Contagion

At the time of writing, the COVID 19 pandemic is well underway. At the end of January, there were almost 12 thousand cases, mostly in China. Now, just two months later, there are over 150 thousand cases, with the highest growth rates outside China.

After China, Europe has become the new focus of contagion. This is probably because they were complacent, and also because of poor detection in Africa and Central Asia where COVID 19 is likely to have already taken root and may be more widespread than Europe. That said, containment measures in Europe should slow the virus in the next month, perhaps less.

The situation in the US is less predictable. There is remarkable complacency and data is noisy.

The infection rate has been about 60 in a million in China with similar numbers in Europe. In China the number has stabilized but in Europe it continues to grow. Given the differences in containment, the number in Europe is likely to rise faster than in China. Infection rates in both countries will rise over time. In the US the number is 8 in a million.

COVID 19 is different from the flu. It is deadlier, as data attest, killing between 1% to 4% of the infected. It may be more contagious given that it is infectious 2 to 3 weeks before symptoms show.

Economic consequences

Our response to COVID 19 is also different from our response to the flu. China was in lockdown for several weeks and is only just restarting its economy, and only gingerly. Europe has begun to undertake serious measures at containment. The US will soon accelerate efforts to prevent the spread of the virus. These containment measures have an economic cost.

More countries will impose travel restrictions, more people will avoid travel. Events such as cinema, theatre, concerts, spectator sports, conventions, et al have been postponed or cancelled. Lockdowns and restrictions on movements will impair retail, food and beverage industries. Manufacturing supply chains will be impaired as workers are quarantined, isolated or their mobility curtailed.

Industry is not a perfectly frictionless process. Shutting down production may not be instantaneous but require safety checks and phased shut downs. Re starting is even more difficult and may require longer periods to achieve capacity. Complex supply chains will require coordination further delaying full capacity.

The economic impact of COVID 19 has become evident. Recession risk has risen substantially and financial markets have begun to attempt to price this risk. The current volatility in markets is indicative of the uncertainty surrounding this pricing.

Policy responses

Central banks have begun monetary stimulus. The People’s Bank of China has cut reserve requirements and interest rates while providing loans to the economy. The Fed has made 2 inter FOMC meeting rate cuts of 50 and 100 basis points and has resumed bond buying to the tune of 700 billion dollars as well as making loans to the economy. Central banks across the globe will be resuming the stimulus policies of a decade ago to fight the economic slowdown.

Fiscal policy will be engaged to shore up demand. China and Britain have already announced large spending programs to boost the economy.

What happens now?

The hopeful scenario is that the virus becomes contained and burns itself out, or we find a vaccine or a cure.

At the same time countries reopen their borders and restart their economies. There is a sharp recovery in activity and the world reverts to the condition it was in before COVID 19.

Even under this scenario, some things will be different. The economy and industry will no longer be run purely for efficiency but for robustness as well, for stability. This means more redundancy and in supply chains, more slack in the system, a greater consideration for safety. ESG factors will become more important. The result will be a slightly less efficient world, but one more resilient against unexpected set backs.

The bad scenario is that no lasting solution to the virus is found and our lives become permanently disrupted. Life will adjust to the new reality but we end up losing some of the conveniences and freedoms we took for granted.

The policies we deploy such as monetary easing may be ineffective. They either pump up asset prices once again without material impact on the real economy, on employment or incomes, or, they don’t even shore up asset prices.

In our pivot from efficiency to robustness, the long term equilibrium levels of investment and consumption are lower and growth settles at a lower rate. At the same time inflation rises as supply chains lose efficiency.

Risks

QE exacerbates inequality. In 2019 there were over 20 instances of civil unrest, potentially driven directly or tangentially by inequality, of wealth, income, access, influence or power. The application of more QE could be a tipping point.

Inequality also manifests as a healthcare apartheid. The rich have access to quality healthcare, the poor do not.

Debt levels in the world are high. The leverage has built up in the corporate and sovereign sectors. A contraction in demand could lead to serious deterioration of corporate balance sheets. Even if policies to help alleviate corporate stress are deployed, businesses may decide to reduce debt which would mean slower investment and employment growth.

In a crisis, the strong are co-opted to aid the weak. The banking system, the private commercial banks were strengthened by force of regulation over the last decade. While the risk of financial contagion is now low, a de facto nationalisation could be effected to co-opt the banks into rescuing the economy.

