When I left our offices in Richmond on the 12th March last year, little did I expect having to write these lines a year later. I obviously knew about this nasty little bug called COVID-19, and of course I knew that the next few months would be difficult for all of us but, did I expect the entire world still to be caught in a nasty web a year later? No!

Next week, we can celebrate the first, and hopefully also the last, anniversary of Annus Horribilis. At Absolute Return Partners, Rishanth joined the research team in mid-November, and I am yet to meet him in person – quite a bizarre experience. That said, I am not asking for your sympathy – not at all. Our industry actually works reasonably well without everyone showing up in the office every morning, although I must admit that I miss the daily chatter, which is part of the joy of going into the office every day. Chatting on Zoom or MS Teams is just not quite the same! The problem for society at large is that many industries are not as fortunate as the financial industry is. Going in every day is critical to the survival of many businesses.

As I started to prepare for this month’s Absolute Return Letter, suddenly, the news rolled across my screen: ”UK suffers record 9.9% slump” it said. I quickly checked if we have ever experienced a steeper GDP decline in a single year in this country, and the answer is yes – in 1709, when a bout of severe frost destroyed the harvest (Exhibit 1).

That speaks volumes about the severity of the downturn in 2020, where Q2 was particularly nasty. Towards the end of the year, things began to look better. In December, for example, the UK economy grew a modest +1.2%. That said, the New Year is not exactly off to a good start. January and February have both been dreary, following the government’s decision to lock the country down again after a Christmas where distancing rules were widely disobeyed, leading to many more deaths in the first few weeks of the New Year.

Andy Haldane, the Chief Economist (and deputy governor) of Bank of England did his very best to spin an upbeat story when, in an interview on the 10th February, he compared the British economy to a coiled spring. By June 2021, he said, British households could have built up savings of about £250Bn, much of which will likely be spent later this year as people return to the high streets.

While I have no reason to believe Haldane is being unduly optimistic on consumer spending later this year, I still believe he ignores a few hard facts which will change not only the British but the global economy for many years to come. That is what this month’s Absolute Return Letter is all about – why the world of tomorrow will look different to the world we know today, successful vaccination programmes or not.

Why sentiment is deteriorating in some regions

The New Year is off to a relatively good start from a health point-of-view. Several vaccines have been approved, and most countries are busy vaccinating as many as they can, given the constraints in vaccine supplies. With many of the most vulnerable having received at least the first injection already, we should soon be able to gradually re-open society. All other equal, that should lead to an uplift in sentiment. Why is it then that sentiment has actually deteriorated in parts of the world over the last couple of months (Exhibit 2)?

As you can see, both in Latin America, Asia-Pacific and Europe, sentiment has taken a turn for the worse more recently. The decline in optimism is most acute in Latin America, but the numbers don’t look too good in Europe and Asia-Pacific either. Why is that? In Latin America and in Europe, the main concern is rising unemployment and the impact that will have on consumers’ spending powers. In Latin America, unemployment is actually considered a bigger risk to the economy in 2021 than the pandemic itself.

In Asia, the concerns are somewhat different. COVID-19 has led to a drive towards economic nationalism at the cost of globalisation and, for many Asian economies to prosper, international trade must continue to fire on most cylinders, and companies from Europe and North America must continue to outsource to Asia. If the economic order has suddenly changed, many Asian countries could get into trouble.

Allow me to add a personal comment on that point. Yes, economic nationalism or, as we call it at Absolute Return Partners, localisation, is clearly challenging the trend towards globalisation which, until recently, was broadly accepted as the economic order of both today and tomorrow.

Having said that, you give the pandemic too much credit if you think it is the root cause which is driving the trend towards increased localisation. The introduction of advanced robotics in many industries have driven companies, which years ago moved it to Asia, to bring manufacturing back. Also, climate change is a major agenda point all over the world these days, and listed companies are increasingly being punished by investors if they don’t take the issue seriously. That has also favoured localisation over globalisation.

Why economic growth may not be sustainable

With those caveats in mind, I do agree with Andy Haldane that we will most likely face a V-shaped economic recovery later this year, but that doesn’t mean it is all going to be plain sailing from here. Let me explain.

To begin with, global economic activity is very dependent on having well-functioning supply chains, and COVID-19 has done immense damage to many of those chains. If we want the global economy to perform robustly later this year, it is critical that we bring global supply chains up to scratch as quickly as possible. In the context of the UK economy, the challenge is even bigger due to the economic fiasco called Brexit, but more on that later.

Secondly, how do you create economic growth in an environment where there is little or no workforce growth and only very modest productivity growth? This must be addressed, and the sooner the better, if we want the economic rebound later this year to be sustained.

