EDITOR NOTE: A bond strategist for a BNY Mellon subsidiary has a slight disagreement with the shape of the recovery that the market appears to be showing. It’s not a V but a U. But here’s the difference: he believes that this U-shaped recovery takes five years, and not a mere five months, to get from peak (pre-pandemic) to peak (post-pandemic). There will be a surge in defaults, downgrades, and inflation. Are we currently seeing the markets approach that final rounding top stage fueled by irrational exuberance?
If COVID-19 carried a warning label, it might read: Exercise caution. Significant economic side-effects accompany this virus.
Investors should prepare for downgrades, defaults and a shuffling of which industries are driving global economic growth, said Paul Brain who heads the fixed-income team at London-based Newton Investment Management, a BNY Mellon subsidiary.
Brain discussed the road ahead with SHOOKtalks in a webinar titled, “Deflation, inflation, and Modern Monetary Theory: Will COVID-19 prove to be the through-the-looking-glass moment?”
Brain’s cautionary words come as market euphoria erupted again this week. Investors drove the S&P 500 to a new high on news that scientists are closing in on a COVID-19 vaccine. Meanwhile, governments across the globe continue to dump money into local economies.
Brain disagrees with the prevailing view that the economic recovery will resemble a V shape.
“We think the economic recovery will be more like a U shape, it goes down and bounces back up, but it takes at least five years to get back to where you started,” Brain said. “This is because large parts of the economy are shutting down, being restructured and it takes time for those employees to get re-employed.”
In his view, the industries facing the biggest threat are: airlines, commercial real estate, commercial aircraft and auto manufacturing, retailing and hospitality.
“There will be casualties and mergers,” Brain said, mostly in areas suffering under the weight of overcapacity. “Trends such as the ever-rising capacity of the airline industry and the building of airports to accommodate that capacity are going to reverse.”
Once the airline industry shrinks, airfares will increase, he said.
Forecasters often compare the current economic downturn to previous recessions. This time is different in several respects, Brain said. COVID-19 laid bare structural changes that were already underway in the global economy, Brain said.
“There were a number of factors here at work - elitism, para-capitalism, bonus structures and the globalization of free trade,” Brain said. “Now, we are looking at a rise in populism, increasing potential power of labor and the potential that governments will support a low, basic level of income.”
Governments have responded to the economic downturn by pumping records amount of money into the economy, most of it going to businesses and laid-off workers. Watch for government to follow up with major fiscal stimulus in the form of big-ticket infrastructure projects, Brain said.
Won’t all this spending be inflationary and lead to the economy to ruin?
Brain said the policies are a form of helicopter money or what some call Modern Monetary Theory. MMT holds governments are free to run big deficits without suffering negative consequences since the government has the power to print its own currency. Critics counter that such policies are reckless and inflationary.
During the 2007-08 financial crisis, Brain said the Federal Reserve injected money into the nation’s banking system. The move increased liquidity but was not inflationary. However, Brain said he feared this time could be different. The money is going directly into the hands of consumers who are currently saving it or paying down debt. “That could change should they start spending it.”
Expect the U.S. dollar to continue to be the mainstay reserve currency and that central banks will continue to keep interest rates low. “In this economic environment no one wants a strong currency,” Brain said. Given low interest rates, and the risk of defaults, bonds remain unattractive from a yield perspective. Investors should consider inflation-protected securities and investments outside of the United States, Brain said.
Brain said the global economy will ultimately recover from COVID-19. “I think there is still a positive GDP number, enough to get us back to where we started. There will be defaults this time around and there will be a loss of capital. For the next two years at least, we are looking at a low-income (investment) environment.”
Originally posted on Forbes