Strategy Note / Global

Business models after Covid-19: Accelerating the next industrial revolution

  • A wholesale relocation of supply chains is impractical and unlikely
  • The adoption of new technology in services will accelerate, hastening decline of “analogue” services
  • Tourism and travel: leisure may survive better than business travel, emerging markets better than developed

In our latest look at the impact of the economic shock brought on by Covid-19, we focus on business models. We think the adoption of automation in manufacturing will accelerate, and stockpiling for corporate and national security purposes will be given greater priority, but a wholesale relocation of supply chains is impractical and unlikely.

There are several reasons why wholesale relocation of manufacturing away from China or full repatriation on an entire vertical chain of manufacturing back to home markets, even ones the size of the US, are unlikely.

  • While reliance on manufacturing located in China has exposed a vulnerability in all supply chains, the relocation of that manufacturing back to a home country large enough to potentially host it (eg the US) would not any better guarantee the availability of product during a truly global pandemic.
  • The diversification of production away from China was already underway (hence the growth in manufacturing across South Asian countries like Vietnam and Bangladesh, and, even, in East Africa in recent years) – it is just that this was being driven mainly by cheaper labour, efficient enough infrastructure, and, more recently, more favourable export tariffs.
  • Many richer countries may no longer have the environmental appetite, or economically viable supply of intermediary inputs in sufficient quantities to support the complete repatriation of manufacturing – this could apply to the UK as much as it does to Qatar.
  • Some countries, both developed and emerging, may be too small – in terms of population, space, and financial capital – to establish manufacturing on a scale to shift away from dependence on China.
  • The shift of a complete vertical manufacturing supply chain means that raw materials and intermediate inputs are required, as well as assembly, and this compounds all the factors listed above.
  • Unless the world shifts entirely to a state-driven model of production, then privately-owned companies will remain the owners of manufacturing production. Private companies will continue to maximise shareholder return and likely resist the relocation of manufacturing unless the state completely skews regulation (through business licencing, tax regimes, and subsidies) and forces more expensive product onto its population of consumers.
  • Self-sufficiency in manufacturing is an illusion. Just ask those who crafted the Saudi national strategy in the 1970s to establish food security, of which self-sufficiency, enabled by the deployment of technical exports and huge fiscal resources, was one component. This ended up delivering, by the 1990s, too much overpriced wheat, for example, and a massive depletion of water resources. Saudi ultimately shifted to a strategy of purchases of overseas land spanning, for example, Australia, the Philippines, South Africa, the US, and Argentina).
  • As a way of repatriating manufacturing (of potentially anything, apart from food), the adoption of 3D-printing may alleviate some of these challenges (eg supply of labour, some raw materials and intermediary inputs) but only where 3D-printed products are durable enough (and we are still very early in the evolution of 3D-printed products for the mass market) and only for countries with sufficient indigenous supply of electric power and petrochemicals.


Figure 1: Global manufacturing share – China is 28%

UN, Tellimer Research

The adoption of automation in manufacturing will accelerate but within limits

While entire manufacturing chains are unlikely to relocate, within existing manufacturing facilities the embrace of automation technologies is likely to occur more rapidly.

Still, there are obvious limits to this: individual companies will only adopt automation when the probability-weighted costs of human indisposal (eg in the event of an epidemic) outweigh the present value of the fixed costs of new machinery, and there are some manufacturing processes involving human input that automation is still a long way from solving (eg manipulating and twisting fabric for stitching complex garments).


Figure 2: Industrial robot installations

Source: International Federation of Robotics, Tellimer Research

Figure 3: Robot density

Source: IFR, Tellimer Research

Figure 4: Installations of robots by industry (2018)

Source: IFR, Tellimer Research


Stockpiling for corporate and national security purposes will increase

While the complete repatriation of manufacturing is not feasible, greater stockpiling – for both corporate inventory risk management and, for essential items, government security risk management – is inevitable. The end result is higher cost for consumers.

The adoption of new technology in services will accelerate, as will the decline of “analogue” services (e.g. traditional retail, banking)

It is an almost universally consensus view, reflected in the outperformance of technology, and in some cases, telecom, equities throughout the crisis, that the delivery of services based on human capital and, traditionally, physical meetings, will shift even more rapidly than it already was to internet-based platforms: eg healthcare, retail, education, finance, and entertainment. In emerging markets, the most widespread instance of this is in the more rapid adoption of online payments and transfers.

While technology companies benefit, with perhaps a few years’ worth of technology adoption gains within the space of a few months, traditional retail, advertising, entertainment (sports, music), real estate companies and banks exposed to increasingly stranded retail and commercial assets suffer.

A few caveats that should be mentioned in this regard:

  • After such a prolonged period of social isolation there may be a backlash in favour of a return to the “bricks and mortar”, face-to-face, analogue, “real-life” version of all these services. At the extreme, for white collar workers, dressing up and working from the office might become every bit as much of a privilege as dressing down and working from home once was.
  • Technology’s gain should not always be mistaken for gains for the entire “sharing business model” and “gig worker” economy. The owner of the underlying asset might maximise utilisation in good economic times but in bad times they may be every bit as exposed to the fixed costs associated with that asset. Furthermore, this crisis has brought home one truth for asset owners in the sharing business model: the flexibility so cherished by home or car owners, or gig workers, in good times has been matched with the horror of near zero protection of income in a downturn.
  • The unexpected windfall of technology application users likely, in the short-term, does not drive higher revenues for technology companies, because most of them will be under, at least, soft pressure from governments not to charge fees for services (and may have been encouraged to cut fees to existing users) which have become mission-critical for most of an economy in lock-down. Whether these technology application companies will be able to start charging once the crisis passes (i.e. will governments interfere, or consumers resist), or will increasingly adopt revenue models based on mining user data for third-party advertisers, remains to be seen.
  • The unexpected windfall of users may also expose architectural flaws in a technology, particularly in terms of scalability, security and privacy. The highest profile example is, perhaps, Zoom Video Communications, which has seen a 20-fold increase in daily online meeting participants to c200m in the first quarter of 2020 but has also admitted to inadequate security defences against hackers and exploiters of private data. Precedents in the technology industry suggest that corporates and governments are more sensitive to data insecurity than consumers (who appear to place greater value on utility of the application than loss of privacy).


