Much has been written about the unprecedented scale of measures undertaken by governments and central banks worldwide to counter the impact of the Covid-19 pandemic, which sent economies into the deepest recession since World War II.
The US alone has implemented several relief and stimulus packages worth trillions of dollars. An initial US$2.8 trillion was allocated within the first few months of the outbreak (including the US$2.3 trillion CARES Act), which was then supplemented by an additional US$900 million in December 2020. One of the first major bills signed by President Joe Biden since taking office was the US$1.9 trillion ($2.5 trillion) American Rescue Plan Act in March 2021. The Biden administration has further proposed a US$2.3 trillion infrastructure plan and US$1.8 trillion family care plan to be spent over the next eight to 10 years.
The European Union is also taking a leaf from the US. Its €807 billion ($1.3 trillion) (in current prices) NextGenerationEU recovery plan is in the process of being ratified by member nations. Its objective: to repair the social and economic damage caused by the Covid-19 pandemic and lay the foundation for a modern and more sustainable Europe. Together with the EU’s long-term budget (2021 to 2027), the total stimulus will be worth more than €2 trillion.
This record spending is being enabled by extreme monetary policies — near-zero (even negative) interest rates and massive quantitative easing (QE) programmes, including open-ended purchase of government (and corporate) bonds.
The pandemic has, without question, brought about a sea change, in terms of people’s behaviours and, notably, policies — for better or worse. This includes widespread acceptance of deficit spending and debt monetisation.
QE is, whether directly or indirectly, a way for central banks to fund massive government spending. That is, effectively, debt monetisation even if convention would argue against using the term, not if it remains the intention of the US Federal Reserve or European Central Bank to normalise their balance sheets at some point.
Markets also make a point to draw a distinction between central banks that are independent and credible and those that are not, though in reality this is a matter of perception and differing points of view. Regardless, the resulting low yields are, at the very least, making it possible to sustain the sharp rise in public debt — by keeping debt servicing to a minimum.
Public debt — especially in the US and Europe — has skyrocketed to record levels. The International Monetary Fund estimates that average public debt will reach 99% of GDP in 2021 globally. In the US, public debt-to-GDP increased to 129.1% as at end-2020 — up from less than 87% after the official end of the Great Recession in 2009 — and is estimated to hit nearly 133% this year.
Debt-to-GDP in the UK rose to 104.5% at end-2020 while that in Italy (155.6%), Spain (117.1%) and Greece (205.6%) too are all higher than they were during the European sovereign debt crisis (see Chart 1).
Are pandemic relief and stimulus packages excessive?
There is little dispute that the relief and stimulus measures, and the speed with which they were rolled out, were absolutely the right thing to do. Many of the initial measures from different countries were very similar in nature, centred around grants and loans to support businesses, wage subsidies to keep employees on payrolls, moratorium on loans, foreclosures and evictions as well as cash handouts to the people — all with the aim to protect and preserve productive capacities while we fight to contain the viral outbreak by restricting movements and implementing lockdowns.
Was the pandemic, however, also a convenient excuse for governments to “overspend”? Government largesse is always popular and democracy is the ultimate populist system of government.
In other words, is the quantum of relief packages excessive? We suspect this is a question that can be answered only in the future, with the benefit of hindsight. What is clear is that even the staunchest advocates for fiscal discipline, such as Germany, are now converts to deficit spending. Countries that were worst hit during the sovereign debt crisis, including Italy, Spain and Greece, are once again on the path to huge deficit spending.
Governments have, through relief and stimulus packages, partly monetised private debts — that is, shifting part of the debt burden from the balance sheets of businesses and households onto public balance sheets.
We have written about how unemployment benefits and cash handouts boosted disposable incomes for US households. At the same time, consumer credit card and short-term borrowing levels have fallen (see Chart 2). For instance, the latest round of stimulus cheques drove personal income 21.1% higher in March 2021, the highest monthly increase on record dating all the way back to 1959. Savings as a percentage of disposable income surged to 27.6%, compared with the average of 7.4% in the 12 months to February 2020 (pre-pandemic).