Thirdly, most leading nations have agreed to a set of sustainable development goals (SDGs), set by the United Nations and to be in place by 2030. Can we comply with all the SDGs we have committed to at the same time as we aim for robust economic growth? The short answer to that question is that SDG compliance combined with a vanilla approach to managing the economy will almost certainly lead to below average GDP growth. You’ll need to think out-of-the-box but more on that below.

How to ensure reliable supply chains

Many underestimate how important international trade is to economic activity. Accor-ding to Statista, in 2019, the total volume of goods exported around the world amounted to no less than $18.9Tn – almost as much as total US output (see here). In that number, you’ll find goods such as oil, gas and coal without which the global economy would freeze up in an instant, and you will find many goods, for example electronics, without which we wouldn’t have been able to work from home during the pandemic.

It is therefore fair to say that the damage done to global supply chains must be addressed ASAP for the economic recovery later this year to be as V-shaped as we would all like it to be. When the global economy was hit by the first wave of COVID-19 in the second quarter of 2020, global trade was down 18.5% year-on-year – much bigger than the drop in GDP growth, and the primary reason was faltering supply chains – fewer flights, limitations on cargo ships’ ability to enter many harbours and various other trade restrictions, many of which were, and still are, supposedly about national security but, in fact, were, and still are, little more than protectionist measures.

In the context of rising protectionism, as you can see from Exhibit 3 below, the US economy imports more from China than most other OECD economies do, and there can be no doubt that the tariffs introduced by Trump’s administration were mostly about protectionism dressed up as issues to do with national security.

Adding to that, in the $18.9Tn mentioned earlier, services are not included. You may think that services are mostly restaurants, hotels and other less critical services (less critical for the overall economy to survive), but migration of overseas workers is included in that number, and overseas workers are far more important than generally perceived.

Take for example the need for overseas doctors, nurses and other carers. In a rapidly ageing society with a shortage of such resources domestically – and that is the case in most OECD countries – society wouldn’t function for long without access to overseas healthcare workers. Having said that, the pandemic has had many implications, and one of the less pleasant ones is a growing sense of nationalism.

A few words on Brexit

The reality is that, despite most Brexiteers being in denial, Brexit will be immensely costly to the British economy over the next few years at a time where it can hardly afford it. When you listen to UK government officials, desperately trying to spin a positive story on Brexit, the theme is almost always along the lines of “we are no longer constrained by EU rules and can therefore do business all over the world”. Whilst technically correct, a couple of important points are being blatantly (deliberately?) ignored when making that statement:

1. Trade agreements that are worth entering into take many years to negotiate – anywhere from five to ten years if history provides any guidance. I am sure we can do one or two quick deals which may look decent on paper, but those deals that you really want to enter into will take years to negotiate.
2. Most countries that are on the UK’s wish list already have a comprehensive agreement with the EU. It is terribly naïve of Brexiteers to think that any country of a decent standard would enter into an agreement with a country of 65 million people (the UK) that would put an already existing agreement with a market consisting of 440 million consumers (the EU) at risk. The best example is the recently established trade agreement between the UK and Canada which was widely celebrated in the Brexit camp. What no Brexiteer was prepared to admit was that, down to the last comma, it was identical to the already existing agreement between the EU and Canada, so I am struggling to see what the British have achieved with this deal that they didn’t already have when in the EU.

If British policy makers ever want to stand a chance of getting the British economy out of this mess, the first thing they need to address is the “them and us” mentality that is now so widespread. In my humble opinion, whether Brexiteers like it or not, in Europe, we are all in the boat together and, the sooner we start to cooperate as civilised human beings, the better.

For the (hopefully V-shaped) economic recovery which is lurking around the corner to be sustainable and not just a flash in the pan, the rather unpleasant sense of nationalism that is now prevalent in many countries must be addressed. I have made the comparison to the 1930s before, but I am going to stick my neck out again. There is a reason populist politicians are in demand at present, just like they were in the 1930s (Exhibit 4), and that reason is falling living standards amongst the not so well-off. Over and above everything else, that should be addressed by our current cohort of political leaders.

How to create robust GDP growth without much workforce growth

As I have repeatedly pointed out in the Absolute Return Letter in recent years, it is an uphill battle to grow GDP robustly unless the workforce is growing at a reasonable rate, and the reason is simple:

ΔGDP ≈ ΔProductivity + ΔWorkforce

Friends often ask me the question: do we really need for GDP to continue to grow? Isn’t life good enough as it is? Maybe, if you live in Denmark (as many of my friends do), where government debt-to-GDP is still only around 40% despite massive public spending in 2020 to fight the outbreak of COVID-19. The problem many other countries are faced with is that public debt is so painfully high now that robust GDP growth is a simple necessity. Otherwise, tax revenues won’t be big enough to cover the bills – not even the most important ones.

