, it’s a war that never seems to end, and thus they always have a role to play, and that means a lot more deficit spending to come, not least because their existing furlough policies may be hiding higher rates of unemployment, and a jump here is politically unacceptable.
  • After World War I, the western nations tried with extreme vigour to get the global financial system back to where it was in 1914, yet turning back the clock ultimately proved futile. Due to massive capital destruction, the UK was unable to act as the financier of world trade as it had done before the war. Conflicts between the trade interests of the City of London and labour interests made the return to the gold standard a titanic struggle, and when Britain finally did so in 1926, it was to a gold-exchange system that differed from the pre-1914 vintage. The world had changed.
  • Britain’s relation to the gold standard in the inter-war years can be used as a paradigm for the radical change in governance in 2020 that is increasingly visible as a result of the pandemic. The classic pre-1914 gold standard only ‘worked’ with a small government and a central bank that was infinitely more limited in its scope than today. The eventual exit of the UK from the gold system in 1931 can be seen as an admission that this idea of small government had really ended in 1914, and the war itself had transformed the state in terms of both what it had to do at the time and what it would continue to think it could do or should do, even in peace time.
  • Roll the clock forward to 2020, and the fusion of monetary and fiscal policy in the form of Modern Monetary Theory (MMT) is now a policy if not fully accepted then at least becoming more acceptable. Green new deals, building back better, green bonds, and central bank digital currencies as a means of direct government lending and financing these type of projects ought to be seen for what they are. There has been a revolution in the powers of government in 2020, and this may well usher in an era of state planning of the sort which was last really fashionable in the 1940s.
  • The immediate reaction of markets to the vaccine news was to rotate a few equity factors around but assume that most of the world would really remain the same. ‘Sell WFH stocks and buy back-to-normal stocks’ can be seen in the graph below where Zoom (ZM.US in red) was tonked and AMC Entertainment (AMC.US, cinemas, blue) roofed on the news. Go algos!

Source: Bloomberg, 12th November 2020. Past performance is not a guide to the future. The price of investments and the income from them may fall as well as rise and investors may not get back the full amount invested.

  • Bond yields rose, gold sold off, the dollar rose along with more rotations, many of them just undoing the big moves from last week’s US election. Tech sold off and there was talk of the vaunted value vs. growth trade finally reversing after so many years, but the follow-through from these initial moves is yet to be seen.
  • The really interesting stuff though is going on outside markets, and is happening in real-time, not in the idealised read-through utopia of equity market factor trading. Europe is in lockdown and risks a double-dip recession even if lockdown 2.0 is shorter and less severe than the previous one. With one eye (both eyes) on the run-off Senatorial election in Georgia, McConnell and the house Republicans are talking down stimulus and somewhat cynically, talking up Trump’s election dispute to energise the base. Without further large-scale stimulus, the US also risks a double-dip recession in Q4. So much for ‘back to normal’ eh?
  • One could argue that the single most divisive issue following World War I was the issue of debt – who should pay for what? The Germans owed reparations, and the British and French owed the Americans (Russia was out of the picture following the Bolshevik revolution). The issue of paying debts, especially those debts which have been ‘on hold’ due to the pandemic in the form of payment holidays and the like, is likely not only to be the most pressing one but the one most overlooked by financial markets.
  • Ground zero for bad debt always seems to be Europe, and true to form, the ECB’s chief advisor Andrea Enria has warned of the risks of a ‘huge wave’ of unpaid loans (the figure mentioned is a staggering €1.4tn) should loan moratoria all expire at once forcing a reckoning about who can pay and who cannot (‘Pandemic payment holidays mask wave of European debt problem’, Reuters, 11/11/2020). Research by Reuters suggests the figure of loans still not being paid is a smaller but nonetheless hefty €320bn. The problem with the ‘extend and pretend’ strategy is that you have to keep on extending. Back to normal comes with a price tag if that means the payment holidays end.
  • The German regulators are wise to the problem too, with BaFin warning on the 12th November that they expect to see credit losses hitting banks’ balance sheets, adding that some banks are set to fail. The regulator is also advising against the resumption of bank dividend payments. Looking at the euphoric rally in the SX7E European Bank Index (graph below) as it reacted to a steepening of the yield curve following the vaccine news, one wonders how many of those piling into the European bank stocks have given due thought to the bad debt and dividend issues.

Source: Bloomberg, 12th November 2020. Past performance is not a guide to the future. The price of investments and the income from them may fall as well as rise and investors may not get back the full amount invested.

  • Over in the US, the banks also rallied as the yield curve steepened. What is interesting is that the same day as the banks went bid, the US Federal reserve Senior Loan Officer Opinion Survey on Bank Lending Practices was published, revealing a tightening of lending standards for all commercial and industrial (C&I) loans to all sizes of businesses, as well as a fall in demand for such loans. A similar story emerged in householding lending, both for residential real estate (RRE) as well as unsecured lending on credit cards and the like. This is a classic symptom of the recessionary stage of the credit cycle where corporates and households repair their balance sheets by paying down debt.
  • All is not lost though. JP Morgan (JPM.US) announced that it was going on an offensive in terms of mortgage lending to the backdrop of rising house prices across the country. Marianne Lake, CEO of the bank’s consumer lending division was quoted as saying, “In the case of home lending in particular, we’ve walked back some of our constraints in a reflection of the fact that we’ve seen home prices continue to improve,” adding, “There’s no question that the last decade has been a quite challenging decade for home lending for the industry, and we were not an exception. A lot of that is in the rear-view mirror. I feel like we’re more on the offensive than the defensive.” (‘JPMorgan Relaxes Mortgage Curbs With U.S. Housing Prices on Rise’, Bloomberg, 10/11/2020).
  • The great criticism of quantitative easing (QE) is that it never helped the real economy. Money got stuck in the financial system in the form of bank reserves at the Fed, and the banks themselves didn’t necessarily lend out to people or companies in the real economy. If JPM’s change of tune is anything to go by, then this issue of lending to the real economy may well be changing, notwithstanding the Fed’s October lending report.
  • US personal savings as a percentage of disposable income peaked at 34% in April and are still at an elevated 14.3% as of September (vs. 7.6% in January 2020 say). That reflects a lot of potential pent-up demand that could be unleashed on a vaccinated US economy. Add in an uptick in bank lending, and a Democrat in the White House wanting to build back better (and probably greener and in other ways too), the recipe for an inflationary surge in the US to accompany the reopening and back to normalcy process is there to be seen.
  • As ever, the more one looks, the more complicated the picture becomes. Perhaps back to normal this time is a sort of parson’s egg affair – good in parts. Different countries and different sectors will see varying inflationary and deflationary pressures, and it’s the job of investors to navigate this altered landscape in 2021 as best they can.

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