The resulting excess savings will provide a big tailwind to consumer spending and growth over the coming months. The strong recovery in global trade and exports underscores this underlying strength of consumer spending and healthy finances, even when the pandemic is still raging in parts of the world. With progressive vaccinations, we expect to see the pace of recovery in the services sector to also pick up steam.
Similarly, businesses are faced with less financial stress than most would have in the absence of massive government aid, so much so that the number of bankruptcies actually fell quite sharply last year compared with historical averages — for example, down 20% to 42% in the US, the UK, Germany and France (see Table).
For the most part, the stimulus spending is necessary, to help scarred economies get back onto the growth path. Massive government stimulus money channelled to the right places — for research and development, investments that create new jobs, improve productivity and the country’s competitiveness — will translate into stronger future economic growth. Higher incomes, and therefore tax revenue, will pay off the debts.
Whether indeed the fiscal stimulus has the net effect of boosting future productivity over the cost of the stimulus itself can be apparent only in the future.
That said, we must acknowledge that record-high public debts are not without risks. As we wrote a few weeks ago, in the short term, bloated public indebtedness is manageable, given near-zero interest rates and, thus, low debt servicing costs. Interest rates must normalise over time. The big risk is if the move comes sooner and, critically, faster than expected. We see two events that could force the hand of central banks: (i) if the stimulus money turns out to be wasteful spending; and (ii) if there is strong sustained price inflation.
Stimulus money wasted on programmes that generate low or no returns
Much of the aid relief measures were blunt and applied across the board, because the outbreak happened so suddenly and time was of the essence. Inevitably, some portion of the money would have gone to support companies that should have been better left to fail, especially those that were already in financial trouble before the pandemic.
Business failures and bankruptcies are the result of efficient capital market at work. Giving continued life support to these “zombie” companies — with cheap money, emergency loans and/or grants — will only prolong the misallocation of scarce resources that will, ultimately, be a tax on the overall economy.
Zombie companies sap the future growth potential of the country because more and more resources need to be spent servicing borrowings rather than on investments that drive growth. Japan, with its stubbornly sluggish economic growth, is often described as ground zero for zombie companies.
In short, current high levels of public debt become unsustainable if the stimulus money is wasted on programmes that generate low or no returns. If this is the case, at some point, investors will start to lose confidence and demand higher and higher interest rates to keep lending — like what happened during the European sovereign debt crisis a decade ago. The fear of debt default will then lead to currency collapse, and all its accompanying issues. It becomes a vicious cycle.
Strong and sustained price inflation
Massive government spending — flooding the economy with cheap money — could drive sustained inflation and risks fanning higher inflationary expectations. Case in point: US Treasury Secretary Janet Yellen roiled stock markets last week by suggesting that rate hikes may be needed to stop the economy from overheating, as a result of the government’s spending plans.
Her warning is very rational and we should stay alert. Currently, the Fed intends to let inflation run hot, to rise above its long-term target of 2% — in order to achieve the average of 2%, given that inflation rates have hovered below this level in the past few years. Furthermore, the central bank said it would only react to outcome instead of anticipating future inflation.
This risks it being taken by surprise if price increases are sustained (embedded in the economy) — and, critically, if inflationary expectations take hold. If this comes to pass, then the Fed (now behind the curve) will be forced to hike interest rates rapidly. And, if so, current record-high levels of public debt will become a much larger problem, possibly even triggering the next major crisis.
Prices are ticking higher now, owing mainly to short-term, pandemic-related supply bottlenecks and disruptions amid robust recovery in consumer demand. Most believe the current price spike is transient and the price gains will slow once economies normalise over the next year or so. We think so too.
Persistent labour shortage could result in sticky wage inflation
One of the biggest inflationary threats is if wages start to rise too sharply — because wage inflation is sticky. In recent days, there has been widespread coverage in news media reporting anecdotal evidence of labour shortage in the US — yet, the unemployment rate stands around 6.1%, well above the pre-pandemic low of 3.5%. What is happening?
