27-3-2020
I would like to focus on the outlook for the next 3 years of our economy. This would be my guidance for the next 3 years. By no means, this is not fixed and economy situation is fluid. I hope to find the law of gravity that governs our investment as we look forward.
The recent swings of stock market is anything but steady. The Fed push USD4 trillion stimulus. US government push USD2 trillion stimulus. The EU nations is preparing to push huge stimulus as well. Never been in our history that both monetary and fiscal stimulus been simultaneously pushed forward. Most would have known Great Depression, 1987 Panic, 2008 Financial Crisis, they are either fiscal stimulus or monetary stimulus but neither together. Not only we are pushing both fiscal and monetary stimulus, but also it will be the first stimulus that is neither war nor recession. It is unprecedented. We are witnessing history. There will be impact.
On short term (3-9 months) scenario, I agree with Ben Bernanke assessment. There will be a fairly sharp downturn, perhaps more than negative 10% QOQ GDP growth, but what follows is a equally strong rebound of GDP growth. There is 50-50 chances that US is able to avoid technical recession after a single quarter of declining GDP. It mirrors what we believed a natural disaster pattern that disrupt economic activities rather than destroying it. It is highly unlikely that any large corporation is in trouble (less some sensitive sector such as airlines and hotel and small medium enterprrise) and very unlikely that US banks is in trouble as in 2008. US banks total loans and asset growth has only been moderate (around 20%) since the financial crisis. And most bank loans portfolio are in commercial mortgage rather than consumer credits. In such scenario, no fiscal or monetary policy would help as the problem itself is the virus. We have to solve the pandemic first. As such, there been a mismatch between the problem and perception. Market been worrying about the impact of virus rather than the virus, and it priced in for the short term rather than the long term. Any long term factor changes will obliterate their base scenario, such as huge fiscal and monetary stimulus simultaneously across the world and the availability of medicine.
A monetary stimulus must take account of liquidity trap and a global saving glut. An example would be Apple. Apple hold more than USD200 billion of cash, yet would raise bonds to add more cash into its account. A yield of 3% would be attractive enough in an environment where US Fed rate is only 0.25% and matching the yields of US Treasuries. Fund flows in and Apple would not re-invest into productions or R&D as it already has sufficient capacity, rather it would repurchase its stock and enhance its equity (return on equity) in lieu of dividend. It has too many cash. A monetary stimulus won’t not help its balance sheet, nor its operation despite expectations. Perhaps more tellingly, the excessive cash that Apple retain will most likely be stored in US-denominated money market instruments, causing further drop in US yields. It is a bad cycle of generating cash to pay out then store it in more cash instruments, resulting in a global saving glut. This is the cost of financing a global economy and company that most people ignore, that US have to run trade deficits and current account deficit. US is the only country presently able to do so without having the effect of an overly expansive currency (Euro) and a domestic deflation (Japan), for decades (post-Bretton Woods). Increasingly, such situation is akin to US dollar tied to gold, or rather shall I said US returns and increasing productivity. When uncertainty abound, US dollar (and Yen) is the safe haven, hence monetary stimulus objective can not be solely be understood only to save US business, but its main objective is to actually prevent the shortage of US Dollar that might jeopardise its global companies and along with it the global economy. The restoration of confidence in global market would create less demand of US Dollar and alleviate the global saving glut (Apple case) that increase the yield and real interest rate to a normal level. Since 2008 up until recently, Fed has been able to achieve this successfully, yet interrupted by the COVID-19 which again see huge spike in demand for US Dollar. Since the end of last QE, Fed managed to shrink its balance sheet from a peak of USD4.4 trillion to USD3.7 trillion last year. However, it has since expanded it balance sheet size to USD5 trillion, and is set to increase more for the latest QE. Given that US economy is at USD 22 trillion, the economy has sufficient space to accommodate the increase of Fed balance sheet.