Figure 5: Price performance of tech-telco bellwethers

Source: Bloomberg, Tellimer Research

Tourism and travel: leisure may survive better than business travel, emerging markets better than developed

The shift of commercial meetings to online virtual meetings likely persists: the resulting cost savings will become embedded. However, for leisure travel the post-crisis outlook is not so clear cut. For potential international tourists at every income level, the liberation from many months of quasi-quarantine may act as a catalyst for a resumption of travel; a ticking off of items on the bucket list at a much earlier age than is usual.

Greater restrictions and higher costs (visas and health screening in advance, more expensive airfares and hotels after the closure of the financially weakest) may reduce value across the industry until sufficient supply exits. In markets with more informal and flexible labour, the tourism industry may survive in better shape than in those markets with highly restrictive labour. All other things equal, that might point to relatively brighter prospects in the emerging markets and the US, compared to, for example, the EU.

Figure 6: Travel and tourism direct contribution to GDP (2020f, %)

Source: WTTC, WB, Tellimer Research


You can read more on how Covid-19 is reshaping the world in our recently published report Waiting on the World to Change, in which we explore how the current crisis will result in new normals for politics, macroeconomics, business models, and finance.

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Strategy Note / Global

Geopolitics after Covid-19: US-China cold war, fragmented EU and GCC

  • The effects of the global demand shock likely outlast the shock itself, risking reform and regional coordination
  • Regional blocs, with incomplete integration, will fragment even quicker (EU, NATO, GCC)
  • US-China friction will shift to a fuller Cold War, dividing the world into two camps instead of renewing globalisation
Hasnain Malik @
Tellimer Research
20 April 2020

In our latest look at the impact of the economic shock brought on by Covid-19, we focus on geopolitics. We think there will be long-lasting negative effects on regime stability, structural reform and relations with neighbours.

In the same way that hysteresis (the impact of shocks far outlasting the duration of those shocks) can impact individuals or segments of an individual economy, it can impact entire countries or blocs of countries. The effects of the global demand shock will likely outlast the shock itself:

Commodity exporters will see greater risks to government stability, particularly where citizen welfare expectations are high, such as in the GCC (where fiscal breakeven oil prices are far above current levels), political legitimacy was already at risk (eg Algeria, Iraq, Iran, Peru), or where Covid-19 responses are particularly poor (eg Brazil, Iran).

Countries in the midst – or in urgent need – of structural reform, likely find it politically much more difficult to implement this reform in a much tougher economic environment (eg France in developed markets, Brazil, India, Saudi, South Africa in the large emerging markets, or Argentina, Egypt, Indonesia, Pakistan, Philippines in smaller emerging markets).

It is possible, of course, that the current crisis may prompt some countries which have been reluctant to pursue structural reform historically to change course. There is no sign of this yet and there likely needs to be much more pain felt before the deep-seated vested interests, which have inhibited reform historically, acquiesce, eg Bangladesh, Indonesia, Nigeria, Thailand, or Zimbabwe could all be candidates for this.

In the same way that inequality is likely to increase between individuals within one country (the regressive impact of the economic shock), it is also likely to increase between countries in the same region. The results are also analogous: more spillover of insecurity, migration, strain on bilateral relations, appeal of nationalist politicians. Note the initially scornful response to the Covid-19 outbreak in Iran by some of its neighbours (and the US) and the subsequent blame directed at Iran when infections spread to those neighbouring countries, or the use of Covid-19 as a pretext for populist politicians in Europe to reinforce their message on refugees and immigration.

Figure 1: Human Capital Index Rank in EM with over 40m population

Source: WB, Tellimer Research

Figure 2Human Development Index Rank (1 = top globally out of 190 countries)

Source: UN, WB, Tellimer Research

Regional blocs, with incomplete integration, will fragment even quicker (EU, NATO, GCC)

Prior to the current crisis, strains were already evident in regional blocs and security alliances, such as the EU, NATO, and the GCC. (In this context, organisations like the African Union, ASEAN, or Mercosur should not be included, because they have hardly acted as coordinated, credible geopolitical actors in the past).

The absence of coordinated responses to Covid-19, in part because these blocs and alliances were not designed for cooperation during crisis so much as for cooperation during more orderly environments, may push some of these alliances towards breaking point.

