06 Aug Capital Markets Update: Can history help us understand today’s environment?
by Justin Lowry, CIO, Global Beta Advisors
In 1968, a virus from Asia swept across the world, which was borne through an Avian influenza. According to data from the CDC, the estimated number of deaths was one million worldwide and about 100,000 in the United States, with the majority of deaths occurring in individuals who were 65 and older. Many experts believe the illness emerged from Hong Kong, therefore, the illness was dubbed the “Hong Kong Flu”. If this sounds familiar, it should. According to Worldometer, COVID-19 has claimed approximately 692,000 lives worldwide and approximately158,000 lives in the U.S. as of the end of July 2020. When we adjust for population growth in both the U.S. and worldwide between 1968 and now, we find that the Hong Kong Flu is still slightly worse than COVID-19. According to worldometer, the world population in 1968 was approximately 3.5 billion versus approximately 7.8 billion at the end of July 2020, therefore, the Hong Kong Flu ended up with a 0.03% mortality on the world population in 1968 versus COVID-19’s mortality effect of 0.01% on today’s population.
Worldometer also shows the U.S. population in 1968 was approximately 205 million versus approximately 330 million as of the end of July, therefore, the Hong Kong Flu had a mortality rate of 0.05% on the U.S. population in 1968 versus 0.05% for that of COVID-19 on today’s population. According to the CDC, the Hong Kong Flu pandemic lasted for approximately 6 months. We are currently 4.5 months into the peak of the COVID-19 pandemic. While it is unknown when and what will end the COVID-19 pandemic, the observations above indicate that the Hong Kong Flu was similarly, if not more, contagious and deadly than COVID-19. It is also important to note there were more treatment options earlier on during that pandemic than this one. Effective treatments for COVID-19 are becoming more widely available now than compared to earlier on in the pandemic. Another important point to consider is that testing was more feeble in 1968 compared to today. It is possible that the numbers from the Hong Kong Flu were comparatively more understated than what is currently being reported for COVID-19 cases.
If you review the headlines from that time in 1968, you would need to go deep into the newspapers to find reporting on the Hong Kong Flu. It should be noted that there was no economic shut down in 1968 like there was during the peak of the COVID-19 pandemic. Is it possible that we made a bad investment decision based on bad information? Why was the Hong Kong Flu not reacted to by policy makers as it was during this crisis? A quick trip back in time may shed some light on the different responses to the Hong Kong Flu versus COVID-19. In 1968, the nation was facing many problems. The war in Vietnam and the battle of the Tet offensive were the main news stories in 1968. The Hong Kong Flu story was relegated to the back pages of the newsprint. Any print space not taken up by Vietnam was filled with reports of riots that occurred in Detroit, Los Angeles, Newark and New York City. Martin Luther King Jr. was murdered in April 1968 and Robert Kennedy had been gunned down in Los Angeles in June of 1968. The upper end tax brackets were over 50% and the nation was in the middle of a contentious Presidential election. There was no Facebook, no Twitter, no Instagram. There was no internet or computers. All news came from newsprint and network television, so we were devoid of the instantaneous, 24-hour news cycle that has come with social media platforms.
It could be seriously argued that the stock market had a lot more to worry about in 1968 than in 2020. Yet, the stock market, as measured by the Dow Jones Industrial Average, rose 4.23% in 1968, despite all the negative news. Investors in 1968 that utilized major news stories to inform their decisions were absorbing distracting and useless information. Over the next 6 years, between 1968 and 1974, the expansion of the U.S. money supply by the Federal Reserve to underwrite the Vietnam War as well as the expanded fiscal and social programs created by Congress would weaken the U.S. dollar, setting the stage for runaway inflation. Looking back to 1968, it is very difficult to find any information that was available to the general public that discussed the Federal Reserve’s actions. Many Investors in 1968 misunderstood what was important in the news at that time, which would prove to be costly. Investors would have been much better off had they focused on the Federal Reserve and fiscal policy, rather than the distractions from the social unrest and the outcome of the Vietnam War. Federal spending on the war, as well as private capital spending, was soaring by 1968. Many investors thought this would provide unending growth in earnings for materials, consumer cyclicals and industrials. Unfortunately, the collapse in productivity, poor fiscal and monetary policy, and the erosion of the U.S. military would result in a collapse in in the financial markets, and ultimately led to the eventual collapse of the U.S. president.
How does this apply to today’s capital markets?
