By Brian Giuliano, Vice President & Portfolio Manager – Brandywine Global
Will the recent worldwide fiscal and monetary moves set the stage for an inflationary future?
The global economy has been brought to its knees by COVID-19, with a collapse in demand unlike anything seen since the Great Depression. Economic shutdowns and social distancing policies have led to mass unemployment and the near-term impairment of entire industries. Authorities have responded with an array of public support policies that have led to trillions in deficit spending and massive monetary easing campaigns. While sweeping policy response is probably better considering the scope of the current crisis, it’s fair to wonder about the longer-term implications of these extreme and unconventional measures.
Preventing a Depression
An enormous output gap—the difference between actual and potential output—has been created by millions of workers sitting idle at home and the economy running well below capacity. Federal Reserve (Fed) Chair Jerome Powell has warned of an “extended period” of weak economic growth saying that “the path ahead is both highly uncertain and subject to significant downside risk.” The International Labor Organization (ILO) estimates that over 80% of the global workforce lives in countries with mandatory or recommended closures. In the U.S. alone, 36 million Americans are unemployed. Hopefully these shutdowns are short-lived and we can all return to a more “normal” environment sooner rather than later, but significant damage has already been done. Given the nature of the health crisis and the absence of vaccine, it’s entirely possible—if not likely—that the rebound in economic activity will be lackluster. A recent working paper by the National Bureau of Economic Research (NBER) estimates that a devastating 42% of pandemic layoffs could result in permanent job loss.
In response to the uncertainty, consumers have cut spending and increased savings, businesses are slashing prices, and wages are under pressure. Deflationary pressures are all around. The environment today is not entirely dissimilar from the early 1930s, the last time a demand shock of a similar magnitude occurred. Chart 1 shows what happened to the Consumer Price Index (CPI) in the immediate aftermath of the Great Depression (1930-33). The good news is that today, unlike the early 1930s, policymakers seem to understand the gravity of the situation, and are acting to aggressively combat both the fall in real output and intensifying deflationary pressures.
Chart 1: U.S. CPI Inflation, 1927 – 1934
%. As of 3/31/2020
Source: Haver Analytics. Past performance is no guarantee of future results. Indexes are unmanaged, and not available for direct investment. Index returns do not include fees or sales charges. This information is provided for illustrative purposes only and does not reflect the performance of an actual investment.
Measuring the Policy Response
By almost all metrics, the global fiscal and monetary response to the current crisis has been incredible, both in magnitude as well as the speed at which the policy support has been deployed. In the U.S., deficit spending this year, as a percentage of GDP, will be close to a 100-year high—eclipsed only by deficits incurred at the height of World War II. If we include the expansion of the Fed’s balance sheet alongside the fiscal response, cumulative monetary and fiscal support in the U.S. is likely to be more than 40% of GDP this year, an astounding figure.
Looking around the world, the policy response has been equally potent. In Europe, Germany, Italy, the U.K., and France have announced even larger fiscal response packages than the U.S. Chart 2 below shows the direct and indirect policy support from around the world. Japan, the world’s most indebted country, announced a $1 trillion stimulus package, roughly 20% of GDP, while the Bank of Japan pledged to buy an unlimited amount of bonds to keep borrowing costs low. These actions go a long way toward preventing economic catastrophe, but they come at a longer-term cost.
Chart 2: The Global Fiscal Response Is Huge When Including All Measures
IMF Estimate of the Q220 Fiscal Response to the COVID-19 Pandemic, % of GDP. As of 4/2020
Source: IMF. Past performance is no guarantee of future results. This information is provided for illustrative purposes only and does not reflect the performance of an actual investment.
A Mountain of Debt
Debt, put simply, pulls future consumption forward. If a country borrows to buy something today, that money will have to be paid back over time and will not be available for other expenditures. Debt proceeds can be deployed for productive uses, but too much outstanding debt is not good either. The debt being incurred today to prevent an economic collapse is not productive in the long run. Governments are merely filling the economic hole created by shutdowns and widespread unemployment. The real challenge is that the world entered this crisis with a lot of debt and large unfunded liabilities. At the end of 2019, global debt reached an all-time high, exceeding $255 trillion at over 320% of global GDP. Debt today is almost $90 trillion higher than it was at the onset of the Great Financial Crisis. These figures will grow considerably once we add the bill from the COVID-19 stimulus packages. Therefore, U.S. debt as a percentage of GDP may end 2020 at a century-level high—at least.
Chart 3: U.S. GDP to Debt
% of GDP, SA. As of 5/27/2020
Source: Macrobond Past performance is no guarantee of future results. This information is provided for illustrative purposes only and does not reflect the performance of an actual investment.
Over-indebtedness, as a society, has been a structural headwind to growth. There’s a good chance that the debt being incurred today will only serve to weaken future growth in addition to exacerbating the disinflationary trends that the U.S. and other countries are facing. It’s entirely possible that the global economy will emerge from this crisis in an even lower growth environment than the past decade.
Monetary Policy to The Rescue?
