Monthly Agenda March 2020 – Long Live Schumpeter
There is a lot of negative news, views and opinions in financial markets right now. This negativity is rightly occurring on a number of fronts – disrupted supply chains that cannot be fixed necessarily by fiscal or monetary policy; the coronavirus not being as contained as previously thought; and the impact on underlying economic fundamentals possibly being deeper and more permanent than expected.
It is hard to argue against any of this in the absence of good quality data. As the Chief Economist from Deutsche Bank Torsten Slok notes, there are three things investors need to know in order to make a fair assessment of the impact of the coronavirus:
1. Morbidity rate (share of population infected)
2. Mortality rate (share of infected cases resulting in death)
3. Number of work weeks lost
Torsten notes that we only have a reasonable understanding of point number two. Points one and three and known unknowns.
One possible outcome
Taking a step back, one of the issues the world has been struggling with since the global financial crisis is the absence of Schumpeter’s creative destruction. This is the theory that economies need destruction for renewal and growth to occur. An economy that is flexible enough to allow inefficient or unproductive businesses to be replaced by thriving ones is said to be a healthy on.
The extraordinarily accommodative monetary policies implemented by central banks in the wake of the 2008 financial crisis meant that we had plenty of creative, but very little destruction. Otherwise unprofitable businesses were put on government-sponsored life support.
It is very hard to go bankrupt when the central bank is your underwriter.
The IMF recognised this when it highlighted the large number of what it called “zombie” firms. These are businesses that are solvent only because of the availability of cheap debt in the form of record low interest rates. If interest rates were to rise, these businesses would cease to exist. They are literally living hand to mouth.
The issue with having the “creative” without the “destruction” is that capacity in the economy doesn’t deplete. It becomes so large that it prevents inflation from rising. Think about the number of coffee shops in your neighborhood. There is one on just about every other corner (the boom in highrise residential apartment building has festered this trend providing a ready supply of street level retail space). Prices are prevented from rising because there is just too much competition.
The cycle of extremely accommodative monetary policy can become self-fulfilling. Low inflation keeps central banks on the sideline which in turn keeps zombies alive, keeping capacity high, keeping inflation low and central banks on the sideline. And so it goes until something causes a destructive break in the cycle.
Is it possible that the coronavirus is the catalyst that will cause Schumpeter’s destruction to finally emerge?
The idea that a negative supply shock cannot be fixed with monetary or fiscal policy has some merit. A direct injection of cash into the pockets of consumers is useless if the consumer is either prevented from leaving home to consume or can’t consume because the supply of goods is not there. The stimulus will have a confidence effect but that would be short-lived if consumer activity doesn’t follow through.
So what would happen to the zombie firms living hand to mouth if the quarantine measures as a result of the coronavirus continue for much longer? In short, they can no longer exist. In our view, this is the weakest link in the chain. This is where the supply-side shock begins to morph into a demand-side shock. If we do start to get business closures, unemployment will begin to rise. Higher unemployment will weigh on consumer spending which will weigh on overall economic growth.
This is bad for the economy in the near term. In the medium term, however, if enough capacity is destroyed, inflation pressures have the potential to rise to the surface. Take away that second coffee shop and the first has a chance of raising prices without risking a decline in business. This then encourages business investment and innovation, something that has been badly lacking in our economy for some time.
Short-term pain, long-term gain?
It could be a painful journey near-term, but we may be on the road to central banks moving back to a normal operation of monetary policy. Higher inflation from the destruction of capacity results in higher official interest rates.
What this means for investors can be illustrated using the capital markets line (CML). This line is simply the relationship between risk and return for different asset classes. The riskier the asset class, like equities, the higher your return should be so the line is necessarily upward sloping.
For too long, the low interest rate environment has been encouraging investors to chase returns, taking on more and more risk like equities. Higher interest rates would reverse that by making safer assets like bonds and term deposits more attractive. In the diagram, this relocation of investors causes a steepening of the capital markets line.
Capital Markets Line (CML)Enlarge Source: Escala Partners, for illustrative puposes only
Ultimately, risk premiums would adjust higher which means instead of constantly revising down our long-term capital markets assumptions, we can begin to revise them up. Expected returns rise.
Savers no longer punished
In this scenario, savers are no longer penalized by lower interest rates supporting the zombie companies. Take the zombies out of the equation, bring back creative destruction, some inflation returns and a normal operation of monetary policy can ensue.
Ultimately, however, the extent to which zombies will fall, and excess capacity is reduced, still depends on Torsten’s point number three – how long will this last. On that, we don’t know but having “air bags” in a balanced portfolio, such as fixed income and infrastructure (defensive assets), will provide a cushion of support in the event it lasts longer than expected. Hope is no substitute for good risk management.
The role of asset allocation
In times such as now, we maintain our belief that asset allocation is the most important portfolio management decision an investor can make.
“On average, 90 percent of the variability of returns and 100 percent of the absolute level of return is explained by asset allocation.” Roger G. Ibbotson.
In other words, asset allocation is as much about risk management as it is about return management. Your allocation between different asset classes will help you achieve your target return while at the same time managing your risk through diversification.
The chart below shows annual returns for Australian bonds and Australian equities. In the past 28 years there have been six years where equities have generated a negative annual return for investors. On each occasion, an allocation to bonds would have cushioned the impact, even in 1994 when both bond and equity markets sold-off together.
Diversification in action (% annual change)Enlarge Source: Bloomberg
Uncertainty is always and everywhere a market phenomenon
It may seem like we are deep in uncertain times right now but the reality is we are always in uncertain times. In the 1970s it was oil price shocks, Vietnam, and Watergate; in the 1980s it was the US savings and loan crisis, the ’87 stock market crash, Beirut, and Tiananmen Square; the 1990s saw the Asian financial crisis and the Russian debt default; and the 2000s saw the war in Iraq, the bursting of the tech bubble, the global financial crisis and the European and Greek sovereign crisis.
With uncertainty comes risk and the best risk management tool is diversification.
Chief Investment Officer