15 Apr 2020
Governments have initially responded to the coronavirus pandemic by slashing interest rates and increasing fiscal support. You might think that increased levels of fiscal spending could increase inflationary pressures and interest rates, but the history of pandemics would suggest otherwise. Three academics at the University of California Davis, one of whom is a member of the Federal Reserve Bank of San Francisco, have issued a paper on the longer-run economic consequences of pandemics. The authors, Oscar Jorda, Sanjay Singh and Alan Taylor, argue that investment demand is likely to wane as labour scarcity in the economy suppresses the need for high investment. They suggest a bigger glut in savings to come which, for those looking for yield, is a frightening prospect in a pre-pandemic world already suffering from demand deficiency. The paper looks at how major pandemics affect economic activity in the medium to long-term and the views expressed being those of the authors rather than the Federal Reserve Bank.
As pandemics are rare events, the authors have had to look at historical evidence over many centuries, using data sets stretching back to the 14th Century, focussing on 15 major pandemics where more than 100,000 people died. They have also looked at major armed conflicts that resulted in a similarly large death toll. They found that significant macroeconomic after-effects of the pandemic persist for about 40 years, with real rates of return substantially depressed (excess of savings). Pandemics induce labour scarcity and/or shift the population to greater precautionary savings.
The most devastating pandemic of the last millennium was the Black Death (1347-1352). Economists and historians are still debating its role in economic, social and political change in Europe. The resultant Peasant Rebellion in England (1381) meant that real wages saw an increase of around 100% increase. In large scale pandemics, the effects are seen across whole economies or wider regions, either because the infection is widespread, or relevant to today, because trade and market integration in capital and/or labour markets means that the economic shock is spread across the world. The authors’ comment that the work by Ferguson et al. at Imperial College places COVID-19 as the most serious episode since the 1918 Spanish Flu pandemic. There are estimates that, even with suppression strategies, the death toll in the UK could hit 50,000 and around 220,000 in the US. This would mark COVID-19 as the second most devastating event in the past 100 years.
The authors have looked to estimate the natural rate of interest after a pandemic shock. The natural rate of interest is the level of real returns on safe assets. The work suggests that the natural rate will see downward pressures as investment demand is likely to wane and savers may react to the shock by increasing savings, either as a precautionary move, or to replace lost wealth.
Surprisingly, there are records, compiled by Schmelzing, showing historical interest rates dating back from 1314 (prior to the Black Death) to modern times. The natural rate of interest has shown a secular decline over the span of centuries, from about 10% in medieval times to 5% at the start of the Industrial Revolution and currently hovers nearer 0%. Volatility of interest rates in the shorter term has declined. In today’s world, there are fewer wild fluctuations in harvests, serious armed conflicts or other short-term factors. In other words, volatility of GDP growth has fallen. The authors believe that, following a pandemic, the natural rate of interest declines for decades thereafter, reaching its nadir about 20 years later, with the natural rate about 150bp lower than if the pandemic not taken place. They estimate that it takes around 40 years for the natural interest rate to return to the level it would have been at had the pandemic not taken place. This reduction in rates is even more persistent than the drop caused by recessions induced by financial crises.
Pandemics have caused a rise in real wages, perhaps because of the lack of a service economy in the historic periods analysed, where job losses may persist, and lower returns to capital. Wars, on the other hand, have tended to be inflationary and have left real rates higher. The authors argue that if the trends play out similarly in the wake of COVID-19, the global economic trajectory will be very different to expectations from only a few weeks ago. Low real interest rates, if sustained for decades, will provide some welcome fiscal space for governments to mitigate the consequences of the pandemic. There are other important implications for investors too, especially when considering growth stocks versus value investment strategies.