In an era of sharply rising digitisation, one could argue that we don’t really need the workforce to grow anymore. By adopting advanced robotics in lieu of human labour, we can still deliver the same output, even if the workforce is in (terminal?) decline. That is almost certainly true, but it is only half the story. Robots do not need a sandwich for lunch, i.e. the more human workers are replaced by robots, the more consumer spending will drop. As consumer spending makes up a significant share of total economic activity in most countries, economic activity will continue to mellow.  Eventually, as the populace at large begins to shrink, so will consumer spending and therefore also GDP.

There is no easy answer to this problem other than to make fundamental changes to our tax system, and that is not easy in the first place, as it would require a global sign-off to be successful. Let me explain. In the digital era, corporate profits have risen dramatically and so has the wealth of the average capital owner. Fundamentally, there are two reasons for that. Firstly, the digital business model allows companies to operate from pretty much anywhere, and it is no coincidence that more and more of the most successful companies are incorporated in tax havens around the world.

Take for example Amazon which saw a 35% rise in UK profits in its last financial year but only paid 3% more in UK taxes (see here). Why? Because the company is incorporated in Luxembourg; hence, it pays most of its taxes in a tax haven, i.e. it pays next to nothing.

Secondly, as robots replace human labour, companies’ payroll costs will decline whereas its profits will improve. From the tax man’s point-of-view, replacing income tax with corporate tax is a bad proposition as the corporate tax rate is much lower than the income tax rate in almost all OECD countries, hence why the tax system must be changed. Otherwise, entire countries will default in the years to come.

How to grow GDP whilst being loyal to SDG at the same time

As I am sure we have readers who don’t know what SDG stands for, let me provide a bit of background (and I paraphrase from the UN website on SDGs which you can find here). In 2015, a comprehensive set of Sustainable Development Goals (SDGs) were adopted by all UN member states. In short, the agreement provides a shared blueprint for peace and prosperity for people and the planet, and everybody has agreed to reach these goals by 2030 at the latest.

There are no less than 17 goals in the SDG programme, many of which will put a lid on the ability to generate robust GDP growth unless you think out-of-the-box. I am often quite critical of Boris Johnson’s government – and for good reasons, I might add – but, from what I have heard coming out of his mouth recently, I think he is on to something here (or, at least, his advisers are).

The UK is, in certain ways, a very dysfunctional country. Its digital infrastructure, for example, is pathetic, but it is clearly ahead of the curve on going carbon neutral and, if the government plays its cards well, this could become a major export opportunity, given how the entire world has signed up to the UN’s SDG agenda.

Take for example Sustainable Development Goal #7: Affordable and Clean Energy or #13: Climate Action – two SDGs which effectively cover one and the same issue. In both instances, fossil fuels come out short. In other words, between now and 2030, assuming most countries honour their commitment to this programme, there will be huge demand for fossil fuel-free energy solutions, and the UK is at the leading edge of this curve.

You many think that I am ‘only’ referring to the UK commitment to wind energy, but the commitment goes far wider than that. Within the not so distant future, traditional nuclear (fission) will undergo a major transformation with the introduction of SMR nuclear, and the UK is there, and not that many years later, fusion will be introduced, and the UK is also there. Once we have electricity from fusion energy, demand for fossil fuels will shrink faster than Big Oil will like to admit.

In the wider scheme of things, if the UK (in this case Rolls Royce) is successful with the rollout, it will result in higher UK exports, stronger UK GDP growth and more jobs – all created whilst loyal to at least some of the UN’s Sustainable Development Goals.

Final few words

I am coming to the end of this month’s letter and hope to have made it clear by now that you cannot assume that all will be back to normal as soon as the economy has been re-opened. The list of issues we are confronted with is massive but, in this month’s Absolute Return Letter, I have only touched the tip of the iceberg. I could have referred to all the idle retail space around the world, and how that will affect commercial property prices negatively, or I could have discussed the rising need for another bedroom in many households, as working from home will be with us for much longer than COVID-19, and how that will affect residential property prices positively.

Alternatively, I could have picked on one or two of the hundreds of other little things that are likely to be different in the post COVID-19 environment but chose not to do so. 3,000-ish words is the maximum I allow myself in these letters, and I am bumping my head against the ceiling now. In earlier drafts, I had a section on the psychological (mental) damage caused to many people by the pandemic, and how long it may take to repair that.

In the end, I took it out, though, as my claims were hard to substantiate, but the gist of it all was (and still is) that many consumer activities may not return as quickly as our policymakers would like them to.

Niels C. Jensen

1 March 2021