  • The EU was already struggling with the repercussion of the sovereign debt crisis (which dates back to 2009), Brexit negotiations, and the rise of authoritarian governments (eg Hungary, Poland, and, for a while, Romania). The perception that the EU (specifically its relatively richer northern states) has failed to provide urgent and adequate assistance to its struggling states is in plain sight in the rhetoric of political leaders in Italy and Serbia. Furthermore, the democratic norms included as a part of EU membership criteria were already under strain with the authoritarian shifts in Hungary and Poland (as well, for a while, Romania); these strains are likely to increase as some leaders impose and hold on to emergency executive powers for an indefinite period.
  • NATO was already divided over issues such as allocation of defence budget needs, Iran, the Sahel region of Africa, and Turkey (in terms of its Russian arms purchases and incursion in Syria). Spillover of Covid-19 infection-related disruption in Syria to Turkey, or regime destabilisation in Iran because of US sanctions which inhibit the Covid-19 response, could test the coherence of the alliance.
  • The GCC was already divided internally on the issue of Qatar and its relations with the Muslim Brotherhood, Turkey and Iran. In the early days of Covid-19, intra-regional travel was restricted but on a unilateral and ad hoc, rather coordinated and systematic, manner. In the event that the crisis brought about by Covid-19 and, more importantly, the oil war, puts intolerable strain on Oman (with its stretched sovereign balance sheet and high fiscal breakeven oil price, relative to other GCC members) from a social or currency perspective, it is not clear whether the richer GCC members will repeat the sort of assistance they provided after the “Arab Spring” in 2011-12.

The fragmentation of these blocs and alliances has major repercussions for the emerging markets, more widely.

  • Further exits from the EU would reduce the utility of the EU trade deals negotiated by emerging market exporters and, more importantly, pit nearby emerging market exporters against competition from those exiting (eg Egypt, Morocco, and Romania might have to compete with an Italy or Spain which has exited the EU and effectively devalued its currency).
  • Strains which saw Turkey exit NATO or Oman exit the GCC would allow for geopolitical rivals to the US and the EU, eg China, Russia or Iran, to expand their influence in these countries.

US-China friction will shift to a fuller-blown Cold War, dividing the world into two camps

The international Covid-19 response, both in healthcare protocol and economic stimulus terms, has been uncoordinated, at best, and characterised by suspicion and beggar-thy-neighbour, at worst. Given the scale of the disruption, it is unlikely that globalisation (or de-globalisation) continues the same trajectory that preceded the crisis.

Logically, there are two outcomes. Either there is a reversal of de-globalisation politics and a move to more coordination, strengthening of international bodies, and assertion of superpower leadership. Alternatively, the opposite occurs and there is acceleration towards isolationism and tribalism in international relations. A scenario positioned between these theoretical extremes may already be playing out: a more formalised cold war between the US and China.

Prior to the current crisis the US and China were already on opposing sides on many issues, for example:

  • Trade access (tariffs, intellectual property protection), with the Phase 1 deal representing an incomplete and fragile agreement;
  • Technology in 5G mobile networks;
  • Territorial control in the South China Sea (from Vietnam to the Philippines);
  • Belt and Road Initiative (BRI);
  • Iran;
  • North Korea;
  • India-Pakistan;
  • Hong Kong;
  • Taiwan;
  • Uighur Muslims;

Control and influence in a range of existing international bodies and agreements (eg UN, IMF, WB, WHO, WTO, IAEA, FATF) and the early stages of establishing rivals to these by China (eg AIIB in infrastructure finance, RCEP for regional trade).

The reactions on both sides to Covid-19 point in this direction, eg

  • China’s triumphalist rhetoric on arresting the rise of reported infections (almost as a means to demonstrate the credibility of its flat-lining of infections);
  • China’s very public show of sending doctors and medical equipment to the likes of Italy or Spain;
  • The Trump administration’s pointed referral to the “Wuhan” or “Chinese” virus long after other political leaders or mainstream media had stopped using these terms;
  • Hints from the Trump administration that China withheld timely information at the time of the Covid-19 outbreak; and
  • Tit-for-tat effective expulsions of journalists.

The challenge for emerging and frontier market investors in a US-China cold war scenario will be to identify the countries able to occupy what might be a very narrow geopolitical space:

  • Feed China’s consumption base directly with finished goods or (indirectly) with commodities;
  • Benefit from China’s export of capital (BRI-type infrastructure investment deals with governments, as well as foreign direct investment into corporates);
  • Benefit from US trade barriers on China which drives relocation of manufacturing to rival locations; and
  • Avoid falling offside of US interests and risk the penalty of trade barriers and sanctions.


Figure 3: Voting rights in multilateral financial institutions

Source: Tellimer Research

Figure 4: China and US non-diplomacy

Source: Twitter (@realDonaldTrump, @zlj517, Lijian Zhao, China MFA)



Figure 5: Defence spending (US$bn, 2019), the US dwarfs all others

Source: IISS, Tellimer Research. Includes procurement, R&D, maintenance.


Figure 6: US versus China defence spending (US$bn), China has stopped narrowing the huge gap in the past 3 years

Source: IISS, Tellimer Research. Includes procurement, R&D, maintenance.

You can read more on how Covid-19 is reshaping the world in our recently published report Waiting on the World to Change, in which we explore how the current crisis will result in new normals for politics, macroeconomics, business models, and finance.

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Macro Analysis / Japan

What will be the economic impact of COVID-19?

Refinitiv Perspectives
13 May 2020

May’s Market Voice focuses on the strategies pursued in the U.S., Europe, and Japan by governments and central banks to mitigate the economic impact of COVID-19. We also analyze the potential consequences asking: Is it boom or doom?

  1. Although U.S. Government debt has surpassed GDP and the Fed is making record expansion of its balance sheet, the fiscal picture remains benign.
  2. The bigger risk lies in the potential of politicization of Fed policy and that it expands into new buying. And there is also serious risk for corporate and muni markets if the economic impact of COVID-19 persists into the end of the year.
  3. While highly indebted euro-area governments face the same constraints as munis, the ECB will continue to provide support for as long as it is pursuing quantitative easing.

