Some Thoughts on COVID-19, Macroeconomics and Banking
This article was first published on Linkedin, April 26, 2020
The world economy faces its biggest crisis in many decades, maybe ever. A simultaneous demand and supply shock affects all countries and businesses globally, threatening their economic survival. Governments and central banks react by lowering interest rates, printing money, issuing debt and filling balance sheet holes with cash. While this will help the world economy survive the current shock, somewhere down the road those actions may lead to inflation and higher interest rates, which in turn will lead to mass bankruptcies and unemployment.
We may well live in a world of low inflation and high debt for many more decades. The example of Japan shows that inflation isn't guaranteed to show up, even when a country is printing money on an unprecedented scale for a very long time. As long as the growth rate of an economy is higher than the interest rate on its debt, debt to GDP ratios are declining over time despite increasing amounts of outstanding debt. Even if debt to GDP ratios are increasing, low interest rates may make that debt affordable. However, that doesn't mean that all is good. High inflation, low productivity and devaluing currencies will redistribute wealth in a big way (declining real wages, subsidized debt etc.), leading to high internal and external conflicts and toxic politics.
Despite this, however, history shows us that politicians, bankers and society at large will do everything in their power to avoid mass unemployment, layoffs and bankruptcies. Every crisis - be it a virus or some other shock - will be fought with money printing and debt issuance by companies, governments and central banks. Considering the enormous consequences of an economic depression, this is understandable. Eventually, though, the discrepancy between an economy's productive capacity and the amount of money and debt outstanding will lead to inflationary pressures, which sooner or later (i.e. hyperinflation) will have to be fought with increasing interest rates. In a world of high debts, this will lead to mass bankruptcies and unemployment.
Maybe most of what I just wrote is wrong. I'm a business analyst and don't consider myself smart enough to fully understand macroeconomics. However, as a long-term investor in the stock market, I use this framework when thinking about what companies I want to invest in. This is especially true for bank stocks, as they represent a leveraged play on their respective economies. Right now, I am not afraid about the survival of most banks in the US and Europe even though they aren't particularly well capitalized. The significant actions by central banks and governments will reduce the amount of write-downs that banks have to make on their assets, helping them stay solvent. Furthermore, the current environment of low interest rates and high debts isn't all bad. Yes, low interest rates reduce earnings, but they also increase the value of these earnings by lowering the discount rate in a discounted cash flow valuation. Furthermore, high debts mean high banking commissions and money-earning assets on balance sheets.
However, once we enter the new economic paradigm of high inflation, the world will significantly change for banks (and many others). Even though higher interest rates will be good for bank revenues, they will lead to mass defaults and therefore high asset write-downs. Banks will have to use the time after the current crisis to increase their capital base so as to be able to withstand significantly higher asset write-downs than they will experience in this crisis. Due to prisoner-dilemma-dynamics, this will only happen if regulators in global cooperation decide to raise regulatory capital requirements for all banks simultaneously.
Without today's significant government and central bank interventions, most banks would already be bankrupt. Let's hope that regulators use this insight and the time after the current crisis to prepare for a future crisis where governments and central banks won't be able or willing to help out because they are too busy with breaking inflation's neck.
Samuel S. Weber, M.A. SIM-HSG
SW Kapitalpartner GmbH - Strategisch, Wertorientiert