Global Beta Advisors (“GBA”) believes paying attention to history is very useful in this environment. The key to making good decisions is having good information and properly understanding that information. There is an old saying that history may not repeat itself, but it often resembles itself. Although 1968 has many similarities to today, the difference in the availability and the intensity of the news is dramatic. Today, we are overwhelmed with the minutia of news. We believe that, in today’s new environment that prioritizes timeliness instead of validity, the quality of the news today is low quality information and low-quality information leads to low quality decisions.
The Comparative Social Unrest of 1968 vs 2020
GBA believes the current social turmoil is similar to the 1968 social turmoil and will fade away as did the 1968 turmoil. It should be noted that we now know Russia was funding and helping campus protests back in 1968. It would not be surprising to learn both Russia and China are active in today’s social unrest. Therefore, our recommendation is to focus on the Federal Reserve’s actions as well actions from the Federal Government with regards to fiscal stimulus.The expansion of money supply today is different than in 1968. The Vietnam war was sucking money out of the U.S. In fact, according to Congressional Research Service in their research paper titled “Cost of U.S. Major Wars”, we spent more money on Vietnam than we spent during World War I, even on an inflation-adjusted basis. At that time, the money supply was expanded without any useful increase in production and services. Although there were certain tax incentives offered by the Kennedy administration in 1963 to increase capital spending, the competition from defense spending and capital expenditures strained our resources by 1968. The Vietnam war finally ended with the U.S. departing and Vietnam adopting communism.
It is important to understand the difference between fiscal and monetary policy today versus the fiscal and monetary policy of 1968. Understanding this difference may help us position our investments for the next decade. However, we must first understand the underpinnings of the economy in 1968.
The global realignment resulting from World War II was catastrophic for some and an economic boom to others. According to usgovernmentspending.com, in 1940, U.S. federal government spending was approximately 10% of U.S. GDP, which ballooned to approximately 47% of U.S. GDP by the end of the war in 1945. The U.S. government spending during World War II was funded by war bonds and an increase in federal taxes. Subsequent to the war, the U.S. government created an unprecedent set of programs to rebuild Europe and parts of Asia, which were devasted by World War II. These programs created an unexpected payoff for the U.S. economy. The U.S. effectively turned Europe and Asia into consumers of U.S. products. This helped the U.S. grow the economy and pay off the war bonds. The cost of World War II and the subsequent rebuilding of Europe and Asia resulted in the U.S. accumulating the largest debt to GDP ratio ever recorded, according to the International Money Fund (“IMF”), dating back to 1800. According to the IMF, in 1946, the U.S. debt to GDP ratio was 121.2. However, strong economic growth in the U.S. between 1946 and 1968 allowed us to reduce the debt to GDP ratio from 121.2 in 1946 to 38.13 of GDP by 1968, according to data from the IMF. According to the U.S. Bureau of Economic Analysis, the U.S. GDP grew cumulatively by 277% on a nominal basis and 135% on a real adjusted basis between 1947 and 1968. Because real GDP represents growth above inflation, this was precisely the type of economic growth needed to reduce the U.S. debt to GDP ratio.
Unfortunately, by 1968, defense spending on the Vietnam War crowded out private sector capital spending. Consequently, the U.S. was unable to create anything from all of the defense spending from the late 1960s. As a result of the Vietnam War, our military was weaker, new enemies had emerged, and no new partnerships were formed. The 1960’s monetary and fiscal policy were funded by printing money and issuing bonds. The combination of these policies ultimately resulted in a sudden development of stagflation during the 1970s. Inflation grew faster than U.S. GDP during the 1970s and early 1980s. As a result of this mismanagement, U.S. citizens suffered an enormous set back in purchasing power and consequently endured stagnant living standards. In this type of macro-economic, the borrower enjoys paying off debt with cheaper dollars, however, the lender suffers a substantial erosion of purchasing power. Consequently, bond investors and tax payers paid dearly for the policies of the late 1960s. The bottom line is that the U.S. lost its comparative global advantage because productivity in the period following 1968 evaporated.