The major stock markets have delinked from real economic activity.

Despite the lack of signs that the unprecedented shrinking of the global economy is moderating, as shown in Figure 1, major stock markets have not just stabilized but, in some cases, have sharply recovered.

Of the four major markets shown in the chart, Europe and the UK are still marginally in bear market territory. And the UK, on top of COVID-19, is also grappling with the uncertainty of Brexit.

While there is some reason for optimism from the prospect of partial reopening of markets, the outlook for economic activity remains highly uncertain and the survival prospects for many companies remain in the balance.

We suspect the firmer tone to the markets primarily reflects the unprecedented support governments — and particularly the U.S. government — are providing to the market both on the monetary and fiscal front.

But could it be that while government intervention is providing immediate support, it might well be doing so by creating the potential for long-term gloom?

COVID-19: Essential market insight and resources: Helping you navigate extraordinary market challenges with our breadth and depth of expert data

Figure 1: G4 stock market indices: Three-month percentage change

G4 stock market indices: 3-month percentage change
Source: Eikon – Click on chart to request a free trial

Mitigating the economic impact of COVID-19

Figure 2 is taken from Refinitiv’s COVID-19 Macro Vitals app, which can be accessed if you have an Eikon subscription. This new app provides a comprehensive set of data, news, charts, and insight that records the economic impact of COVID-19.

While the U.S. and UK central banks have been the most proactive, the Bank of Japan and the ECB have also been adding to their balance sheets, with the total gain in global liquidity up roughly $2 trillion — a more than 10 percent increase — since the onset of the crisis.

In addition to the increase in balance sheets, policy rates have been cut — or kept well within negative territory — since the onset of the crisis.

And perhaps most significantly, central banks are becoming more creative in the ways they are injecting liquidity into the economy. This is particularly true for the Fed, which has set up special facilities to make direct investments in corporate and municipal securities.

Figure 2: G4 central bank balance sheets

G4 central bank balance sheets. What will be the economic impact of COVID-19?
Source: Eikon – Click on chart to request a free trial

As shown in Figure 3, there has also been action on the fiscal stimulus front to mitigate the economic impact of COVID-19. The U.S. and UK have been far more proactive than Japan or the euro-area governments.

U.S. government debt was already on an upward trajectory prior to the COVID-19 crisis, reflecting the passage of tax cuts in 2018. But this did not dissuade the Trump Administration and U.S. Congress from taking aggressive spending measures to provide support to the economy, pushing fiscal debt above 100 percent of GDP to its highest levels since World War Two.

The absence of a transnational fiscal authority in Europe has prevented a significant response (and caused some cross-border tensions about the uneven burden of dealing with the virus).

Japan has also been slow to respond because of the perception that the impact of fiscal spending is muted by the already high level of government debt — pushing towards 300 percent of GDP.

Figure 3: Government debt as percentage of GDP — 2021 projections

Government debt as percentage of GDP — 2021 projections. What will be the economic impact of COVID-19?
Source: Datastream and OECD

Does the U.S. fiscal stimulus pose any risks?

As noted above, the U.S. government has led the economic stimulus charge on both the monetary and fiscal fronts — taking government debt to levels not seen during peace time.

While the break of the 100 percent of GDP barrier may have psychological importance, it does not have any immediate macroeconomic implications.

As shown above, Japan has been operating with government debt well in excess of 200 percent of GDP for many years without creating any severe problems for the economy.

Japan does have the advantage of holding a substantial net foreign asset position — in large part the mirror image of the net foreign liability position of the U.S. — but Italy has also operated for many years with debt in excess of 100 percent of GDP.

Italy not only has a negative foreign investment position but it also cannot monetize its deficit since the authority to print euros lies with the ECB.

Italy’s relatively high debt position has created vulnerabilities, but passing the 100 percent threshold did not in itself have any immediate implications for macroeconomic performance.

Figure 4: U.S. fiscal debt and interest payments as percentage of GDP

U.S. fiscal debt and interest payments as percentage of GDP
Source: Eikon – Click on chart to request a free trial

The most important mitigating factor for the surge in U.S. debt levels is the extraordinarily low level of interest rates.

As shown in Figure 4 above, despite the surge in government debt, the projected interest burden versus GDP for this year remains close to a 30-year low. There is room for substantial additional fiscal stimulus without creating a significant servicing burden.

In the short run, the rising debt burden does not appear to pose any risk to the economy, but this is contingent on interest rates staying at historic lows.

A sharp rise in interest rates could push up the cost of servicing debt to levels where it would force the government to look for offsetting cuts in spending. Is there a risk that the Fed’s aggressive monetary expansion is going to ignite the fires of inflation?

Figure 5 suggests that there is actually very little risk of surging inflation in the next few years. While the Fed has engaged in a record expansion of its balance sheet in absolute terms, the percentage gain is still dwarfed by its activities in the wake of the 2008 Financial Crisis.

Also, as shown in the chart, the earlier balance sheet expansion had only a modest and delayed impact on total credit creation, suggesting there was only a marginal impact on aggregate demand, and by inference inflation.

Indeed, as is also shown, there was little feed through to inflation, and the Fed failed to achieve its target of a sustained two percent rate.

Figure 5: Fed balance sheet expansion impact on credit creation and inflation (percentage Y/Y change)

Fed balance sheet expansion impact on credit creation and inflation
Source: Eikon – Click on chart to request a free trial

Inflation not the only risk

As was the case following the Financial Crisis, the uncertain economic outlook is likely to deter companies from taking on large amounts of additional debt to expand operations.

