Storm of the century

Global fiscal and monetary stimulus measures sparked by the COVID-19 pandemic have been massive and many investors are wondering about the short and long term implications. Vin de Lucia, Chief Investment Officer at New England Asset Management (NEAM), gives his thoughts on where we are headed, in particular with inflation. Longer term he believes the fallout could lead to supply chains being less global with a greater focus on bringing manufacturing processes closer to home, a big discussion about the distribution of profits between capital and labour and inevitably higher taxes at both the corporate and individual level.

As we began 2020, and services. To appreciate why, one the global economy needs to consider the following critical was on relatively fact: Rising price levels for goods and sound footing, with services are ultimately a function of a “phase 1” trade end demand which drives prices of raw deal between the “As we begin to emerge materials, labour and services. US and China proThe aging demographics prevalent viding some tailwind. Now as we head from the shutdown period, across advanced economies, combined through mid-year, unemployment with efforts toward globalisation over rates across most of the globe have it is entirely possible that we the last 25 years have been significant risen massively and budgets have been counterweights to price level increases upended by the extraordinary impact experience some temporary and have mitigated the inflationary and economic dislocation caused by tendencies of ultra-easy monetary Covid-19. price increases as demand and fiscal policy. Demographics in

The combined fiscal and monetary developed economies puts a proverbial response has amounted to over 20% of may temporarily outstrip lid on end demand while globalisation global gross domestic product (GDP), of supply chains has kept both much of it financed by additional supply in various areas.” materials and labour costs in check. borrowing, particularly in the US. This Another more recently discussed turn of events has investors concerned item of note which has held inflation about the long run impact of these Vin de Lucia in check is income inequality. While emergency measures. New England Asset Management (NEAM) income inequality is not usually INFLATION: STIMULUS VS. it most certainly has played a role. DEMOGRAPHICS With greater concentration of wealth To say that the last few months have been stunning is in fewer hands comes a disinflationary impulse, since the stating the painfully obvious. The US government mandatmarginal dollar is saved (or invested) versus consumed ed rescue programs are to be financed by the issuance of by those with the most wealth. Hence, while income and even more debt which will be purchased in large part by the wealth disparity are discussed in terms of “equity” or what seemingly endless rounds of quantitative easing have ballooned central bank Federal Reserve and other central banks. These are price insensitive buyers, effectively creating money out of thin air. balance sheets to levels is fair versus not, it can also be thought of in terms of suppressing end demand which ultimately is what pushes once unimaginable (see chart 1). This scheme will ostensibly keep interest rates very low since these central banks are poised to buy as much debt as price levels higher. Hence, despite easy money policies which keep interest Chart 1. Central Bank Balance Sheets as a Percentage of GDP necessary to fund the rescue measures. This begs the question of whether this can go on ad infinitum, or whether CENTRAL BANK BALANCE SHEETS Central Bank Balance Sheets at some point, inflationary pressures As a percentage of GDP as a Percentage of GDP make a comeback. This question has 50.0 120.0 been pondered for over a decade now, as zero interest rates, negative interest rates and seemingly endless rounds of quantitative easing have ballooned central bank balance sheets to levels once unimaginable (see chart 1). Yet despite the seemingly endless money printing which largely became the policy prescription of choice after % of GDP (U.S., EU, UK) 5.0 10.0 15.0 20.0 25.0 30.0 35.0 40.0 45.0 20.0 40.0 60.0 80.0 100.0 % of GDP (Japan) the financial crisis in 2008-2009, 0.0 0.0 inflation in the price of consumer goods and services has remained benign. 1/1/2008 12/1/2008 11/1/2009 10/1/2010 9/1/2011 8/1/2012 7/1/2013 6/1/2014 5/1/2015 4/1/2016 3/1/2017 2/1/2018 1/1/2019 12/1/2019 To illustrate this, we have used the US Consumer Price Index (see chart U.S. Federal Reserve European Central Bank 2). Indeed, monetary policies have had Bank of England Bank of Japan a much greater impact on financial discussed in the inflation context, asset prices than on prices for goods Source: Bloomberg, NEAM Source: Bloomberg, NEAM The Marine Insurer P&I Special Edition | July 2020 Yet despite the seemingly endless money printing which largely became the policy prescription of choice after the financial crisis in 2008-2009, inflation in the price