Global Health Pandemic Response
Now that we reviewed the historical context surrounding the 1968 pandemic, we can fast forward to present day and draw comparisons to the current global health pandemic from COVID-19. The onset of the 2020 pandemic has set back the U.S. economy like no other time in history. In our view, the decision by federal and state policy makers to shut down the economy was perplexing. The information concerning the virus continues to evolve, despite poor information concerning the virus. It appears that several local government officials were shutting down some businesses arbitrarily. Despite the shut downs, the virus continued to advance. The most disturbing information available to us is that, according to the NY Times, 40% of the deaths from the virus have occurred in nursing homes, as of 07/30/20. This revelation runs in comparison to the 1968 pandemic where the most vulnerable group was over the age of 65. However, it seems that policy makers have profoundly exacerbated the crisis. Ordinarily, nursing homes send their patients to the hospital when they become seriously ill, however, when nursing homes attempted to send their residents who became seriously ill with COVID-19 to the hospital, several state governors ordered nursing homes to take back their patients. They did this to make room for new patients to enter hospitals and wrongly believed nursing homes had the ability to provide the requisite care to their own residents. This proved to be a careless and costly decision. Nursing homes were not only ill-prepared to handle COVID-19 patients, but the returning ill patients spread the disease rapidly among the nursing home community. The government policy makers and local governors created a catastrophe from these orders. In our view, it calls into question whether and to what extent there would have been a national lockdown of the U.S. economy had those decision makers responded more rationally when dealing with what we now know to be the most vulnerable population to this virus. Unlike past global health pandemics, like in 1968, there seems to be unmounting social pressure from the existence of social media platforms, which may have impacted the mishandling of these issues. We see the contagion and ill-effects of the current pandemic run statistically in parallel with the pandemic from 1968, however, the handling and purported misinformation seems to be impacting the response this time around, and as a result, is economically weighing on this country more than any other crisis observed in U.S. history. However, the U.S. Treasury and Federal Reserve were wise this time to respond swiftly and aggressively with unpresented monetary and fiscal stimulus that likely staved off an economic depression. That said, make no mistake that, despite the federal response, there will continue to be economic pain and hardship as businesses attempt to come back online in the face of restrictions. Therefore, monetary and fiscal policies are paramount as we move forward. Because of deflationary risk that has stemmed from these resulting circumstances, we expect the Federal Reserve to enable access to liquidly. Unfortunately, we believe that new taxes that may result from government stimulus, will depress equity and real estate markets, which are currently the only two drivers of inflation. If the equity markets suffer another significant correction, deflation will become an even greater economic risk. It is our belief that the upcoming presidential election will put a chill on equity markets as the bond market seems to be indicating a struggling recovery from the COVID-19 economic shut down.
We urge our readers to avoid the distractions of bad news pouring out of the multitudes of news outlets. We believe this economic crisis, as it was self-inflicted, will resolve itself over time and potentially more efficiently than past recessions. The virus was made worse by government officials, therefore, it is our estimation that the virus will ebb and flow and ultimately mitigate without destroying civilization. We believe it is important to keep that kind of leveled perspective as you digest daily news headlines from major outlets and social media platforms because it is a global topic that has the attention of everyone, which may lead to hyperbolic reporting of potentially bad information, motivated by achieving network rating watermarks.
However, we believe there is good news that resides in the potential of pent-up demand from U.S. consumers. We have seen anecdotal evidence of this through consumer behavior with stay-at-home orders being lifted and businesses re-opening. The demographic that has demonstrated the most willingness to reacclimate to some semblance of a pre COVID-19 life has been millennials and Gen Z’ers. While the uptick in consumer demand has come along with an uptick in COVID-19 cases, the death rate seems to be dropping, according to data from the CDC. We believe this is due to the fact that it is affecting a population that is less susceptible to lethal outcomes. We believe we may be working our way to herd immunity. In fact, former FDA commissioner, Scott Gottlieb, estimated in July that at the current infection rate, we could be closing in on some type of herd immunity as the infection becomes unable to spread efficiently. We are hopeful that this short-term evidence in consumer behavior will sustain and overcome some of the poor decision making that has occurred and handicapped our economy.
Government spending today is demonstrating similarities to the recovery programs post World War II. We believe this will create growth and bring back inflation. As a result, we believe growth from government stimulus will create growth above the inflation rate. Additionally, we think that the U.S. economy will also benefit from the slow up in China’s growth. It is our estimation that the long overdue challenge over the distorted trade agreements will have a long-term positive impact for U.S. companies and that more production will be generated in the U.S. as the potential flow of capital and jobs to Asia potentially slowing and possibly reversing. We also see capital spending expanding rapidly as we approach the U.S. presidential election. We are concerned heading into the upcoming elections because unlike periods in history before where the U.S. enjoyed a comparative advantage over the rest of the world and high tax rates could be justified, we are currently in a vulnerable economic state and will likely remain vulnerable for some time beyond the presidential election. Considering our only comparative advantage seems to be within the technology sector, higher taxes on capital and income concerns us. Given this uncertainty, we believe it is imperative that investors focus on strategies and companies that focus on dividend growth and revenue growth as opposed to simply buying the broad market.
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Distributor: Compass Distributors
Justin Lowry is the Chief Investment Officer for Global Beta Advisors, in Philadelphia, PA.