Do you know those parties where everybody is having a great time and there comes a time when they all naturally want to open the champagne? And a guy immediately says “hold on, do not open the champagne for another year, it is not time yet!”. And all of the sudden he/she becomes the most unpopular person in the room. That is the person I have decided to be today.
I basically want to invite to caution because it is my belief that the circumstances are very misleading. What do we see if we look around? High growth rates, whether relative to consumption, or the GDP, we see the economy seemingly bouncing back, so a very encouraging picture. We also see stock markets at record highs, investors eager to buy stocks, so the question on everybody’s lips is “how far is the market going to grow again tomorrow?”. And we also hear governments and central banks repeatedly talk about a V-shaped recovery. That is everybody’s dream and expectations are there to be met.
I don’t think that is any cause to get carried away. Stop being delusional, because according to Carmen Reinhart, Chief Economist of the World Bank Group, we are in a “pandemic depression”. Understandably, depression is a word shunned by many people as it is a reminder of the `30s and we all know what a terrible economic shock that was. However, if we look at a series of numbers, we realize that in fact ours is a completely exceptional moment. For example, the US unemployment rate is at its highest in 72 years. The Bank of England has estimated that the UK is going to experience the steepest economic decline since 1706. These are the times that we are living in and we should be aware of it.
I would like now to refer to the three variables already mentioned: high growth rates, stock markets and the shape of economic recovery. As far as significant growth rates are concerned, we need to be aware of the following: an economic decrease of, let’s say, 50% will not be cancelled out by a 50% growth! To make up for a 50% drop you need 100% growth. This is simple math. What I mean is that, even though today’s rates seem spectacular, they are not high enough to take us to where we started. The Chief Economist of the World Bank Group stated that, looking back at the worst economic crises, it took 7 to 8 years to return to pre-crisis levels.
Let us now move on and discuss about stock markets. Their case is absurd: they are completely decoupled from the economic fundamentals. We are now in an unprecedented situation when companies, such as Hertz or JC Penny, the day after filing for Chapter 11, saw they stock price significantly rising. We are in a situation when, probably for the first time in stock market history, a bankrupt company, such as Hertz was granted approval to sell $1 Bn in shares. Meanwhile, the bonds of such companies were indeed trading at the price of bankrupt companies.
This is a time when investors are grappling to invest in something. Interest rates reflect the financial repression cultivated by central banks through negative real interest rates which destroys the wealth of most people investing in fixed income instruments. Under these circumstances, the only instrument at hand, risking overvaluation, remains the stock market. And everybody is looking for exposures to tangible or intangible assets.
This is the consequence of the massive money printing by central banks that is not backed up by goods or services. But this can only be a short-term solution. Central banks are intent on avoiding a freeze in banking and economic activity. This may be the only immediate answer but it comes with significant medium and long-term costs. And one of the costs will be the destruction of personal wealth. Ordinary people do not have the possibility or the acumen to invest in sophisticated instruments. They are more inclined to use interest-bearing instruments and as a result they are bound to lose money over the medium and long term.
Most investors on the stock market are guided by the P/E ratio (price-to-earnings), but the price-to-sales ratio is equally interesting. It tends to be more stable as profitability is more volatile and can be subject to “creative accounting”. Historically speaking, a P/Sales ratio of 10 is rather unusually high. Today, about 530 of the 8,500 stocks listed in the US exceed the 10 mark. Moreover, the US stock market capitalization relative to GDP is 200% which is an all-time high. Tech companies are the main driver of growth. Any business remotely involved in digitalization, manufacturing of e-vehicles or working from home platforms gained investors’ attention laying the groundwork for bubble formation.
The third element that I mentioned was the shape of economic recovery. A V-shaped recovery means that a sharp decline is followed by an equally sharp growth. As already explained, to have a V-shape recovery a 100% growth is needed for a 50% decline. It is hard to believe that this will happen. An alternative would be an italic V in which recovery takes longer than the plunge. But even in this scenario, the assumption is that we will get where we started in a relatively short amount of time. I would take this shape of recovery with a pinch of salt and I will explain later why.
Another type of recovery is the K-shaped. The K is used because its two halves may indicate the development direction of two separate parts of the economy. The first part has fully taken advantage of the pandemic and is the upper half of K. The lower half represents all businesses feeling the brunt of the pandemic, the hospitality industry, transports, to name just a few. This is a letter that stands for all the divergent trends across the economy.
The last sign used for the economic bounce-back is the reversed square root symbol used by professor Paul Krugman which suggests a severe drop followed by partial recovery. I think it makes sense. And this is why.
Firstly, the likelihood of a second wave is high. There are strong signals in this respect. I do not believe, however, that the economy and the population will be placed on a second lockdown. We are much wiser now, we know what needs to be done, so instead of a total lockdown we may see selective closures of cities or regions. We will still need time to come up with a vaccine and then time to make it available to all. Finally, we should ask ourselves another question: how effective will the vaccine be? As we already know, viruses mutate which may render the vaccine ineffective even before people are immunized.
A second reason for caution has to do with the ongoing capital destruction which is set to continue. The European Commission estimates that the EU companies will lose EUR720 Bn in 2020. Moreover, and more importantly, a quarter of the companies employing up to 20 people will run out of circulating capital and available cash. A come-back will prove extremely difficult for these companies. Undercapitalized businesses will not be able to invest and some will remain captive to servicing their debts, drawing out the turmoil until they will become insolvent.
Another threat lies in the good intentions of governments eager to help the business environment. Their efforts may not lead to fast recovery because by subsidizing all economic sectors they will delay the death of companies that under normal circumstances have no reason to exist. The key to economic recovery is channeling resources to those industries with a future.
The third reason relates to the collapse in exports. World Trade Organisation puts the drop in exports worldwide at 13-32% in 2020. If the actual decline is somewhere in the middle, that would be the highest rate since the early `30s. We should note that during the 2008 crisis China continued to grow which provided support to the entire world economy. That will not be the case now.
Which economies will feel the blow? Both developed and emerging economies. We have industrialized countries exporting technology, such as Germany, then service exporting countries, meaning the biggest destinations for tourists, and finally we have the great exporters of goods, such as oil, gas and minerals. So we can think of three categories of states, both advanced and emerging economies, which are bound to suffer.
A fourth reason is persistent unemployment. We must be aware that some businesses will never reopen. Some people will never find work again. Others will work below their qualifications for less money than before. Graduates will have difficulty finding a job, and many young people will be forced out of schools as they lack the means for remote learning. And not only the poor countries, but also the rich world will face these challenges. The money that they so easily dole out on welfare will have to be returned. That means that budgets will be directed from development to repaying public debt.
The fifth reason is polarization between and within countries which can be easily overlooked if we only take the averages. It actually means that there will be fewer consumers to generate the much needed economic rebound.
Finally, the last reason, probably still underestimated, is the delayed impact of the current situation on banks. So far, banks have not experienced major issues caused by unpaid loans or client bankruptcy thanks to massive support from governments. But the worst is yet to come for them. 2021 will be a much challenging year for banks because it will reveal the true weaknesses in the economy. There will be more personal bankruptcies, more businesses will go under and more countries will go bust as well.
I would end by urging you not to take a positive correlation, such as the current one, for a sustainable economic recovery. Do not open the champagne yet!
(speech held at the “Critical choices for leaders” event organized by ASEBUSS [Bucharest Business School] and Kenesaw University in partnership with AmCham)