The expansion of the Fed’s balance sheet is likely to have a modest and delayed impact on credit growth and inflation. For at least the next two to three years, there seems little risk that higher interest rates are going to turn the growing debt levels into a significant financing burden.

The expansion of the Fed’s activities, however, may potentially cause more immediate challenges. The extension of its asset purchases into lower quality corporate and municipal securities could create policy conflicts.

There is a clear risk that the Fed could become increasingly politicized in its decisions of which companies to support. There is also the possibility that the Fed’s insistence on repayment could force municipalities into painful politically unpopular cuts in wages and services.

It is generally recognized that the Bank of Japan’s rapid credit creation and adoption of zero rates in the wake of the late 1980s stock crash allowed insolvent companies to rely on near free financing to continue operations.

But tying up capital in walking-dead or “zombie” companies resulted in many years of stagnant productivity and slow growth.

Hopefully, an immunization for COVID-19 will be forthcoming by the end of the year, allowing a quick move back to the normal.

But there is certainly risk that it will be years rather than months before reliable treatment emerges, forcing society and the economy to restructure activity to moderate contagion.

Under this circumstance, there is risk that monetary and fiscal support for existing companies (especially large employers) will stall the process of restructuring.

The risk is that like Japan, zombie companies will eat up our capital, creating many years of painfully slow growth.

Figure 6: Selected credit spreads

Selected credit spreads
Source: Eikon – Click on chart to request a free trial

Not all borrowers can print currency

The economic impact of COVID-19 is creating funding stresses for borrowers in virtually every market.

The U.S. government has the advantage that control of the dollar printing press means there is little risk of default — although there is the long-term threat of inflation — but corporate and municipal borrowers do not have this luxury.

The difficulty that these borrowers face as their sources of revenue collapse was the reason why the government has been so aggressive in providing support through grants and loans.

Figure 6, however, suggests the support has not been adequate to dispel concerns about credit risk as COVID-19 takes its toll on the economy.

While spreads on both corporate and muni bonds have moderated since the government measures were announced, they remain wide by historic standards, and are comparable to spread levels during the Financial Crisis.

The government support, to date, is giving these borrowers a lifeline into the third quarter. However, the future remains dim if there is not a significant pickup in economic activity before the end of the year.

The curse of the euro

Although Italy is a sovereign state, its adoption of the euro as its currency means that like a municipal borrower it does not have the ability to print money to cover its debts.

Not surprisingly, the spread of Italian rates versus German bonds (the risk-free euro proxy) is closely tracking the U.S. muni spread.

However, the U.S. government is considering providing fiscal support for the muni market while the structure of the euro precludes any such support for Italy (or other stressed borrowers, such as. Spain, Portugal, and Greece).

Indeed, the Maastricht Treaty, the legal basis for the euro, precludes any cross-border fiscal transfers.

Pressure on Italian bonds was more severe in 2015 when Greece was on the verge of default and possibly leaving the euro.

However, the spread collapsed when then ECB President Mario Draghi said he would do “whatever it takes” to maintain the euro.

As shown in Figure 7, the ECB has since gone on a buying spree of resident-issued bonds, which includes general government bonds.

In essence, the ECB is funding the heavily indebted euro-area governments, and this has been facilitated by the asset accumulation required by its policy of quantitative easing.

Like the U.S. fiscal situation, the primary risk for Italy is a pickup in inflation limiting the ability of the ECB to continue expanding its balance sheet.

Figure 7: 1Y USD vs EUR LIBOR spread and EURUSD 1Y forward premium

1Y USD vs EUR LIBOR spread and EURUSD 1Y forward premium
Source: ECB

The bottom line

Although U.S. government debt is now greater than GDP, the servicing burden remains low due to the historic low levels of interest rates.

Indeed, there appears to be room for substantially more fiscal expansion as long as interest rates stay low.

The experience of the 2008 Financial Crisis suggests that there is little risk that the Fed’s current exercise in balance sheet expansion will lead to a quick rise of inflation.

But if the contraction caused by the economic impact of COVID-19 extends into 2021, the Fed may face an uncomfortable trade-off of providing support to contracting sectors when disrupted supply chains and firming demand create pockets of inflationary price increases.

There is also serious risk that both Federal and Fed support for key sectors could become politicized and impede the economy’s transition to an extended adjustment to COVID-19.

The outlook for muni and corporate debt looks dire if the economic contraction extends into the fourth quarter because it is not clear how long the government is prepared to provide support.

In principal, this is also true for heavily indebted European sovereign borrowers, but they should continue to get a lifeline from the ECB, as long as interest rates remain in negative territory and they are pursuing quantitative easing.

COVID-19: Essential market insight and resources: Helping you navigate extraordinary market challenges with our breadth and depth of expert data

© Refinitiv 2020. All Rights Reserved.

The opinions expressed are those of the author(s) and do not necessarily reflect the views of the firm, its clients, or Refinitiv, or any of its respective affiliates. This article is for general information purposes and is not intended to be and should not be taken as legal advice.

The post What will be the economic impact of COVID-19? appeared first on Refinitiv Perspectives.