The paper by academics at Davis argues that pandemics produce structural forces, lowering the path of interest rates. This is now occurring at a time when there are secular disinflationary forces in the global economy. The recession following the GFC was not a severe form of a standard business cycle recession resulting from an inflationary boom, it was a financially driven or balance sheet recession. Recovery from this type of recession is typically slow, hesitant and more drawn out, usually taking many years, even up to a decade, before economic growth normalises. 2017 saw a brief upswing in synchronised global economic activity, but interest rate rises in the States saw a peak in the Fed funds rate of 2.50% and this monetary tightening resulted in an economic slowdown in 2018. At the peak of the last economic cycle, both interest rates and inflation were significantly below recorded levels in previous cyclical peaks. The factors behind this are described as ‘Living in a 3D world’, referring to debt, demographics and devices. The combination of these, through both demand and supply side effects, has imparted a secular deflationary force on global economies. Even during an economic upswing, these powerful secular forces acted as underlying constraints on both growth and inflation.
The GFC was an outcome of the realisation that debt had reached unsustainable levels. Yet globally the ratio of total debt to GDP, even before the pandemic, was higher than 2007. The principle drivers of this have been rising public debt in the developed world and rising private debt in the emerging world, mainly China. Corporate debt in the United States has also increased as companies have sought to use financial engineering to increase reported earnings. Over time, debt acts as a drag on economic growth as it involves borrowing today to boost growth and requires slower growth going forward to repay the debt. Governments worldwide are currently taking the necessary stops to avoid a global depression, but this involves borrowing even more heavily and is likely to mean slower growth going forward. In other words, there will be a need for increased savings to pay down debt.
Demographics are also a negative for economic growth. Ageing populations and a decline in the growth of the population in the developed world and some emerging countries such as China, are associated with slower trend economic growth, a consequence of having fewer people in the workforce and a tendency for older generations to spend less, in part because they borrow less than in their earlier years. Unless there is an offset in the increase in productivity growth, of which there is currently no strong evidence in the developed world, underlying economic growth rates will remain subdued. One promising area for productivity growth globally was in the emerging world, so it remains important that the pandemic doesn’t hit these regions disproportionately hard. Overall, demographics globally will continue to be a drag on growth rather than a positive. The fiscal positions of governments are now further stretched and with the pressures of an ageing population and demands for better healthcare post the pandemic, the ability of governments to stimulate economies through further fiscal stimulus may well be limited.
Technology has had a dramatic effect on the cost of producing goods and providing services. Some would view disruption as a modern-day word for competition, but there is no doubt that competitive forces of change have accelerated in many industries. This has been seen through the consumption of media, which has moved away from print and traditional linear TV, to online and streaming, along with the hollowing out of the retail sector in favour of online. Technology has unlocked capacity by taking out the middlemen. There has been dis-intermediation or disruption to many industries and whilst it is still clearly at an early stage, this seems to have been accelerated by the COVID-19 pandemic. This supply side effect will continue to impart downward pressure on prices for many years to come.
Compared to pandemics in the past, governments are supplying high levels of fiscal stimulus to global economies. Outside the widespread adoption of MMT (Modern Monetary Theory), the effect is likely to be transitionary and limited due to debt constraints and the role of governments in economies is likely to increase. Analysis of previous pandemics suggests downward pressure on interest rates results. Combining this with secular disinflationary forces, the 3D’s, would result in a lower discount rate being applied to future corporate earnings, benefitting true growth companies.
Despite the already large dispersion between growth and value in the marketplace, the acceleration of the strong move to new economy and disruptive businesses and the lack of mean reversion in the market, could well result in highly rated companies trading at an even larger premium going forward. To date, value investors have not seen any protection in this economic and market downturn as shares that aren’t highly rated are generally so for a reason. Many of these businesses are heavily cyclical and highly leveraged, so their operational gearing means that returns on capital will deteriorate and the solvency of some businesses may well be threatened. Overall, the future environment is likely to favour quality growth businesses and, in an even lower growth world, those few companies able to demonstrate genuine secular growth are likely to remain in favour with investors.
Graham O'Neill, Senior Investment Consultant, RSMR
Looking for a whole host of informative, up-to-the-minute content from the fund rating experts? Click here to head to RSMR Connected.
This information is for UK Professional Advisers only and should not be given to retail clients.The value of investments and the income from them may go down as well as up and investors may not get back the amounts originally invested.
Rayner Spencer Mills Research Limited is a limited company registered in England and Wales under Company Registration Number 5227656. Registered office: Number 20, Ryefield Business Park, Belton Road, Silsden, BD20 0EE. RSMR is a registered trademark.