Catapult Insights – Global Macro Perspectives – June 2020

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Why Macro perspectives matter?

With three “once in a lifetime” crises in the last 20 years and the worlds complexity and interdependence ever increasing, one would be ill advised to make financial or other business decisions without a global macro perspective and/or framework.

Given this complexity I would argue it is almost impossible to have, but one view and thus a scenario approach is probably best suited to help prepare for what will inevitably surprise you (more often than you think/want).

As Marc Twain eluded “History doesn’t repeat itself but it often rhymes”. With global central banks and policy makers having increasingly eased monetary conditions to alleviate the impact of corrections post dot-com-, real estate- and credit bubbles of the last 20 years, one has to question how long such postponement of inevitable corrective pain can continue.

With interest rates near the zero bound in the western world and sovereign, corporate and household balance sheets stretched beyond classic solvency limits already, it is not inconceivable that this time the world will have to “take the painful medicine”.

Having spent the month of April in disbelief looking at the equity market rebound and the last month watching the dust settle somewhat, I think there are some clear trends developing that can inform possible outcomes/ scenarios and give signals as to which way things are heading.

Let’s start with the Macro Perspective

• Even though it feels like we might have seen the worst of COVID in mainland Europe, globally the number of infections and deaths is still increasing linearly with the US, Brazil, Russia and India making up for declines elsewhere in the world (i.e. re-opening local economies will not magically put an end to the global economic impact of COVID-19).
• “Re-opening” of China has shown that although production can be restarted, consumption and economic activity does not necessary follow in lock step with first signs of inventory build up and producer price index (PPI) weakness in Asian macro data together with continued low consumer & business confidence.
• In the US even Trump’s own economic advisor now admits unemployment will rise through June and will remain in double digit territory through the rest of the year – i.e. there is no V- or U-shaped recovery this year!
• After negative Q1 GDP numbers, April stats show the true extent of the economic carnage with the Atlanta FED now expecting over 40% (yes you read that correctly, 41.9% to be exact) QoQ GDP decline in Q2 for the US.
• If one uses US employment recovery shape for GDP recovery from that Q2 low, my aggregate US GDP decline estimate of 15-20% for 2021 and 10-15% for 2020 squares with most estimates and I just don’t see how Europe can fare that much better in the long term.
• Many European countries have dampened lay-offs with temporary part-time work subsidies. When these end, necessary restructuring will result in permanent unemployment and restructuring of balance sheets which in my view has yet to begin in earnest.
• No amount of government policy can stave this off indefinitely and indeed businesses with compromised balance sheets and/or limited access to capital markets are already coming to that conclusion (Hema, J. Crew, J.C. Penny, Nieman Marcus & Hertz being but leading indicators of what is to come).
• Global supply chains have been disrupted and labor-market impact in emerging markets – although less well documented – is even greater than in developed countries. The global labor market is thus likely to be in oversupply for some time to come.
• Producers & service providers globally are facing a new reality that is becoming increasingly clear with changes in consumer and business behavior, driving under-utilization and margin pressures – which combined with the inventory cycle and deleveraging – will result in deflationary pressure and the need to restructure.
• The monetary stimulus has staved off short term liquidity issues in the capital market and allowed all those caught “off-guard” by COVID and access to such capital markets to refinance/term-out financing with record issuance in the past months.
• It has also caused seemingly “detached” stock market valuations, but underneath the headline numbers the new world order is becoming clearer by the day, favoring those with healthy balance sheets and low capital and labor intensity (read largecap tech stocks) over “old economy” business models and financial leverage.
• With the monetary stimulus fueling asset prices, postponing deleveraging, and simultaneously decreasing the velocity of money, the ability to resurrect the real economy with such additional liquidity asymptotically diminishing to zero. The question thus becomes: for how long will we be able to continue and – more importantly – how will it end? I see only three scenarios:
  Deflation/Deleveraging followed by controlled gradual reflation (“rinse & repeat” after which growth resumes)Deflation/Deleveraging followed by stagflation (“Japan scenario” under which growth remains stagnant due to low productivity, high leverage and financial/fiscal repression)Deflation followed by uncontrolled inflation (“Reset” and/or “Debt Jubilee”)
• It seems to me that the more governments and central banks do to avoid the inevitable economic pain of restructuring, the greater the risk of ending up in scenario 2 or 3.
• US/FED decisiveness and pro-activeness in response to COVID crisis is in stark contrast to that of the EU/ECB. Both however appear flat footed in comparison to China’s response to the virus and its ambitions as stated in its 14th 5-year plan. With trillions being spent on strategic initiatives including digitization of economy and currency, Artificial Intelligence & 5G, environmental improvement & sustainability, healthcare, agricultural self sufficiency, etc.
• China is for sure as affected by the COVID crisis and subsequent global economic slowdown as the rest of the world, and I am not able to weigh China’s “ticking demographic timebomb” and/or the financial leverage hidden in its national banking system versus the issues we face in the West. But their leadership appears to have a clearer focus on the way out of this mess, whilst the west appears stuck in a “catch 22” of trying to “save” the status quo at the expense of the creative destruction, change and innovation necessary to preserve the prosperity of future generations.
• That said, it is my contention that as long as the USD remains the global reserve currency, the EU continues to fail to get its act together and both China and Russia have not switched to either crypto or gold as preferred medium of exchange the USD will strengthen as the flight to “safety” and the structural global USD shortage in a deflationary environment continues to suppress commodity prices and the currencies of those dependent on their export.
• I believe the fiscal and other quarrels between EU member states that grace the front pages of our news papers are the mere surface of much deeper and likely impossible to reconcile differences as discussions necessarily migrate from how to distribute EU subsidies to how to allocate actual losses/write-offs. That said, in a digital/crypto currency world it may be much easier to retain the single market and possibly even a Euro or some other trade weighted international unit of exchange whilst giving sovereigns back their individual currencies and fiscal autonomy.
• US Equity market indices (Dow / S&P) especially the NASDAQs ability to “see” beyond the COVID abyss, do not seem to rhyme with the unprecedented unemployment, GDP and other economic stats. There doesn’t appear to be a single or rational explanation, other than some combination of light volumes, renewed millennial/retail interest, FOMO1, TINA2 and/or FED intervention.
• What is clear and rational is the ongoing underlying differentiation related to geographies, sectors and business models. It is therefore not the absolute levels, but rather the stark underperformance of emerging markets, cyclicals and especially the financial services (banks/insurers) that are the true indicators of the severity of the credit and solvency issues that lay ahead.
• We are in the currently “hope” phase of the post COVID recovery, where positive sentiment and news flow from “lifting” of lockdowns outpaces negatives from credit & solvency issues which I expect to materialize only gradually over the coming months. Equity markets are therefore likely to continue trading sideways – or even slightly upwards – with heightened volatility, whilst markets continue to sift the wheat from the chaff.
• When the full extent of the resulting credit & solvency issues becomes clearer and/or such issues become systematically problematic again for the financial system, markets have further to correct.
• Banks in general are better capitalized than before, but a market dislocation in Hong Kong or failure of a systemically important bank or sovereign in Europe, could easily trigger a rough second leg down.
• Expect sovereign rates/curves to decrease/flatten in the near term, close to or below zero and corporate and high yield spreads to remain elevated.
• As inflation (CPI) goes more negative / deflation picks up, rates in the US too may be forced to go negative to keep real rates close to zero and avoid unnecessary monetary tightening. Inflation will only become a topic when short term rates start to pick up again which central banks seems hell-bent on avoiding for the near term.