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Strategy Note / Global

Active investing in EM equity after Covid-19: A final chance against passive

  • Outperformance of large EM index weights, China and Korea-Taiwan tech, in the Covid-19 crisis suits passive funds
  • But China disruption from economic fallout and worsening US relations might be a final chance for active funds to shine
  • Failure to reach critical mass, not passives, is the problem in FM. More of a private equity-type mandate is needed
Hasnain Malik @
Tellimer Research
25 May 2020

As part of our look at the consequences of Covid-19, we focus here on institutional fund management in emerging market equities. Our view is that the disruption and dislocation of markets and business models may offer a last chance for active management in Emerging Markets, against the growing passive onslaught. For Frontier, the index may already be broken, and mandates which look more like private equity may be needed

Passive funds have been winning share from active funds for many years. In developed markets they now account for over half of the asset class. Drivers of this include lower fees, more sophisticated versions of passive (thematic passive funds), steadily rising markets, and the underperformance of the average actively managed fund.

And the rise of passive funds has made outperformance of actively-managed, bottom-up, fundamentally driven asset allocation more challenging, because the weight of passive flows – particularly when prompted by index changes – can overwhelm specific company or country investment cases and, all other things equal in a rising market and within a steady drop of inflows, the performance of passive funds can become somewhat self-fulfilling.

The vulnerability of passive funds should be greatest when there are major shifts in the backdrop of the market; breaks in the fundamental trends which have supported the largest components of an index. Passive funds have no defence against this, almost by design. 

Furthermore, the damage in performance can act as a reminder of the need to think longer-term, in terms of wealth creation; ie closer to the sort of time frame needed by successful, fundamentally-driven managers to achieve outperformance on the basis of a repeatable investment process.

So far the outperformance of China and Korea-Taiwan tech suggest passives will march on in EM

China and Korea-Taiwan Technology drive the majority of the weight in the EM equity index and EM traded value (liquidity). They also happen to be among the beneficiaries of China’s rapid emergence from Covid-19 disruption, the accelerated adoption of new technology across a range of services, and the gravitation of liquidity further into these dominant parts of EM during the current crisis. This should reinforce the outperformance of these largest index weights: all other things equal, this would suit passive fund strategies. 

Brazil, India, South Africa and Russia were already small relative to these markets and the likes of Saudi and Thailand were already too small to sway the performance of mainstream EM funds. The tail of irrelevant emerging equity markets (but sizeable countries and economies) for those benchmarked to the EM index has grown very long indeed.

But what if China on the cusp of one those major shifts to which passive strategies cannot easily respond?

However, we are sceptical that China can so easily recover (we find it incredible that infections, on official data, flatlined so early) and think that social distancing will reappear, that the shock to export demand has been felt fully, and that there will be lasting ripples in, for example, the shadow lending system, from the economic sudden stop. If this proves to be the case then this would equate to one of those periods when actively managed funds, positioned for this change in consensus view, could substantially outperform the passive comparators. 

Furthermore, the increasingly intense cold war between the US and China may present mainstream EM funds (both active and passive) with questions they have not faced before: will the weaponization of diplomatic, technology, territorial, and trade tools used by both sides in this cold war extend to capital markets and does that mean that, at some stage, there is a material risk that Chinese equities are deemed offside by US regulators? If so, that is not a question that passive strategies can easily take a view on in advance.

The challenge in Frontier and small EM has not been passives so much as failure to scale to critical mass

In Frontier Markets, the passive threat is much less advanced and should be much easier for active fund managers to defend against. A long list of factors suggest that actively managed strategies should outperform passive in small EM-FM: 

  1. Large swings in the country weights in indices such as MSCI FEM and MSCI FM (usually when a country is upgraded to EM) which drive disproportionate flows in and out of the stocks in those countries well in advance of the day those changes take effect.
  2. The loss of otherwise attractive investment cases at the stock level when that stock is removed from the index (eg as part of a country upgrade to EM).
  3. The high representation in indices of relatively mature companies or state-owned enterprises (which often do not have the most compelling investment cases).
  4. The extreme diversity of the investable universe (multiple geographies, languages, FX regimes, regulatory structures).
  5. High all-in trading costs (including commission, FX conversion, custodian, structured product access charges), and (vi) generally low trading liquidity (which inhibits the ability to easily trade in and out of stocks).

The biggest challenge for the small EM and FM asset class is that it has not yet reached a critical scale where asset allocators, as a whole, have to consider it and are drawn to individual funds by performance relative to a benchmark or peers alone. Instead the fate of a small EM and FM equity manager is perhaps much tougher; they need to substantially outperform DM and large EM and, ideally in more normalised environments, deliver positive absolute returns in US$ terms (regardless of DM and large EM performance).

FM may have to redefine itself as a quasi-private equity asset class, with much longer-lock up periods and the ability to invest in local currency and US$ sovereign bonds as well as public equity.

In the interim, small EM and FM equity markets likely return to being an almost entirely locally driven market where the catalyst for re-rating comes not, as it might have done in the past decade, from foreign investors but, rather, from local investors attracted to local equities when valuations relative to local bond yields and bank deposit rates become attractive.

Of course, for any small EM and FM fund able to withstand this crisis, the fruits of perseverance could be unrivalled; valuations are arguably attractive across the board (given the mainly strong balance sheets in every country’s bellwethers) and structural reform and growth themes should ultimately reassert. 

You can read more about how Covid-19 is reshaping the world in our recently published report Waiting on the World to Change, in which we explore how the current crisis will result in new normals for politics, macroeconomics, business models, and finance.


