Some forward-looking views on the economy and bonds

I think we’re close enough to the end of the Covid era to start talking more about what happens when this period is over. By that, I don’t mean that COVID-19 is over as a major public health threat. I mean more that the period of time when it will be the driving force of economic outcomes looks to be coming to an end.

In the short-term, I am still concerned about another virus wave caused by highly infectious mutated COVID-19 variants, especially when US states like Texas and Mississippi are opening up and simultaneously completely undoing mandated protocols. And I also know that the virus has caused a double dip in the EU.

But, after a full year of living in this pandemic, I believe we have adjusted to the COVID-19 normal enough that the virus will soon no longer be the end all and be all for our economies. For example, as I wrote this, the US ADP private sector jobs report came out, showing the net creation of 117,000 jobs in the US in February after an upwardly-revised 195,000 jobs in January.

I believe we are at a juncture where, if we want to be forward-looking, we have to think about the economy and financial markets in that post-vaccine period. This is a period during which the virus will still be with us and it will still be mutating. But enough people will be vaccinated that we will be able to consider it a new normal. And depending on how much the virus continues to mutate, variants of COVID-19 could be with us for the long haul. This new normal could actually be our long-term future.

The marginal consumer

Two questions for you then:

1. Thinking about ‘pent-up demand’ and compared to the pre-Covid period, are consumers likely to be more or less attracted to businesses where virus infection levels are highest?
2. Thinking about ‘pent -up demand’, are households likely to save more or less money per month compared to the pre-Covid period?

I think these are the two most relevant questions we don’t know the answer to regarding the post-vaccine new normal. But I would posit that the pent-up demand thesis is only relevant to a limited period of time after a full re-opening. And it is thinking mostly about changes relative to the Covid era, not the pre-Covid era.

The real question is not whether we see a boost to spending, particularly in retail, leisure, travel and hospitality. The real question is whether that boost is permanent and whether it is a ‘boost’ relative to pre-Covid levels. Think of it this way, each and every person on earth can now ask themselves if they will alter their lives in any way relative to the pre-Covid baseline. And if any of them say they will, we have a new normal.

Let me use myself as an example. I used to do a lot of business travel and a moderate amount of holiday travel and hospitality use. If you asked me today what my plans are after I am vaccinated and nearly everyone else is, I would tell you that – at the margin – I will use restaurants less, vacation closer to home more and cut back on business travel a decent amount. I might be wrong about my eventual behavior. But what counts here is that there is likely to be a shift. Not everyone is going to change, of course. But, again, it’s at the margin that it counts. For some businesses and industries, maybe you will only need a shift of 5 or 10% of people for it to matter.

In a nutshell, it’s the marginal consumer that matters. And if, at the margin, consumers use less or more of your product or service, it will alter your profitability as an industry or as a business. You may need to adjust prices, cut back or hire new staff. You might expand or even go out of business.

Just as an example, let’s say that a local restaurant used to get 90 patrons a night who spent $30 each on average plus $5 tip. And it also got 10 patrons who ordered food and spent $20 each on average plus a $2 average tip (since a lot of this is take out). That’s revenue of $3150 plus $220 or $3370 total.

In a pent-up demand scenario, they get 100 patrons who spend $36 each and tip $6 while maintaining the 10 who spent $20 plus tipped $2. That’s revenue of $4200 plus $220 or $4420. You could hire extra staff that way.

But if, at the margin, people like me go out less and move to take out and some don’t even use restaurants at all, the picture looks different. You get 75 patrons at $35 each for indoor dining and 20 patrons at $22 each for takeout. That’s $2625 + $440 or $3065, a loss of 9% of revenue. Some restaurants would cut staff in this scenario. Some might fail.

So, it’s at the margin that this all matters.

More on pent-up demand

So, when we unpack the pent-up demand story sector by sector, we come up with some different answers than what the prevailing market narrative based on aggregates tells us. For the pandemic-affected sectors, I believe there will be a permanent shift – meaning that consumer behavior is altered materially for years to come.

My bet is on much less long-haul business travel, more planned business travel and less unplanned travel, moderately less long-haul vacation travel, restaurant and hotel usage and leisure activity and moderately less in-person retail shopping. At the margin, all of the pandemic-affected businesses will get less revenue. And I see commercial airline travel particularly negatively affected because their highest margin customers are the ones most likely to stop using services. That’s going to be a huge shift. Some of these companies will adjust. They might even get away with higher fees to make up revenue losses. But some won’t make it.

The question here then goes to aggregate demand and savings. If people are going to do something less, it isn’t necessarily true that they will do other things more, even if they can afford to do so. I might screen in my porch and weatherize it to do more at-home dining. But I am not necessarily going to buy more china.

And finally, on the pent-up demand story, after an initial burst of activity that makes up for lost time or even pulls forward demand, we will settle into a new normal where the marginal consumer matters most. And that’s a consumer who may want to save more for a rainy day given the trauma of the pandemic. We just don’t know yet how much of the increased savings will flow back out into purchases once the economy opens up.

So, I am sceptical about the pent-up demand story. I think there will be an initial flurry of activity to make up for lost time. But after this period ends, I believe people will settle into a new normal where their consumption patterns will still be slightly altered in favour of stay-at-home activities compared to the pre-Covid period. And I also believe there will marginally higher savings rates given the trauma of the pandemic and the prospect of more such events in future.

My view

If I am right, then we are about to enter a world in which the so-called savings glut would be greater than it ever has been. That’s not a world of high nominal growth rates and high interest rates. It’s a world of savers and investors chasing yield and return and bidding up asset prices, even more so than in the pre-pandemic world.

As we get from here to there, we could experience a change in relative price levels due to altered demand patterns. But that’s not inflation. We might even get a step up in the aggregate price level because of the initial flurry of ‘pent-up demand’. But that is transitory. So I don’t see the case for inflation yet. What I see is the case for weak aggregate demand growth lowering inflation pressures and making the world more Japanese-like as the changing consumption patterns, demographics and precautionary savings take their toll.

That’s bullish for bonds. And the tail risk is that bonds overshoot to the upside, meaning that if you want a tail risk hedge, it would be a bullish bond bet. And that’s true whether that hedge coming good is the result of a crash up and crash down yield outcome or the result of a collective realisation that inflation price level changes are transitory and relative. Now, when everybody thinks rates are going to the moon, is the time to put on those hedges.

As for equities and other risk assets, we might be in for a longer period of continued high multiples due to the amount of money chasing returns. That doesn’t mean we won’t have air pockets when stocks fall or that we won’t see the travel, leisure and retail stocks take it on the chin when the new normal is less bright than the old normal. But it might mean that a low rate environment puts a floor on shares via the discount rate.

This is how I am thinking about the post-pandemic world right now as my wife gets her second Moderna Covid-19 shot today. Stay safe and look forward.