It is becoming evident that if not the virus, the response to it, will cause recession. Fighting the virus is the responsibility of health authorities, not central banks and treasuries. Treasuries can help financially of course.

Central banks and treasuries should concentrate on mitigating the economic costs of the virus and our containment measures. There are many ways to do this of varying efficacy.

We have already seen the US Fed’s response: a 50 basis point rate cut in between FOMC meetings. Investors are asking for more rate cuts. The Fed was right to cut rates, but for a specific reason, and perhaps not the reason hoped for by many asset owners. The Fed needed to mitigate yield curve inversion which clogs the bank credit channel. At least some investors will hope it props up the stock and corporate bond markets. The Bank of England has also cut rates. At this time the ECB has yet to act.

The risk is that governments act to boost the economy from the top down yet again. That would involve rate cuts and bond buying, a campaign that lifts the economy from the richest to the poorest. At a time of high inequality, and when a pandemic threatens a sort of healthcare apartheid, this is not efficient. What is needed is a bottom up policy of supporting the economy. Buying bonds, stocks, ETFs, assets, will not help. We need two things. Universal basic income and loan support for SMEs.

Universal basic income has high impact as the poor consume more of their incremental income. It will not exacerbate the existing income inequality. Wealth inequality is being addressed somewhat as asset markets fall.

SMEs are the marginal employer and driver of economic development and growth. They will require support as credit tightens as it has and will continue to do in this pandemic. The ECB’s TLTRO is a good example of how to do this, but collateral standards must be relaxed.

Budget deficits will result. Late last year, central banks implored their treasuries to turn on the fiscal taps. Political realities stood in the way that are now moot. The path is paved for fiscal stimulus. The opportunity presents to have a progressive program to mitigate against the economic cost of the COVID 19 pandemic.

In mid-January we noted the following:

Valuations were high. Equity multiples were high, credit spreads were tight and real estate cap rates were low. Whatever it was an investor considered buying, large numbers of investors had already bid prices up and were squatting on large quantities of inventory.

Economic growth was slowing. The global trade war had sapped some of the vitality out of the global economy and the age of the recovery phase was beginning to manifest in some fatigue. Around Q4 2019, there seemed to be some stabilization in high frequency macro data such as PMIs, indicating the potential for a cyclical rebound in economic activity, but the longer term prognosis was not as optimistic.

Central banks were close to or at their capacity for monetary stimulus. The ECB was well into negative policy interest rates and already doing QE. The BoJ’s negative rate and bond buying policies are so entrenched anything else would be a shock to the market. The PBOC was already stimulating the economy through reserve requirement cuts, rate cuts and expansion of open market operations like repo. Among the majors, only the Federal Reserve had much room for rate cuts. And even the Fed had already been forced into bond buying by technical ruptures in the financial infrastructure.

The strategy going into 2020 had included the following:

Reducing equity exposure and running a closer allocation to the MSCI World Index, as macro risks were high and it was not clear how the chips would fall if the market corrected.

Being careful with duration. If monetary policy lost its edge, fiscal policy would be engaged, and deficits and big debt burdens tend to steepen sovereign curves. The only way to buy duration would have been to focus on the short end which would mean increased notional exposure, itself a risk.

Prefer IG to HY, senior secured to senior unsecured and mortgages to corporate debt. For caution, the first two preferences are obvious. The third is supported by over leverage in the corporate sector while household balance sheets remain healthy and employment and wages at least appear stable.

Along comes a pandemic: COVID19

How bad is the pandemic? We are not epidemiologists or medical professionals, although it appears even the professionals struggle to quantify and specify the human and social costs. Just observing and not extrapolating or forecasting, the contagion appears to have slowed in China, its place of origin, whereas it seems to be accelerating in the rest of the world. The US has so far been lightly impacted. Distance, relative connectivity and a federal health agency will likely allow the US to escape with relatively less damage. Europe is vulnerable and the numbers support it. No pan European health authority with executive powers, no border controls within the Schengen, tourism and strong economic ties to China have led to relatively intense contagion. The rest of Asia seems vulnerable as well just given how integrated the economies are in China’s economic network including tourism. Central Asia is another at risk region. The epidemic within Iran and the Belt and Road activities in Central Asia must lead one to consider interpolation. The near absence of the virus from Africa should also be questioned given Chinese involvement in African economic and infrastructure development.

