Pyrford International August Monthly Commentary

The month of August ended with a paradigm shift in the monetary policy framework of the Federal Reserve. Chair Powell announced a move to ‘average inflation targeting,’ whereby the Fed would allow an overshoot of inflation beyond its 2% target to make up for periods of weak inflation. One of the main purposes of such a move is to raise market expectations for the future level of inflation. As Powell stated: ‘Longer term inflation expectations, which we have long seen as an important driver of actual inflation and global disinflationary pressures, may have been holding down inflation more than was generally anticipated.’

The potential risk of high inflation is a topic that has divided the investment community. What is certain is that COVID induced lockdowns have created immense deflationary pressures. GDP figures, released earlier in the month, confirm that the second quarter has been the worst ever recorded in modern history. Real GDP among OECD economies contracted by an average of -9.3% in Q2, far worse than at the height of the Global Financial Crisis (GFC) in Q1 of 2009 (-2.3%). With such a large output gap and elevated unemployment rates, as well as record low levels of capacity utilisation across major economies, it is hard to envision an overshoot of inflation above the 2% level in the immediate future. Additionally, the pandemic has accelerated the digitisation of the economy across many sectors, which adds to the disinflationary pressures in the long run.

 

However, those who argue for inflation will point to record levels of growth in M2 money supply, which tracks the level of cash, deposits and money market securities in the economy. Contrary to the GFC, this crisis has prompted a coordinated monetary and fiscal response, which has left households and corporations sitting on ample levels of cash. M2 has risen a record 23% YoY, more than double the peak during the GFC. As noted in previous commentaries, the personal savings ratio across major economies are at record highs. Some of these savings have undoubtedly fueled the recovery in housing and stock markets, where aggregate prices are now above pre-pandemic levels in the US. The future path of CPI inflation will depend upon how rapidly this extra disposable income is spent on goods and services in the wider economy. Although the money supply has increased, money velocity, which tracks the frequency of transactions in the economy has collapsed.

Boosting consumption has been the primary focus of UK Chancellor Rishi Sunak after a devastating collapse in output in the second quarter. Real GDP contracted -20.4% in Q2, the sharpest fall amongst the G7 nations. This was more than double the contraction in the US (-9.3%) and Japan (-7.8%). GDP in France, Italy and Germany fell by -13.8%, -12.4% and -12% respectively. GDP statistics are of course backward looking and fail to reflect real time economic activity, which has been extremely volatile and almost impossible to forecast during this crisis.

The dismal second quarter is likely to be followed by a record breaking third quarter after fiscal measures have encouraged a rebound in consumer spending. The government’s ‘Eat Out to Help Out’ scheme launched earlier this month and was preceded by a 5% VAT cut in July for the battered hospitality sector. Retail sales are now 1.4% above the level in July of last year. To refill the government coffers, tax increases on the wealthy, pensions and companies have been suggested as being part of the upcoming Autumn budget. Public borrowing could do with additional support given the Office of Budget Responsibility estimates the deficit could top £370bn by the financial year 2020 / 2021. Nevertheless, uncertainties around the future path of the virus and the release of a vaccine remain.

Given the policy driven nature of the recovery so far, the lack of progress on a renewed fiscal package in the US is cause for concern. The $600 a week in unemployment benefits has expired with unemployment still above 10%. In terms of the absolute fall in income, Treasury payouts to the unemployed have fallen by over 50% since the beginning of August, around $10bn a week. With Congress in recess until September, President Trump has attempted to force through legislation with a series of executive orders. However, these proposed measures do little to offset the fall in income. The total level of funding for unemployment benefits is only $44bn, which would be depleted in a matter of weeks, even if payouts are halved from $600 to $300. Uncertainties in the US outlook remain given the delay in the fiscal support package, expected volatility ahead of the upcoming election and how the US market has been led by a narrow section of the market.

In assessing the long-term damage to growth from the coronavirus, we continue to observe the path of bankruptcies across major economies. As was the case following the GFC, both Europe and the US have adopted opposing strategies in how they deal with failing businesses. In the US, 45 companies with assets over $1bn have filed for bankruptcy year to date. This exceeds the 38 companies who filed during the same period in 2009. On the other hand, new bankruptcy filings in Europe have fallen relative to filings last year before the pandemic hit. Governments in Europe have either suspended bankruptcy court proceedings or waived the obligation for pandemic hit businesses to file. Bankruptcies can lower the potential growth rate of an economy as labour demand and capital investment is destroyed and not easily replaced. However, the pandemic has accelerated the downfall of companies that were arguably already heading for bankruptcy. In this sense, allowing weaker companies to fail can create room for more productive firms to fill the gap. Such trends have certainly taken place in the retail sector. The risk for the European economy lies in the creation of more ‘zombie firms,’ that continue to exist and drag down the productive capacity of the economy.

In assessing the long-term damage to growth from the coronavirus, we continue to observe the path of bankruptcies across major economies. As was the case following the GFC, both Europe and the US have adopted opposing strategies in how they deal with failing businesses. In the US, 45 companies with assets over $1bn have filed for bankruptcy year to date. This exceeds the 38 companies who filed during the same period in 2009. On the other hand, new bankruptcy filings in Europe have fallen relative to filings last year before the pandemic hit. Governments in Europe have either suspended bankruptcy court proceedings or waived the obligation for pandemic hit businesses to file. Bankruptcies can lower the potential growth rate of an economy as labour demand and capital investment is destroyed and not easily replaced. However, the pandemic has accelerated the downfall of companies that were arguably already heading for bankruptcy. In this sense, allowing weaker companies to fail can create room for more productive firms to fill the gap. Such trends have certainly taken place in the retail sector. The risk for the European economy lies in the creation of more ‘zombie firms,’ that continue to exist and drag down the productive capacity of the economy.

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