We think this is due to a temporary mismatch in demand and supply. The pandemic-driven recession is different from previous recessions in several aspects. One, the US and global economy were humming along nicely before Covid-19, meaning businesses were generally doing well. Two, governments reacted very quickly to protect productive capacities. Thus, most businesses survived intact (more or less) and could restart operations as soon as it was feasible to do so.
Three, the average US household is in good financial shape after a decade of paring back borrowings, and bolstered by generous and expanded unemployment benefits and stimulus cheques as well as gains from the stock market. This is in stark contrast to the years following the global financial crisis, when the US housing market collapse severely damaged household balance sheets. People sitting on excess savings are not desperate for a job, certainly not any job.
Furthermore, a good percentage of the unemployed workers are probably on furlough — waiting for the call-up from employers — instead of having been laid off. As such, the number of people actively seeking jobs is likely far fewer than the headline unemployment numbers suggest. In addition, others may still be worried about infection risks or have childcare responsibilities (schools and day care centres have been closed).
Some, too, may be taking the opportunity — and buffer from excess savings — to retrain and upskill, therefore temporarily dropping out of the labour force (labour participation remains below pre-pandemic levels). Structural changes resulting from the pandemic have created some mismatch between current and required skill sets.
Statistics show that there are 8.2 million fewer employed people today compared with pre-pandemic levels (see Chart 3). So, unless all of these millions of people have decided to drop out of the labour force permanently — though some may decide to join the gig economy for good — the short-term labour shortage should work itself out with time. But this certainly bears a close watch in the coming months.
If there is a real and persistent shortage — at this point, we do not think this is the case — we will see sustained higher average wage growth. And if so, inflationary expectations will rise swiftly, setting off a chain reaction of higher interest rates and increased market volatility.
Average wage growth in the US has been in secular decline for the past two decades (see Chart 4). This is often attributed to globalisation — abundance of cheap labour in China and emerging economies — as well as technological innovations that increased productivity and prioritised capital returns over labour.
Looking ahead, the China deflationary effect will taper off. Wages in the country have risen sharply in recent years. There is increased protectionism around the world, underscored by the US-China trade war. The pandemic is likely to have accelerated the resulting shift in the global supply chain and at least some reshoring (localisation) of manufacturing activities.
On the other hand, we see continued gains in technological advancements — including mechanisation, robotics, automation and artificial intelligence — which will keep the lid on future labour demand and costs. On balance, we think the risk of runaway inflation remains low.
In conclusion
To summarise, governments have reacted faster, and with much larger aid packages, to the Covid-19 pandemic than in previous crises. The massive flood of cheap money, including cash handouts for households, is driving pent-up demand and higher inflation, especially given short-term supply disruptions that include low labour participation and a resulting shortage. The real question is whether the inflationary pressures are transient or permanent — wage inflation, in particular, is sticky.
Whether the current inflation uptick is transitory or embedded will have a critical effect on interest rates, public debt sustainability and future economic growth potential. It is too early to make a definitive call — the answer will be clearer with time. As such, we are sticking to our current portfolio composition for now, including investments in high-growth tech stocks that are more vulnerable to rising inflation and interest rates.
The Global Portfolio closed marginally lower for the week ended May 11. (We closed the portfolio early this week because of the long weekend in Malaysia). Tech-related stocks remain under pressure, with almost all ending lower for the week, led by Okta (-4.7%), ServiceNow (-2.7%) and Taiwan Semiconductor Manufacturing Co (-2.7%). On the other hand, Builders FirstSource (+6.6%), Home Depot (+2.7%) and Johnson & Johnson (+1.9%) were the notable gainers. Total portfolio returns now stand at 55.2% since inception. We are still outperforming the MSCI World Net Return index, which is up 49.6% over the same period.
Disclaimer: This is a personal portfolio for information purposes only and does not constitute a recommendation or solicitation or expression of views to influence readers to buy/sell stocks, including the particular stocks mentioned herein. It does not take into account an individual investor’s particular financial situation, investment objectives, investment horizon, risk profile and/or risk preference. Our shareholders, directors and employees may have positions in or may be materially interested in any of the stocks. We may also have or have had dealings with or may provide or have provided content services to the companies mentioned in the reports.
