As much of the global economy emerges from an enforced lockdown, it is time to think about the likely long-term impact of the response to the pandemic from the perspective of investors. There is plenty of bad news, but there is some good news also.
The Bank of England has predicted that UK GDP will have fallen by 30% at the halfway point of this year. Although the Bank expects a strong recovery, particularly in the final quarter, the predicted fall in GDP for 2020 as a whole is 14%. This would represent an economic decline that is four and a half times greater than experienced during the financial crisis.
We are not alone, as much of the developed world is experiencing economic contractions of a similar magnitude. Overall, the global economy is likely to contract by around 6% this year.
With so little time to prepare for such a fast-moving pandemic, governments had little option but to employ the blunt instrument of enforced social distancing, which necessitated a broad ranging economic shutdown. In the UK, our version has been effective but if there is one thing that many of the best medicines have in common, it is that too much of them will kill the patient. Social distancing is sure to prevail in one form or another but it is clear that there was no choice but to commence a meaningful return to work.
To alleviate the impact of the short- term economic effects, governments around the world have dug deep to create substantial fiscal packages. So far, these pledges amount to over $8 trillion. Very few governments had a fiscal surplus to finance these pledges so ultimately this money must be borrowed and one day, in one way or another, repaid by future taxpayers.
In the UK, government debt will balloon to well over 100% of GDP. In normal circumstances, financial markets would not tolerate this level of debt, but these are not normal times. A useful comparison is that when we exited the Second World War, government debt stood at an eye watering 220% of GDP.
Of course, the borrowing of money requires a willing lender and this is where central banks around the world are playing an important role in financing their governments. In the UK, it is evident that through ‘quantitative easing’ the Bank of England is effectively printing money to match the additional funds that Government needs to borrow. It is a similar story in the US and Europe. So far this year, the US Federal Reserve has effectively print- ed $4 trillion; more money in the last six months then it has in the last nine years.
How will this be paid for?
The soft option is to pursue a benign approach to inflation control, which would allow the real-terms significance of government debt to erode over time. In normal circumstances, investors would not tolerate this because ultimately, they would bear the cost of such depreciation. However, central banks are now the primary investors in government debt and are likely to be a willing recipient of this effect.
Nevertheless, in the short to medium term, inflation is unlikely to provide governments with a helping hand. If anything, the risk of deflation looms. The tough option is less palatable because it requires an increase in government revenue through taxation. Although tax rises too soon might be counterproductive, there is likely to be a political appetite for increasing the tax burden on those of greater means. We should expect that a combination of the two options will be used, with the relationship between them changing over time. However, the urge to increase taxes will be strong because as inflationary pressures eventually build, central banks will have less freedom to increase interest rates. If this happened, governments could not afford to service the huge debts that are accruing.
My expectation is that capital taxes are most likely to become heavier. Governments need economies to start growing again and taxing existing wealth provides less of a disincentive than taxing the creation of wealth. Capital gains tax, inheritance tax and council tax for high value properties could well rise substantially. Some form of tax on overall wealth is also a strong possibility, particularly as the increased digitalisation of information would make this easier for government to administer and police.
You might be wondering why, if the economic and fiscal outlook is so depressing, financial markets produced a strong recovery in both April and May. The reason is that financial markets are benefiting from the significant financial stimulus provided by central banks. Although the money they create is targeted at government bonds to keep government borrowing costs down, it causes a degree of displacement, pushing money into other assets such as shares and corporate bonds.
The short-term prospects for many companies may not be good but investors are hoping that things will return to normal over the next few years. In- vestment returns might well be lower but they will still be a better prospect than cash or bonds, on which interest rates are likely to supressed for a decade or more.
Simon Lewis is writing on behalf of Partridge Muir & Warren Ltd (PMW), Chartered Financial Planners, based in Esher. The Company has specialised in providing wealth management solutions to private clients for over 50 years and was voted Wealth Manager of the Year: Southern England at the City of London Wealth Management Awards 2019. Simon is an independent financial adviser, chartered financial planner and chartered fellow of the Chartered Institute for Securities and Investment. The opinions outlined in this article are those of the writer and should not be construed as individual advice. To find out more about financial advice and investment options please contact Simon at Partridge Muir & Warren Ltd. Partridge Muir & Warren Ltd is authorised and regulated by the Financial Conduct Authority.