Covid-19 will reshape economic thinking, create big buying opportunity

TWO months ago, when people were still referring to Covid-19 as "the China virus", global markets seemed ambivalent about the depth and duration of any economic slump that lay ahead. The initial sell-off in stocks was shallow and short-lived, though the US dollar was quietly strengthening.

Now, we are getting a taste of how ugly things could look when companies begin reporting their Q1 2020 numbers. This past week, the Caixin/Markit composite manufacturing and services purchasing managers' index (PMI) for February came in at a record low of 27.5, down from 51.9 in January. Readings above 50 indicate growth, while those below 50 indicate contraction.

It is also becoming clear that Covid-19 is as capable of causing irrational panic in the West as in the East, with reports in recent days of shoppers in the US and UK flocking to supermarkets to stock up on food, bottled water and, yes, even toilet paper.

The policy responses to Covid-19 on opposite sides of the world have been quite different though. China first tried to suppress reports of the virus, but later imposed a widespread lockdown that does appear to be containing its spread.

On the other hand, Covid-19 did not seem to be on the radar of the US government until the last couple of weeks, when capital markets were engulfed by turmoil and the S&P500 Index sank by more than 10 per cent. This past week, the US Federal Reserve announced an emergency 50-basis-point interest rate cut.

These policy responses are far from perfect. Quarantining people and restricting the flow of business travellers and tourists might be effective in containing Covid-19, but it is resulting in a slowdown in economic activity that will be intolerable over the long-term.

On the other hand, it is hard to see how lower interest rates will stop people from succumbing to Covid-19, and make them more confident about venturing out of their homes. Indeed, lower interest rates might simply make it less profitable for banks to extend credit to businesses, just when that credit is most needed. And, instead of helping to support risk assets, looser monetary policy might just inflate demand for safe havens like gold and US Treasury bonds.

Demand & supply shock

Kenneth Rogoff, Professor of Economics and Public Policy at Harvard University, says in a column earlier this month that Covid-19 is creating both a demand shock and a supply shock to the global economy. Millions of people are suddenly not indulging in consumption activities like travelling and shopping, and they are raising their precautionary savings. At the same time, millions of people aren't able to go to work, which is causing global supply chains to break down.

Against this backdrop, Prof Rogoff is recommending that affected economies "engage in massive deficit spending to shore up their health systems and prop up their economies". However, he also warns that the supply-side element of the downturn will result in sharp declines in production and widespread bottlenecks. "In that case, generalised shortages - something that some countries have not seen since the gas lines of 1970s - could ultimately push inflation up, not down,"

He adds: "Rising inflation could prop up interest rates and challenge both monetary and fiscal policymakers."

The oil shock and stagflation of the 1970s, to which Prof Rogoff refers, marked a turning point in economic thinking, when the influence of John Maynard Keynes gave way to the neoliberal ideas of Friedrich Hayek. In the decades that followed, governments cut taxes, rolled back regulation, and encouraged the cross-border flow of goods and capital.

Around the same time, the world began embracing Milton Friedman's philosophy that the social responsibility of business is only to increase profits. Among the most admired companies of this era was General Electric, run by the legendary Jack Welch, who died last week. Mr Welch relentlessly pruned business units that were vulnerable to competition, and invested in those that were the lowest-cost players in their respective markets. He also advocated the regular culling of the bottom-performing 10 per cent of GE's employees.

The results were spectacular. By some estimates, during Mr Welch's two decades at the helm, GE's market value went from US$14 billon to US$410 billion.

Shifting politics

Of course, this blind pursuit of shareholder value had a dark side. Corporate bosses like Mr Welch were incentivised in a manner that probably promoted excessive risk-taking. When he retired in 2001, GE's profits were heavily dependent on its financial services unit, which left it vulnerable to the Global Financial Crisis. GE has lost some 80 per cent of its market value since Mr Welch stepped down.

More importantly, treating workers as a cost item that needs to be reduced, rather than a source of competitiveness that ought to be developed, led to stagnant middle class incomes in the US and contributed to broad mistrust in capitalism and globalisation.

This is the reason US President Donald Trump's rhetoric about trashing trade deals and bringing jobs back to America's Rust Belt was such a vote-winner in 2016. It is also probably why Senator Bernie Sanders - a self-confessed socialist - has garnered such strong support among young people in his bid for the US Democratic Party's presidential nomination over the past year.

Despite the growing leeriness, the neoliberal-shareholder-first system has avoided a real comeuppance, ironically, because outsourcing and globalised supply chains kept inflation subdued. That enabled interest rates to be cut at the first sign of trouble, and any economic pain to be salved with ever more debt.

The potential for Covid-19 to deliver a supply shock that tanks the global economy and drives up inflation could be a game changer though. Loose monetary policy and broad tax cuts would not be suitable tools in this instance. Lawmakers would be under pressure to come up with fiscal mechanisms to directly support segments of their economies most affected by the recession. It could perhaps be an important step towards rediscovering the benefits of widely shared prosperity.

Buying opportunity ahead

So, what should investors do? In my view, the slump in economic activity and corporate earnings over the next couple of quarters will be truly frightening for the markets, especially as it becomes clear that looser monetary policy isn't helping. That would be a buying opportunity not to be missed.

My own playbook in such situations is to come up with a list of companies that have strong businesses, and begin buying when their share prices fall below a certain level. For instance, I would be a buyer of Singapore's banks if they traded below their book values. Battered airlines, cruise companies and casino operators would be a bargain if their market capitalisations sank far enough below the replacement cost of their key assets minus their liabilities.

It would be important, of course, that the companies have strong enough balance sheets to ride through the slump. And, it would be a good idea to ensure that your portfolio isn't too concentrated in any particular stock or sector.