China appears to have contained the outbreak. If so, the economy should be switched back on in a quarter, maybe a month or two more. China’s approach to containment has been intense and effective. There are grounds to erring on the side of caution and it appears China has done so. Countries or regions with poorer surveillance or stronger civil liberties may struggle to enforce similar controls.

How long will containment measures be deployed and what is the economic impact?

Factories can be shut quickly but re-starting can be more complicated. Supply chains need time to resynchronize.

China may have contained the outbreak domestically but will have to vigilant against importing the virus from abroad.

The share of China in countries’ imports of intermediate goods has doubled to trebled since 2001. In the US the number has more than doubled from less than 5% to 10%, in South Korea it has gone from less than 12% to over 25% and in Japan it has gone from 10% to 20%.

Before the pandemic, the IMF estimated GDP growth to rise from an estimated 2.9 % in 2019 to 3.3 % in 2020. Current estimates, which are quite noisy, put 2020 GDP growth at 1.5% (revised down from +2.9%).

As of Feb 21, 2020, the S&P 500 traded at 19 times 12-month forward earnings, the highest the P/E level has been since May 23, 2002, according to FactSet. Credit spreads across IG and HY are at similar levels of overvaluation.

Has the COVID 19 market correction broken the buy the dip mentality?

In the last 10 years, buying the dips in the stock market have paid off very well. Market dips resulting from US debt ceiling impasses, European sovereign debt crisis, the China slowdown of 2015, the Fed failing to roll its put in 2018, et al, were all buying opportunities. Growth while positive, limped along at times in the last 10 years, credit quality decayed, earnings fluctuated, yet staying invested with the central bank’s stimulus wind at your back always worked. Will it work this time?

I think the downside is more substantial and the risk of a more protracted downturn is real.

Growth was slowing to begin with. Japan was about to slip into recession before any pandemic was contemplated. Europe was slowing precipitously before China flagged the COVID 19 epidemic to the world. America was recovering from a mild slowdown, but it was a weak recovery. The COVID 19 pandemic front loads the slow down and exacerbates it.

What can policy do, both monetary and fiscal?

We have managed to use monetary policy to force the economy to function at an artificially high rate of growth for a long time. Unhappy to let the economy slow, we never allowed the policy levers to be reset even when the economy was stable and growing. The result is that there is little capacity left for central banks to stimulate the economy. There is some room left for the US Fed but the ECB, BoJ and PBOC are mostly close to capacity and facing diminishing marginal efficacy.

The COVID 19 pandemic will allow countries to engage in fiscal stimulation without too much political resistance. Expect budget deficits to expand in 2020 and beyond. This could steepen term structures going forward.

In summary:

• Weaker equity and credit markets still to come.
• Weaker commodity markets, specifically in industrial metals and energy.
• Steeper term structures. Could be driven by rate cuts or rising longer term bond yields.
• Continued strength in USD and gold.

• China is first in and first out.
• Europe is slow to react and over-reacts.
• US might be spared the worst.

Note. This is an incompletely developed train of thought.

The path to artificial (general) intelligence will involve the entire human race. The achievement of AGI could be as mysterious as the distinction between the brain and mind. When AGI is attained it will be the sum of all of us, participating in its evolution and action. Each human mind, each human contribution, would be like atoms in molecules in cells in neurons in a collective brain generating a collective intelligence. There will not be an evil AI which destroys us because when we achieve AGI, it will be a part of us as much as we are a part of it.

With the current focus on climate change and resource sustainability its interesting to think more deeply about the sources and uses of energy on earth.

Fossil fuels. Fossil fuels represent 85% of global energy generation. General opinion is shifting towards the view that fossil fuels are unsustainable because, a) there is a finite endowment which is being exhausted, b) alternative energy will be more economical, and c) the climatic consequences of fossil fuel consumption are too high. Whether one agrees or not with these arguments depends on one’s point of view, time horizon, and economic interests.

