How COVID-19’s Deflation Shock May Spawn Inflation Outbreak
Coronavirus has sent economies swooning, toppling consumer price indices. Rebounds in stock and bond markets on policy stimulus don’t mean market volatility is over, or that inflation is dead.
In the month to mid-March, COVID-19 drove the S&P 500 Index into bear market territory and corporate bond spreads up by several multiples. Less than a month later, U.S. blue-chip stocks, along with most global equities, rebounded into bull territory while credit spreads tightened by more than a third, as fiscal and monetary authorities open the stimulus floodgates to buoy fast-sinking economies.
Investors cheered by the waves of liquidity should keep in mind that many industries are operating far from capacity. While lockdowns to “flatten infection curves” help hospitals from being overwhelmed, they have sharply depressed demand for, and supply of, goods and services, as businesses retrench and unemployment skyrockets. Near term, this is deflationary, as economic growth collapses, bringing down prices with it.
Longer-term, though, investors shouldn’t ignore the risks of artificially fueled asset prices divorced from their underlying business fundamentals, and, at the macro level, the risk that long-lost inflation returns. Such risks simply can’t be discounted because “ZIRP” (zero interest rate policy), “NIRP” (negative interest rate policy) and “QE” (quantitative easing) didn’t produce inflation after the 2008/09 Global Financial Crisis.
This Time Is Different: Much More Severe Crisis, and Far Bigger Policy Response
The scale of the stimulus this time around is at least an order of magnitude greater, because fiscal stimulus is now complementing monetary stimulus, and banks, rather than seeing regulation and capital requirements sharply rise, are being used as conduits to get government aid to people and companies. Roughly half of the more-than $16 trillion in global stimulus is fiscal, much of which is central bank-financed debt monetization. The U.S. is leading the way, with combined monetary and fiscal stimulus of $7.62 trillion, equivalent to more than a third of national GDP. The eurozone and Japan are throwing more than 20% of their respective GDPs at their thawing if not frozen economies.
The U.S. Federal Reserve has certainly kept the financial-market plumbing from seizing up, preventing a liquidity crisis from turning into a solvency crisis and, in turn, impacting the banking system. After hitting a daily sky-high of 83 on March 16, the CBOE Volatility Index, the “Fear Gauge” reflecting market expectations of volatility over the next 30 days, has receded to around 40. That’s still about two-and-a-half times its average level over the last five years.
But as ugly economic and earnings data roll in, more volatility shouldn’t surprise. U.S. jobless claims over the last four weeks have topped 22 million. Consensus estimates put the U.S. economic contraction in the second quarter at a dizzying -25%, with rebounds of 7.2% and 5.7% in the third and fourth quarters. China’s 6.8% contraction in the first quarter was its worst in modern history, though it’s expected to snap back over the next three quarters. The International Monetary Fund has just chopped its global growth forecast for 2020 to -3% from +3.3%, which would be a far deeper decline than the -0.6% world-wide recession registered in 2009.
The IMF expects global growth to rebound 5.8% next year, with both the U.S. and eurozone jumping 4.7% and China soaring 9.2%. At the same time, it’s predicting consumer price rises of 1.5% in advanced economies and 4.5% in emerging markets. Bloomberg consensus sees U.S. CPI for 2021 at 1.7%, up from 1.0% this year, and China’s at 2.1% next year, down from 3.3% this year.
The assumptions built into those economic growth forecasts seem to incorporate second-quarter lifting of stay-home and business closure orders in the U.S., Europe and elsewhere, much as China’s labor force has largely returned to work since it shut down roughly three months ago.
Portfolios That Can Survive and Thrive in Adverse Environments
Whatever the assumed recovery timeline, though, the longer economies are hobbled by social distancing to constrain COVID-19’s spread, the longer the current damage to them, and the deflationary overhang, will linger. Elected officials in the U.S. are already suggesting that more government stimulus is necessary, and doubtless took note of Fed Chairman Jerome Powell’s statement last month that the Fed’s firepower is limitless. But money creation to finance budget deficits is usually inflationary, as Latin America learned in years past. The U.S. now risks learning it: Goldman Sachs forecasts a U.S. federal deficit for the current fiscal year ending in September of $3.6 trillion, or about 18% of GDP.
Whether a quick V-shaped rebound or drawn out U-shaped recovery, one thing is clear: a lot more money will ultimately be chasing fewer goods and services. That should not just juice risk asset prices, but also prices on those remaining goods and services available, once the economy starts to mend and consumers, after so much pent-up demand, begin spending again. That’s particularly so as more stimulus this time around is going straight to consumers and Main Street rather than Wall Street.
Moreover, if populism continues to gain steam and drives deglobalization in the form of trade tariffs and supply-chain re-alignment, which seems probable with respect to medical equipment and pharmaceuticals, production costs will also rise.
“Suppressed demand will come back and surge, which could trigger a shortfall of supplies as consumption should rebound before production normalizes,” says Portfolio Manager Lei “Rocky” Wang, who runs Thornburg’s international equity strategies.
While the pandemic may depress consumer and business sentiment for a while, restraining spending and investment, notes Wang, who early in his career worked at China’s central bank and a New York-based hedge fund trading currencies, “once the virus is under control, what will remain are very elevated public debt levels and political pressure on central banks to maintain low benchmark interest rates.” Sea-level interest rates amid an ocean of monetary and fiscal liquidity, less efficient supply chains and normalizing economic activity could together create a powerful inflationary impetus.
We’ll see if central bankers are disciplined enough to raise interest rates in a timely fashion. They tend to take the elevator down, and the escalator up, as the market saying goes.
Fundamental investors with an eye on the bigger picture can take advantage of continued market volatility to upgrade and position their portfolios to perform in a variety of market climates. Thornburg strategies have been targeting attractively priced securities of highly select companies with strong business models and balance sheets, visibility into future cash flows, as well as quality management. “In our experience,” Wang says, “these are the kinds of portfolios that can survive and thrive in adverse macroeconomic and volatile market environments.”