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The second global crisis in just over a decade has certainly confirmed the importance of a functioning economy in a modern society but also the need to strengthen the resilience of the global economy. The success of globalisation over the last 4 decades has thus also become the Achilles heel of this economy.

The supply problems caused by the closure of factories in China will thus lead to a reappraisal of the risks associated with the displacement of an increasingly large share of production to regions where labour is cheaper. Supply chain security will once again become a priority. At the same time, the national interest is clearly regaining the upper hand. The re-establishment of borders within the European Union and the lack of a coordinated response to the pandemic thus raise questions about the long-term survival of the European project.

1. The general environment

If the crisis will therefore reinforce the anti-globalisation trend that has been present for several years, other questions should also emerge. These questions will include the role of the state, the relationship between shareholders and other stakeholders, the ownership of assets and the moral hazard that goes with it (should listed companies in need of state support be nationalised? Many of these companies are currently in difficulty because in past years they have paid all their cash flow to their shareholders instead of building up financial reserves) and the relationship between protecting people and maximising profits.      

I fear that the loser in the current crisis will be the market economy. This would be all the more ironic since the rules of a market economy have not been respected for a long time. Much of the blame lies with the central banks. The research firm BCA Research introduced the concept of the 'debt supercycle' a long time ago to describe the behaviour of central banks. The idea behind this concept is that for the past 40 years the monetary authorities have been trying during every economic downturn and during every small crisis to stimulate demand by relaxing their monetary policy, rather than letting the excesses of the previous cycle be unwound (which would be stipulated by respect for the market economy). As a result, each new growth cycle over the past 40 years has started with higher financial imbalances and debt levels than the previous one. Each cycle of contraction therefore requires increasingly extreme measures, measures which subsequently lead to even greater excesses and imbalances. At the same time, monetary authorities encourage excessive risk-taking based on the principle of "privatising the gains and socialising the losses". Moral hazard becomes omnipresent. The most important price in a market economy is the price of money, i.e. the interest rate. If this rate is manipulated and kept at an artificially low level, the market economy will no longer function effectively.

The manipulation of interest rates reached new extremes after the financial crisis. The argument often put forward that low rates are necessary to sustain economic activity does not hold water. On the contrary, it can be argued that artificially low rates discourage productive investment by encouraging companies to go into debt in order to buy existing assets - through buying up their own shares or taking over competitors - and by preventing zombie companies from disappearing. They also discourage consumption. People are not fooled. They are aware that, given the very low return on their savings, they will have to save all the more. Low interest rates have also led to higher prices for financial and real estate assets and accelerated the divide between rich (who own such assets) and poor (who do not).

There is no reason to believe that central banks are ready to question themselves, especially since they are happy in their role as saviours and will increasingly be called upon to finance government deficits.

2. The markets

- In the short term:

Since their lows, most stock markets have risen quite sharply. At the time of writing (07/04), the main indices have risen by some 20% from their mid-March levels. Spectacular rallies are quite normal in bear markets. Especially since the markets have never lost so much in such a short period of time. Does this mean that a sustained uptrend has been restored? That would be surprising in any case. It would mean that this bear market would have been very short and that the leaders of the bull market that preceded it would have come out of it without too much damage. (In the past, bear markets have generally signalled a shift in leadership from some sectors to others. The current bear market, however, seems to be encouraging investors to buy the winners of the bull market that preceded it, especially technology stocks). It is true that nothing in this bear market is normal: The cause of the stock market decline is an unprecedented economic slowdown that the authorities deliberately provoked in order to fight the spread of a virus. At the same time, these authorities quickly put in place unprecedented monetary and fiscal stimulus measures. The duration of this bear market could therefore be abnormally short.

The main question at the moment is how long the economic slowdown will last and what form the recovery will take when it comes. The market is currently expecting an optimistic scenario: a very bad second quarter followed by a strong re-acceleration in the second half of the year. All this is obviously based on the assumption that the spread of the virus will come to a rapid halt.

