There is some sense that markets are beginning to feel somewhat calmer, although the daily swings in markets we are continuing to see confirm that the volatility experienced over recent weeks is not over. Politicians are increasingly referring to the efforts to counter the effects of Covid-19 as a war on the coronavirus. It might therefore be worth exploring this metaphor and compare the economic impact of the virus with that experienced under wartime conditions.
We have seen a significant increase in governmental participation in economies in response to the dramatic spread of Covid-19 and some of the normal rules of capitalism have been suspended, in line with what we would expect during a war. However, there are some notable differences. Usually in wartime, production increases significantly to meet the demand for raw materials on the frontline and to aid the war effort. This typically has an inflationary effect as the workforce continues to have money in their pockets and need to be dissuaded from using those funds to purchase non-war critical goods. However, the war against Covid-19 is potentially far more deflationary. Many people face unemployment or at least are finding themselves on furlough, putting a strain on disposable income, and large parts of the economy have been effectively closed down. Although sectors linked to the medical industry will experience increased demand, these represent a relatively small part of the overall economy and the net effect is highly deflationary. It is for this reason that central banks have been so active in ensuring cash flows through the system in an effort to offset these deflationary pressures and to prevent an economic slump occurring as a consequence of this crisis.
There are marked economic differences between domestic and external wars, and If we are going to liken this struggle against Covid-19 to a war, it is important to determine which sort of conflict it most resembles. During domestic wars, the impact is felt most keenly on home territories. During the Second World War, the fields of combat within Europe were in Germany, France and to some extent the UK which suffered extensive damage from bombing. In external wars, such as the Gulf War or the UK’s involvement in 19th century Napoleonic War, the bulk of the repercussions are suffered overseas with little impact on domestic infrastructure or the workforce. An external war is perhaps a better metaphor for what we are currently suffering. Clearly this virus will have a tragic impact on the population, but it is principally those who are economically inactive, such as the elderly or those suffering from long-term illnesses, who are worse hit. Historically, in the face of external wars, stock markets have suffered short-term downturns, but they have typically rebounded rapidly once the threat has disappeared.
Wars are typically financed by borrowing and we expect a huge surge in government borrowing and a ballooning in national debt. This is not unprecedented: if we take World War Two as an example, government debt increased drastically. It is somewhat unprecedented in peacetime but if we are to continue with the war metaphor, we need to consider governmental borrowing in these terms and in similar time frames. During the Second World War and the Napoleonic War, national debt reached levels of between 220 and 240% of GDP which is two to three times greater than it is today. We expect national debt to climb and to climb significantly, but it is still well within historic precedent. It clearly increased significantly during the Second World War but that was long and drawn-out, and hopefully this war against the coronavirus will be relatively short in comparison. If national debt can be kept within manageable limits there is no need for it to result in inflation. Inflation can occur as a result of war, as witnessed in Germany following World War One, but it does not necessarily follow that governments have to resort to inflation to deal with a significant increase in national debt. At this stage, it is impossible to put a precise figure to the probable growth in national debt – to say it will be an increase of 10%, 20% or 30%, would simply be pulling figures from the air. However, debt at these levels are fundable and, particularly if funding costs remain low, it is likely that the economy will be able to cope without resorting to inflation. Taxes may rise for many of us, but the repayment of the cost of this crisis will be spread over several generations.
To conclude, this virus could have inflationary consequences, but we need to be more much alert to the deflationary impact this crisis may have, certainly in the short term. We do not need to be resigned to inflation over the long term although this is a risk that investors need to bear in mind when structuring portfolios.
Source: Square Mile Investment Consulting and Research Limited. Investment Partners to Ernest Grant.
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