As central bankers have become more creative, boundaries continue to be tested. Unconventional monetary policies, such as large-scale quantitative easing (QE) have become commonplace. Even the emerging world has joined the action with at least a dozen central banks s launching QE programs in response to the current crisis. As the lines between fiscal and monetary policy continue to blur, will these actions spark inflationary pressures? In the near term, it’s highly unlikely considering the deflationary malaise that will be with us for some time. Perhaps as the crisis abates, signs of inflation could appear if the money created by central banks makes its way into the real economy. This too, seems unlikely given the longer-term structural headwinds facing the world, including the mountain of debt discussed earlier. The experience from Japan over the past 20 years—and Europe over the past decade—is that bloated central bank balance sheets and unconventional monetary policies alone do not create inflation, nor are they an answer to a low-growth environment.
Perhaps the most concerning by-product of our current situation, and one that would lead to an inflationary outcome, is outright financing of government deficits by central banks—some form of Modern Monetary Theory (MMT). Recently, the Bank of England/ agreed to directly finance the U.K. Treasury for a small amount, over a short period in response to the COVID-19 crisis. While this small action seems harmless, and unlikely to spur inflation, the risk is that once the door is opened, it’s hard to walk back from it. In today’s politically charged environment—and considering how much debt is outstanding—there’s no saying how “creative” politicians might get to finance deficits. What’s easier to sell to constituents: raising taxes and cutting pensions, or having the central bank coordinate policy with the government? Any move to give central banks the power to spend, would be quite negative and inflationary for the country that chooses to walk down this path.
Conclusion
The world is amidst a significant deflationary shock and extreme policy measures are warranted to prevent us from falling into the abyss. But there is no free lunch and these extreme measures will come at a longer-term cost to society, especially when you consider the less than ideal starting point for the current crisis: a massive debt overhang, large unfunded liabilities, and bloated central bank balance sheets. Time will tell how great the cost will be.
Legg Mason Key risks and Disclaimers
Forecasts are inherently limited and should not be relied upon as indicators of actual or future performance.
All investments involve risk, including possible loss of principal.
The value of investments and the income from them can go down as well as up and investors may not get back the amounts originally invested, and can be affected by changes in interest rates, in exchange rates, general market conditions, political, social and economic developments and other variable factors. Investment involves risks including but not limited to, possible delays in payments and loss of income or capital. Neither Legg Mason nor any of its affiliates guarantees any rate of return or the return of capital invested.
Equity securities are subject to price fluctuation and possible loss of principal. Fixed-income securities involve interest rate, credit, inflation and reinvestment risks; and possible loss of principal. As interest rates rise, the value of fixed income securities falls. International investments are subject to special risks including currency fluctuations, social, economic and political uncertainties, which could increase volatility. These risks are magnified in emerging markets. Commodities and currencies contain heightened risk that include market, political, regulatory, and natural conditions and may not be suitable for all investors.
Past performance is no guarantee of future results. Please note that an investor cannot invest directly in an index. Unmanaged index returns do not reflect any fees, expenses or sales charges.
The opinions and views expressed herein are not intended to be relied upon as a prediction or forecast of actual future events or performance, guarantee of future results, recommendations or advice. Statements made in this material are not intended as buy or sell recommendations of any securities. Forward-looking statements are subject to uncertainties that could cause actual developments and results to differ materially from the expectations expressed. This information has been prepared from sources believed reliable but the accuracy and completeness of the information cannot be guaranteed. Information and opinions expressed by either Legg Mason or its affiliates are current as at the date indicated, are subject to change without notice, and do not take into account the particular investment objectives, financial situation or needs of individual investors.
The information in this material is confidential and proprietary and may not be used other than by the intended user. Neither Legg Mason or its affiliates or any of their officer or employee of Legg Mason accepts any liability whatsoever for any loss arising from any use of this material or its contents. This material may not be reproduced, distributed or published without prior written permission from Legg Mason. Distribution of this material may be restricted in certain jurisdictions. Any persons coming into possession of this material should seek advice for details of, and observe such restrictions (if any).
MeDirect Disclaimers
This information has been accurately reproduced, as received from Legg Mason Investments (Europe) Limited. No information has been omitted which would render the reproduced information inaccurate or misleading. This information is being distributed by MeDirect Bank (Malta) plc to its customers. The information contained in this document is for general information purposes only and is not intended to provide legal or other professional advice nor does it commit MeDirect Bank (Malta) plc to any obligation whatsoever. The information available in this document is not intended to be a suggestion, recommendation or solicitation to buy, hold or sell, any securities and is not guaranteed as to accuracy or completeness.
The financial instruments discussed in the document may not be suitable for all investors and investors must make their own informed decisions and seek their own advice regarding the appropriateness of investing in financial instruments or implementing strategies discussed herein.
If you invest in this product you may lose some or all of the money you invest. The value of your investment may go down as well as up. A commission or sales fee may be charged at the time of the initial purchase for an investment and may be deducted from the invested amount therefore lowering the size of your investment. Any income you get from this investment may go down as well as up. This product may be affected by changes in currency exchange rate movements thereby affecting your investment return therefrom. The performance figures quoted refer to the past and past performance is not a guarantee of future performance or a reliable guide to future performance. Any decision to invest should always be based upon the details contained in the Prospectus and Key Investor Information Document (KIID), which may be obtained from MeDirect Bank (Malta) plc.