It will take a long time to exhaust the current endowment of fossil fuels. The practical supply is much dependent on the costs of extraction and processing and the willingness and ability to pay these costs. Given sufficiently high energy prices, the feasible reserves increase and move the point of depletion further and further away. However, the question is one of time horizons. Given a sufficiently long horizon, we will exhaust the resource. The time it takes to produce fossil fuels is too long, much longer than the time it takes to extract, process and burn it. Since reserves are finite, however large they may be, and we are net destroyers of that resource over time, in fact at any given time, the resource must eventually be exhausted, not in the limit but at some finite time horizon. The impact of extraction alone, needs to be considered, not just the waste products of consumption. What does a planet denuded of fossil fuels look like, what is its geology, geography and ecology? One possibility which may not have been given much consideration, and perhaps with good reason, is to find ways to replace the fossil fuels more quickly than they are depleted. Is this cost effective? Is it possible or practical? Are there better alternatives?

What are the viable alternatives to fossil fuels? Wind, solar, hydro and nuclear power are the main alternative sources of energy. Wind and solar power suffer from inconsistent supply. Apart from generation costs, they are also dependent on storage costs. Batteries, capacitors, flywheels and weights can be used to store energy depending on how long it needs to be stored. Wind power is a sustainable and renewable energy which is a viable alternative to fossil fuels. It currently represents about 5% of global power usage achieving grid parity in Europe in 2010 and in the US in the near future. That said, grid parity is of limited use as a measure of comparison. Even then, the impact of wind power is not fully understood. What happens to the frictional properties of the earth’s surface under the proliferation of wind turbines? Solar power, another sustainable power source currently provides some 2.8% of global energy usage. The International Energy Agency predicts that by 2050, solar power would be the dominant source of energy. In a way, solar power has parallels to the energy transformation process in the production of fossil fuels. Fossil fuels are organic stores of chemical energy stored in the ground which trace their energy source to photosynthetic capture of solar energy millennia in the past. Hydroelectric power is still small scale and largely dictated by the physical geography of the earth.

In the end, there are only so many sources of energy. Nuclear energy powers the sun. Light energy brings that energy to the earth where photosynthetic plants convert the energy into chemical energy which is then stored in the earth’s crust until it is extracted in the form of fossil fuels. Heat energy from the sun also powers convection resulting in winds that power turbines. Weather pulls water from oceans to high ground where they accumulate. On their return to the sea, the gravitational potential energy is converted into kinetic energy which is harvested by turbines and generators into electrical energy. In large scale, there is but one single energy source: the nuclear energy of the sun. All this planet can do, is harvest it and recycle it. Failure to harvest sufficient energy will lead to an eventual catastrophic deficit. Recycling helps mitigate short term deficits.

Harvesting of sunlight can take several forms. The oldest is photosynthesis. Plants form a part of our solar panel array. The chemical energy they accumulate has to be processed to form combustible compounds such as biodiesel, ethanol or methane which can be burnt for fuel. There are practical, engineering reasons why currently, biofuels may not be efficient alternatives to fossil fuels, but theoretically, they can be. Photovoltaic cells, and concentrated solar thermal power is another way of harnessing the sun’s energy. How they differ from fossil fuels, is time. Fossil fuels are millennia of inventory, inventory that we are now drawing down. As we do so, we also release the carbon captured when the energy was stored.

An alternative to harnessing the power of the sun, is to replicate that power source on earth. This is nuclear power, which currently represents 10% of total energy production. Nuclear power is potentially inexhaustible since as long as there is matter available for conversion, there is power. The issues around nuclear power are safety and cost. On the basis of cost, nuclear power ranks well, on a total basis including capital costs and operating and maintenance costs with the capital costs being the greater share by far. Nuclear power is almost as cheap as coal and far cheaper offshore wind and solar, both photovoltaic and thermal. The consistency of supply is not even in question. The main issue with nuclear power, is safety. The memory of Three Mile Island, Chernobyl and Fukushima remain with us. Despite a low death toll, these nuclear accidents generated a disproportionate public reaction. There are good reasons to suspect that the long-term effects of these accidents, beyond the immediate death toll, are not yet fully understood. However, the low cost and energy efficiency of nuclear power makes it a viable source to pursue. What is needed is to improve safety with a view to large scale deployment. Reactors based on alternative fuels to uranium which can be dangerous and weaponized could be found such as thorium.

Yet another alternative solution to our energy problems is to either produce the energy off-planet and send it back, something called space-based solar power (SBSP), or to relocate energy intensive industry off-planet.