The expanded money supply, however, in long term see a moderate upwards of inflationary pressure, although in short term a contraction of money supply will be inevitable as people and corporate choose to hold cash. As the world recover and expectation of inflation increase, Fed will see that inflation would persist and be forced to raise interest rate despite its intention if the inflation surge upward continually. Fed has been very successful to push its target of getting full employment (3.5% unemployment) and 2%-3% inflation (2.3%). A downward spiral deflation that caused by price pressure is highly unlikely as the QE has floor priced such scenario, at the first sight of deflation or price pressure it would simply print more money to guarantee the price, no matter how inelastic the money become in future, in short it would take risk on liquidity trap rather than take risk on deflationary situation. It is the demand of cash that push down the yield (and inflated the bond price) rather than the lack of the said demand. The dominant thinking at the moment is that Fed would rather prevent a Japan-style economy due to strong demand of its currency more than a rerun of 1970s stubborn inflation. Based on this observation, the current yield has already priced in for the short term risk, while the long term yield not priced in the future inflation yet due to still early development of the COVID-19 pandemic.
QE → i↓ m↑ → (s↑ + n↑ > e↓) v↑ → p↑ t↓ → i↑
i = interest rate
m = money supply
s = speculative money inflow/outflow
n = nonspeculative money inflow/outflow
v = economic activities
p = domestic price level
t = trade deficit/surplus
b = budget
e = exchange rate
On March 27, 2020, US passed a stimulus that potentially reach the size of USD2 trillion. On paper, it is the largest stimulus to date and include a direct payment to US citizen. Its nature is similar to those TARP program that essentially to save business and preserve economy, though this time through lending rather than direct capital injection or bailouts. Given its nature, we shall compare TARP to this stimulus. Overall, TARP has been authorised up to USD700 billion, the final cost is USD426 billion, an utilisation rate of 60.8%. Given its authorisation to purchase direct stakes and capital injection, it is much more effective in disbursing the funds to large financial institution and large corporations. It is also quite straight forward that it purchase assets and can recoup its cost by selling these assets or equity in bailout companies. Unlike TARP, the 2020 stimulus involved targeted cash injection towards companies and individuals. It provides cash payouts to US citizen to buffer its living expanses and provide partial reimbursement of income through unemployment insurance, help them surviving throughout COVID-19 lockdown. It provides loans to corporations as another means to buffer the economy lockdown in place of direct tax cuts or cash transfer. It also provide payroll tax credits as a means to retain employments. As most funds are geared towards large corporations bailout, loans and tax credits, the utilisation rate could be much lower than the TARP. These loans, tax credits and funds all comes with various conditions set in. For example, if I am a small business owner that manufacture, if I were to take the loans, there is a precondition that I can’t outsource my manufacturing to other country. Also, I would have to retain my employees to be qualified for the payroll credits, which only to be utlised forward 50% for current year and another 50% for next year, this assumed I can survive and won’t layoff anyone to save the rest, or ask my employee for any pay cuts. Though the number is huge, the final utilisation rate might be 30%, which is low by any means. Though, all these should be seen as a relief measure to provide buffer through the COVID-19 rather than to jump start the economy. The keyword here is mitigation. Any measure to prime pump the economy won’t be effective as long as the virus is still there. The stimulus can be seen as targeting for relief and its objective is quite limited. All said, the stimulus should be sufficient for now and its objective could be achieved. We shall expect another prime pump stimulus once the COVID-19 is over. The second stimulus is expected to focus on telecommunications (5G), infrastructure (ports, pipeline, rails, highway, airport) and defense (Boeing, United Tech) and the size will be similar or even large than the first stimulus. The second stimulus main objective shall be to reignite the engine of growth and increase resource optimisation of the economy, such as ways to bring resources to market (infrastructure), enhanced productivity (R&D, 5G), exploring new ventures (new market access).