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Strategy Note / Global

Domestic politics in EM after Covid-19: Authoritarianism and inequality

  • Governments will impose more limits on liberal society, and relations between local and central governments will strain
  • Covid-19 is, to use tax terminology, regressive. The economic impact hits the poor harder.
  • This likely causes a lasting impact on inequality, with resulting negative implications.
Hasnain Malik @
Tellimer Research
6 May 2020

In our latest look at the long-term impact of Covid-19, we focus on the implications for domestic politics in Emerging Markets. Unfortunately, we think many of the changes may be for the worse, with governments imposing greater controls on society, more strained relations between local and central governments, and widening inequality.

Authoritarianism: governments will impose more limits on liberal society

So far in the imposition of social distancing, travel restrictions, contact tracing and quarantine policies in the response to Covid-19, governments globally, whether in authoritarian or democratic regimes, have taken steps to limit individual behaviour. In many cases, emergency executive powers granted under constitutional rules have been invoked. The timeframe over which these emergency powers will be exercised is as ill-defined as the timeframe during which Covid-19 will remain a systemic threat.

Furthermore, the surveillance capabilities of modern communications technology (communication on an open internet network, location-pinpointing and widespread smartphone use) provides a mechanism for governments wishing to prioritise security over personal information privacy. In the same way that governments, authoritarian or democratic, can appeal to nationalism or populism over individual liberty in determining the social contract, they can appeal to security over individual liberty.

The Covid-19 crisis may act as a catalyst for more widespread occurrence of this surveillance, as citizens grow as used to governments using their private data as corporations (Facebook et al) do.

In the initial response to Covid-19, many pointed to a relative advantage that explicitly authoritarian governments, eg China and Vietnam, have in imposing draconian measures such as social distancing. But it is no coincidence that the executive leadership with authoritarian leanings in notionally democratic governments have used the Covid-19 as an opportunity to strengthen their powers under a constitutional framework, eg Hungary and Sri Lanka.

The control of information and the shaping of popular perception is a part of this discussion. One of the challenges in countering Covid-19 has been the availability of objectively verifiable data on the number of infections, on the nature of the virus itself (many weeks into the global spread, the Trump administration in the US was still downplaying its significance), on the appropriate responses (whether to wear face masks, how communicable is the virus, the concept of herd immunity, the effectiveness of lockdowns), and on the state of preparedness (many weeks into the global spread, the Trump administration was also overplaying the resilience of the US). Governments will seek to control narratives via all media even more in a post-coronavirus world, because their political legitimacy is tied to popular perception of how well they have prepared for and responded to crises. The sort of censorship of online media traditionally associated with China may be as likely to spread to countries that consider themselves highly democratic.

Decentralisation: Relations between local and central governments will strain

In the case of countries as far apart as the US and India, central (federal) governments have appeared to follow the local (state) government policy responses in, for example, imposing social distancing or procuring healthcare equipment. 

In multi-layered and multi-party political systems, relations between central and local government, particularly when there is significant devolution of sovereignty and both are not controlled by the same political party, may strain more often after the precedents set during the Covid-19 episode.

Greater inequality between citizens

The sudden economic stop brought about by policy responses to Covid-19 is, to use tax terminology, regressive. The economic impact on lower-income segments (who lack the liquid savings needed to sustain their consumption) has been proportionately much greater than on higher-income segments.

This is seen starkly when comparing the effectiveness of fiscal relief on informal segments of the workforce compared to formal (and is one of the reasons why many emerging markets, with large informal workforces, are reluctant to mothball their economies for long).

Hysteresis effects (the impact of shocks to parts of an economy can far outlast the duration of those shocks) manifest themselves particularly acutely in low income and informal workforce segments: the increased incidence of starvation in a sudden economic stop or the permanent loss of jobs.

The overall result is that a major shock, such as Covid-19, likely causes a lasting impact on inequality with the resulting negative implications (eg crime and insecurity, strain on welfare states, appeal of populist politicians, recruitment of disenfranchised members of society by terrorist or anarchic movements).

Table 1: Inequality (Gini Coefficient, zero = full equality)

Source: UN, WB, Tellimer Research

You can read more in our recently published report Waiting on the World to Change, in which we explore how the current crisis will result in new normals for politics, macroeconomics, business models, and finance.

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Macro Analysis / Global

Covid fiscal tracker: Stimulus measures continue to balloon

  • Since April c2/3 of countries have expanded Covid-related stimulus, pushing deficits and debt to historical levels
  • The response of advanced economies has dwarfed emerging & frontier markets due to higher borrowing capacity
  • Consolidation is urgently required post-Covid to reduce the massive debt overhang and rebuild buffers
Patrick Curran @
Tellimer Research
30 June 2020

Roughly four months since the Covid crisis became a global issue, governments around the world have rolled out stimulus programmes unprecedented in breadth and magnitude. In the annex to the IMF’s June 2020 World Economic Outlook (WEO) Update, they take account of the fiscal response to Covid.

At the time of the April 2020 WEO, governments had announced fiscal measures amounting to US$8tn (see our initial thoughts – here). This has since increased to US$11tn, with more than two-thirds of governments scaling up support since April. Of this amount, roughly half is additional spending and foregone revenue that will directly affect government budgets (i.e. “above the line”). The other half is liquidity support including loans, equity injections, and government guarantees which will not have an immediate budgetary impact but could materialise on the government balance sheet down the road if guarantees are called or interventions incur losses (i.e. “below the line”).

However, the magnitude and composition of the fiscal impact varies widely by country. In advanced economies the 2020 fiscal response averages 19.8% of GDP, including 8.9% of GDP above the line and 10.9% of GDP below the line.

In larger mainstream emerging markets the magnitude of support is a much smaller 5.1% of GDP, including 3.1% of GDP above the line and 2.0% of GDP below the line.