What does all that mean for (Dutch) SME’s?

• Central bank and other governmental support measures are stop gaps to dampen the blow from COVID, but make no mistake things are not going back to the way they where before any time soon.
• As turnaround professionals, we know that an ounce of prevention is better than a ton of cure. Entrepreneurs should prepare proactively for changing consumer behavior and preferences and a future less dependent on leverage and with higher required resilience (lower costs, higher capital adequacy and more inventory and working capital).
• Use scenario’s specific to your line of business to determine necessary strategic and financial actions to be implemented and to keep financiers “on board”.
• The improvement of the Macro environment and the “purge” of non-viable companies and business practices will take a lot longer than people think/hope, and thus people should prepare for a longer period of economic weakness/low growth during which only the fittest will survive. Cash conservation and buying time will be key to survival.

Other points of interest, risks and asset allocation perspectives

• I remain keenly interested in digital fiat and crypto currency developments as leading indicators as to how long, or indeed if, the US Dollar dominance will last.
• Equity markets remain difficult for retail investors with volatility (VIX) still double normal levels, elevated valuations due to central bank liquidity intervention and the reward risks skewed to the downside.
• My preferred current asset allocation is 1/3 USD cash, 1/3 USD treasuries, 1/3 Gold and a bitcoin for every family member, just in case.

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Catapult Insights – Global Macro Perspectives – 2020.06