GDP is calculated using Private Consumption, Investment, Government Expenditure and Net Export (or import). As lockdown initiated, business will closed and economic activities reduced. Private consumption is expected to fall heavily. Investment, on the other hand, comprise of both inventory and fixed capital. Inventory is set to fall as business closure set in, while fixed capital is minimally bolstered by the stimulus loan effect. Whilst government expenditure, both expenses and investment, is set to growth due to response to the COVID-19. A transfer to US citizen as tax refund although not accounted as GDP itself (loss of government revenue), it would have increase private consumption during normal times. But given current scenario, it would exist in the bank account of US citizen as there is no where to spend due to lockdown and the effect is not immediate. The trade deficits however would see some improvements as import lessens while export decline marginally. Overall, the increase of government part would not sufficient to offset a fall of private consumption, moderate fall of investment and a neutral trade deficits. The fiscal stimulus is unlikely to generate as much inflation as Fed QE. It however should note that there is a current huge push toward demand-push healthcare and medicine item. Also there will be some demand push inflation coming from food related. An offset could be seen from the fuel and energy related price slump. However, it is very unlikely that the lockdown could be prolong more than 3 months to make the effect year long or long term.
Stimulus → b↓ → G↑ < C↓ I↓ t↨ → m↑ → v↑ → p↑ → I↑ C↑ t↓ → (s↑ n↑ > t↓ b↓ ) = e↑
C = private consumption
G = government spending
I = investment
At international scene, we are seeing US is currently leading the stimulus effort. Although there is sentiments that not enough have been done and not early on, we are seeing US as the only country that is doing large scale fiscal and monetary stimulus at the moment. Some country did start responding on drafting or announcing stimulus, they will follow US leads and templates. An example of loans targeting business can be traced in the recently announced Malaysia Stimulus plan. It is interesting to note that China has not announce any large scale fiscal or monetary stimulus yet, aside from some small decrease in Reserve rate and Interest rate. This can be attributed that China prefer to adopt and wait-and-see approach to gauge the full impact of US lockdown as demand worsen. Unlike US, although China managed to control the spread of virus and can now resume production, the global demand for its good has fallen. The trade environment is worse than the trade war. In long term, if the pandemic continue, and nations adopt a passive lockdown (closed border, activities resume), there would be serious demand issue for China factories. As the trade war already eroded its factories margin, a lesser demand would be dangerous. Whether China would have sufficient buffer to handle the transitions of COVID-19 pandemic to a normalised situation remains unknown. At the moment, China government has low national debt to GDP at 50%, but it remains to see the local government and its SPV debt will have any impact to the overall situation. At best scenario, China growth would only be 4%-5% if not negative, and going forward this would be China headline growth number. At China 300% Debt-to-GDP ratio, it would not be far from US 365% Debt-to-GDP ratio. Considering US as world financial center with 45% of AUM globally, US ratio would be substantially inflated while I estimate the real ratio might only be at 200% including public debt. US spend 200 years to reach the kind of depth and maturity level (financial products, insurance) while China financial rely more on Banking. This explains the world top 5 banks in term of asset size are concentrated at China. At 300% of banks asset-to-GDP ratio (CNY297 trillion vs CNY99 trillion), it is worrisome that China Banks might not be able to inflate further to encourage more economic growth and there is suspicion that the current growth is more toward financial leveraging rather than productivity growth.
As China economic grow while US economy shrinks, the economic size gap will get lesser and there will be some quarter that worry about the growing size of China economy at the expense of US. This is likely to elicit response from trade groups and the administration while future trade agreements get increasingly tough. Tariffs might be raise to satisfy some domestic political pressure (and some revenue) while global strategy shift from encouraging outsourcing to restructure of global supplier chains. Another strategy is to inflate US GDP through large stimulus by expanding government investment towards promising sectors such as 5G, infrastructure, biotech, defense. US might attempt both strategy to placate its domestic demands. There is a risk of an economic cold war between China and the rest of the world after the pandemic due to mistrust issue that build up before and during the pandemic.