July 31, 2020

4 min read

Fintech and Innovation

The Long-Term effects of the Corona Crisis: Part 1
Nicholas Flaherty Image

Nicholas Flaherty, Investment Strategist at FWU Invest S.A.

Every economic crisis leaves its mark and the current crisis will likely be no exception. Of course, we are still in the midst of the crisis and there is a whole of uncertainty to come in the months ahead, but nevertheless it does already make sense to take a step back and reflect on how the world will look like once the dust settles. This, in turn, can ensure that we as investors are as prepared as possible to deal with a new world and the investment challenges it presents.

So, what kind of effects will the crisis have on our economies?

There are myriad effects of the crisis, ranging from the broad macroeconomic down to sector and company-specific outcomes. But for the sake of simplicity, today we will concentrate on one of the most obvious and impactful economic changes: the massive rise of government debt.

Indeed, the Corona Crisis is driving us quickly into a world of markedly higher government debt. Government debt prior to this crisis was already high in many countries but is now significantly higher still. In the United States, for example, government debt to GDP now stands at over 130%, up from around 60% prior to the 2008 crisis. The same jumps can be seen in Europe as well.

In order to pay down this debt, three choices are possible: default, austerity or inflation. We can basically rule out default; it would be too disruptive and would end doing more harm than good. Austerity, meanwhile, has also gone out of fashion in a big way: governments, unlike in the wake of the last crisis, are not looking to save money, quite the opposite, especially considering the rise of populist forces.

In the end, this leaves us with inflation. This is a tried and tested way to get debt under control and has historically been used following wars. Primarily, the way this works is that interest rates are kept very low for a prolonged period, leaving inflation running significantly higher than the prevailing interest rate. In this way, the debt can be ‘inflated away’, without having to resort to austerity or default.

Thus, this being a highly likely scenario, we should be prepared to see very low interest rates for as far as the economic eye can see. This is, all things equal, good for the equity markets, especially for the high growth stocks, which benefit to large degree from low rates, but it does have some clearly negative side effects in some areas.

The most obvious area is the banking sector. It has already been plagued by lower net interest margins and heightened regulatory scrutiny, but now with low rates basically ‘locked in’ for the foreseeable future, structural pressure on the sector will only be heightened. From our perspective, this means although we will intermittently invest in banks in the coming years, as they will experience short-term rallies, we are preparing to have a structurally lower allocation to banks in the years ahead.

In sum, government debt needs to be paid for somehow.

The likely choice is that it will be paid through by keeping interest rates extremely low and letting inflation run higher. This is not necessarily bad for the stock market, but it will be bad for large parts of the financial sector.

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