It is clear that the longer the current situation lasts, the greater the damage to the world economy. It is in this context that the monetary and budgetary measures decided by the authorities should be seen: these measures are not taken to avoid recession (since it is the authorities themselves who, by their decision to impose a generalised lock down, are at the root of it) but rather to keep the economic machine structurally intact and enable it to restart as quickly and as strongly as possible once the health crisis is behind us. The idea is to avoid entering into a vicious circle that would lead to huge job losses and corporate bankruptcies, or even a financial crisis comparable to that of 2008. In the short term, therefore, these measures must be seen as support measures, rather than stimulus measures.

The scenario of a strong recovery in economic growth in the second half of the year, what economists like to call a V-shaped recovery, seems to me to be illusory, however. First of all, while it is true that for some industries revenues could quickly return, this will not be the case for others. Secondly, the damage to supply chains should not be underestimated. Finally, it is impossible to predict today how people will behave once the lock-down measures are relaxed. Especially if such a release would cause a second wave of the virus.

At the level of the markets, while the downturn has been severe, signs of a general capitulation (which generally characterizes market bottoms) are otherwise absent. On the contrary, many investors seem to be attracted to so-called bargains. However, the stock markets are not particularly cheap, especially considering the decline in earnings and upcoming dividends. The fall in the markets, however spectacular, must also be put into perspective: stock prices had risen significantly before. Their current levels do not incorporate any margin of safety in the event of a further deterioration in the situation. After its rebound in recent days, the S&P 500 index is now more or less at its level of a year ago. 

- long term:

In the long term, there are positive and negative elements to be highlighted for the stock markets.

On the positive side, first of all, it can be noted that, all other things being equal, equities have become cheaper. Their long-term return potential, which was very low before the fall, has therefore increased. The second positive point is that it is to be assumed that central banks will wait a very long time before starting to tighten their monetary policy. At the same time, they will do everything they can to prevent a rise in bond yields. In other words, interest rates will remain very low for a very long time. It can also be assumed that the trend towards expansive fiscal policies will also be maintained. This could lead to an acceleration of economic growth (in nominal terms). 

A priori, this appears to be an ideal scenario for the stock markets: acceleration of growth without a rise in interest rates. Nevertheless, a number of disruptive factors should be pointed out.

The environment of the last 40 years has been extremely favourable for financial assets. Two trends in particular have characterised this environment: the decline in inflation, which has led to an unprecedented fall in interest rates, and globalisation, which has led to an increase in corporate profit margins. In addition, in some countries, such as the United States in particular, the obsession to maximise shareholder value has led numerous companies to have recourse to debt to buy back their shares (which increased earnings per share) or increase dividends. Each of these trends now appears to be under threat:

If the current crisis is deflationary in nature, its longer-term ramifications could well be inflationary. The over-indebted economies of the Western world will not be able to tolerate a prolonged period of deflation. Expansive fiscal policies financed more or less directly by willing central banks will sooner or later push inflation up. (As noted above, however, it is far from certain that bond yields will be allowed to rise in such an inflationary environment. This reinforces the investment thesis in favour of gold). As indicated at the beginning of this article, the current crisis will also reinforce the anti-globalisation trend that was already present before the virus appeared (which was disinflationary). This crisis has exposed the fragility of a system optimised for the needs of investors, where buffers and security measures have gradually been reduced or eliminated altogether in order to maximise returns. Making this system more resilient will require a decline in corporate profitability. In the same vein, the current crisis will also shift the balance of power between capital and labour in favour of the latter. Finally, measures to optimise the financial performance of companies will diminish and may even disappear completely in the case of companies that call on public aid. Share buybacks will thus become the exception rather than the rule. This is far from insignificant if we know, for example, that in recent years the main source of demand for US equities has been the companies themselves through share buybacks.

While it is too early to make accurate predictions about what the investment environment will be like once this crisis is over, it is likely to be quite different from the pre-crisis environment. In particular, the role of the state in the economy is likely to increase, especially in the euro area, where there has always been a strong willingness to regulate, at least in some countries.

Guy Wagner, Managing Director

An economics graduate from the Université Libre de Bruxelles, Guy joined Banque de Luxembourg in 1986 where he was head of the Financial Analysis and Asset Management departments. He was appointed Managing Director of BLI – Banque de Luxembourg Investments in 2005.

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