Lastly, in low-income developing countries (LIDCs) fiscal support totals a negligible 1.1% of GDP, including 1.0% above the line and 0.1% below the line.   

Borrowing capacity dictates space for Covid-related stimulus

Intuitively, countries that have responsibly managed their debt should be rewarded with greater market access during the Covid crisis, thus enabling them to fund much larger stimulus programmes and associated deficits. A strong correlation is evident between credit rating and the size of Covid response, with each one-notch upgrade to a country’s composite credit rating increasing Covid-related stimulus by 0.45% of GDP.

However, the relationship is not always straightforward. Regressing the 2020 Covid response on the 2019 debt-to-GDP and debt service-to-revenue ratios shows that with each percentage point rise in debt service-to-revenue, the size of the Covid response shrinks by c0.3% of GDP. However, each percentage point increase in debt-to-GDP actually increases the size of the Covid response by c0.1% of GDP, suggesting that countries with a higher debt burden have actually been able to deploy more resources to fight Covid.

To control for the fact that developed countries tend to have both higher debt burdens and higher debt carrying capacity, we add the composite credit rating and a developed country dummy variable and re-run the regression. Surprisingly, the positive relationship between the debt stock and Covid response remains intact, while the relationship between debt service-to-revenue and the Covid response becomes insignificant. Meanwhile, the developed country dummy is statistically significant and implies that developed countries have been able to deploy on average a 6% of GDP larger fiscal response to Covid than their developing counterparts.

Taken together, these conclusions seem to support the requests of many emerging market policymakers for debt relief to enable them to counter the impact of Covid. While smaller stimulus packages in emerging and frontier markets partly reflect weaker debt dynamics, the positive relationship between debt and Covid-related spending and relatively large impact of the developed country dummy suggest that funding availability may be dictated more by perceived rather than actual credit risk. Developed countries may thus be benefiting from “exorbitant privilege” related to their reserve currency and safe-haven status, allowing them to respond more forcefully to Covid regardless of their fiscal position.

Overall fiscal impact exceeds stimulus measures

Aside from Covid-related stimulus, the overall fiscal impact reflects several additional factors. Automatic stabilizers from taxes and social protection will help cushion the fall in household incomes but will also contribute to c1/3 of the rise in deficits as government revenues drop by 2.5% of GDP on average amid contracting economic growth. Likewise, many countries will fund part of the Covid stimulus by reallocating spending from non-priority items, helping to cushion some of the impact. This is an encouraging strategy when the majority of cuts are to non-essential recurrent spending, but could dampen future growth if the cuts come from slashing capital expenditure.

In advanced economies, 8.9% of GDP of above-the line spending will give way to a 13.3% widening of the fiscal deficit in 2020 and will increase the debt stock by 26% of GDP. This implies 4.4% of GDP deterioration from automatic budget stabilizers and a 12.7% of GDP increase in debt from automatic debt dynamics (such as the interest rate-growth differential or currency movements). The difference could also reflect projected realization of guarantees on-budget.  

In emerging economies, the overall fiscal deterioration of 5.7% of GDP is actually smaller than the 5.8% of GDP of above the line Covid measures, reflecting a greater reliance on expenditure reallocation vs. debt creation. However, the overall debt burden is still expected to rise by 10.7% of GDP, reflecting unfavourable debt dynamics. Lastly, LIDCs will see deficits widen by only 2% of GDP amid 1% of above the line Covid measures, contributing to a 5.1% of GDP debt increase.

Globally, public debt is expected to rise from 82.8% of GDP in 2019 to 101.5% of GDP in 2020 amid a widening of fiscal deficits from 3.9% of GDP to 13.9% of GDP. The 18.7% of GDP rise in debt far outstrips the 10.5% of GDP rise at the height of the GFC in 2009, while the 10% of GDP widening of fiscal deficits is more than double the 4.9% of GDP seen in 2009. As before, there are significant differences by country classification (see below), with the deterioration greater in higher-income countries.

Lessons for post-Covid policymaking

Since April, the size of the fiscal response to Covid has expanded greatly. However, advanced economies perceived to have a high debt carrying capacity have offered far greater support than their lower-income counterparts and have experimented with a greater variety of off-budget liquidity measures and guarantees. This serves as a potent example to emerging and frontier economies, who must strive to build fiscal buffers and policy credibility as the global economy begins to recover, to enable them to respond more forcefully to future shocks.

The global policy response has dwarfed that of the GFC despite a much weaker fiscal starting point, shattering conventional wisdom that a decade of procyclical (or at the very least historically loose) fiscal and monetary policy would erode the policy space needed to respond to future shocks. That said, moving forward it is essential for policymakers to roll back stimulus measures as the economy begins to recover. With public debt now averaging over 100% of GDP globally, there will be no space to deploy spending of such massive proportions in response to future shocks.

Budget deficits are expected to consolidate to 8.2% of GDP on average in 2020, a sharp drop from the 13.9% of GDP forecast for 2021 but still twice the 2019 average. While automatic fiscal stabilisers will contribute c2.5% of GDP to the consolidation as growth and revenue pick back up, a reversal of Covid-related stimulus measures will also be necessary to put debt on a sustainable path and rebuild buffers. Failure to consolidate budgets as the recovery accelerates will leave future generations with a massive debt overhang, crowding out investment and stifling growth. Policymakers must ensure that double-digit deficits and triple-digit debt are a cyclical anomaly, not the new normal, and investors may discriminate across countries accordingly in that regard.

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