Chart 2. U.S. Consumer Price Index (CPI) as a Measure of Inflation

rates at astonishingly low levels, unless sustained end demand gathers momentum, it seems very U.S. CONSUMER PRICE INDEX Year over year change U.S. Consumer Price Index Year over Year Change likely we will continue to see more of the same – asset price inflation 4.5 without a corresponding and 4.0 . sustained lift in general price levels. 3.5

As we begin to emerge from 3.0 the shutdown period, it is entirely 2.5 possible that we experience some temporary price increases as demand may temporarily outstrip supply in various areas. Oil and 0.0 0.5 1.0 1.5 2.0 gasoline prices, for example, -0.5 are likely to rise as we reopen economies globally. Oil production had declined by over 10 million barrels per day (mpbd) and is now 1/1/2010 6/1/2010 11/1/2010 4/1/2011 9/1/2011 2/1/2012 7/1/2012 12/1/2012 5/1/2013 10/1/2013 3/1/2014 8/1/2014 1/1/2015 6/1/2015 11/1/2015 4/1/2016 9/1/2016 2/1/2017 7/1/2017 12/1/2017 5/1/2018 10/1/2018 3/1/2019 8/1/2019 1/1/2020 at around 8mbpd less than preCPI Year over Year Change 12 month moving average Fed Target crisis, so we may now need to reestablish equilibrium because of supply side considerations. Time Source: Bureau of Labour Statistics, NEAM Source: Bureau of Labour Statistics, NEAM will tell, but if major central banks are to be successful in maintaining core consumer price inflation (and expectations) at or above their target levels of 2% on Another more recent leverage to enhance shareholder gains will, one way or ly discussed item of note which has held inflation in check is a sustained basis, some combination of the previously discussed factors will need to change. another, be asked to shoulder more of the “insurance” costs going forward. income inequality. While income inequality is not usually discussed in the inflation context, it most To that end, policy adjustments will be necessary certainly has played a role. With greater concentration of wealth WHAT LIES AHEAD? Looking ahead to the next three to five years, we will to deal with the massive costs of this pandemic or the endless monetisation of debt that will eventually be likely in fewer hands comes a disinflationary impulse, since the marginal dollar is saved likely see a world where supply chains are less global with (or invested) to significantly debase all major currencies. versus consumed by those with the most wealth. Hence, while a greater focus on bringing manufacturing processes closer to home. In a post Covid-19 world, where government is called upon to be the lender of last resort and the guarantor of income and wealth disparity are discussed in terms of “equity” or what is fair

The last 25 years has seen a focus on cost minimisation versus not, economic and financial stability, tax rates will likely rise it can also be thought of in terms of suppressing end demand which via globalisation. The next several years will likely focus on national security and self-sufficiency, particularly in key ultimately to compensate for the fact that only governments have the wherewithal to deal with systemic shocks which, is what pushes price levels higher. areas of pharmaceuticals and medical supplies. Somewhat when they occur, entail enormous costs. Corporate tax higher price levels should be accepted in exchange for rates should probably rise first and most, but individual Hence, despite easy money policies which keep interest rates at astonishingly low security and national pride. Another likely outcome of the pandemic is a tax rates will also likely rise. This seems likely to be a global phenomenon and we would expect this topic to levels, unless sustained end demand gathers momentum, it seems very likely we reassessment of the distribution of profits between capital find its way onto the agenda of future G-20 meetings. will continue to see more of the same – asset price inflation without a and labour. For decades, capital’s share of profits has increased as compensation for labour was held in check, Insurance has a cost, and it will likely be paid for in the future by higher taxes at both the corporate and corresponding and sustained lift in general price levels. as were consumer prices, by globalisation and automation. There is, once again, an acute awareness that profits are individual level. NEAM is maintaining our emphasis on fixed income As we begin to emerge from the shutdown period, it is entirely possible that we distributed to shareholders while systematic downside spread products, as the rescue measures and Fed, ECB, experience some temporary price increases as demand may temporarily risks are “nationalised.” As “the bills come due”, this will attract more attention, supply in various areas BoJ and BoE programs have supported credit markets. There is likely additional assistance coming for US state . Oil and gasoline prices, for example, are likely to rise as given we currently have some of the highest rates of and local government as well, as they navigate the abrupt unemployment that developed markets have seen since the interruption of heretofore steady income streams. If the Great Depression. While wage inflation isn’t on anyone’s duration of the disruption is measured in months and not radar with the spike in unemployment rates, it does seem years, most states, local governments and agencies should quite plausible that companies that employ financial be able to weather the storm of the century.

ISSUE 2 | MARCH 2020

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