'It's as if a bomb has gone off in our economy'

Ex-Governor Stephen Poloz backs central banks to get inflationary balance right but warns defense is the best offense for portfolios

'It's as if a bomb has gone off in our economy'

Stephen Poloz believes economists will continue to underestimate the resiliency and innovation of Canadians during the pandemic but admitted that the complex investment environment means defense is the best form of attack.

Poloz was speaking at the recent Portfolio Management Association of Canada’s virtual 2020 National Conference, which WP attended, and the former Governor of the Bank of Canada – he stepped down in June – gave his assessment of where the economy is at under seige from the second wave of COVID-19.

He backed the popular K-shaped recovery, with sectors like travel, oil, hospitality, in-person retail and commercial real estate struggling badly. The former central banker, now on the board of Enbridge and a special advisor to law firm Osler, Hoskin & Harcourt, believes that while some elements could bounce back with a vaccine, there is likely to be some permanent behavioural change. Virtual meetings, for example, are likely to remain and continue to impact the demand for oil.

On the plus side, while the Canadian economy fell 19% during March and April, by September it was running at 96% of where it was pre-COVID.

He said: “It indeed has been the deepest recession since the Great Depression but I think that is a completely irrelevant and meaningless comparison. It was also the shortest recession ever, it only lasted a couple of months, if you want to call it that.

“Of course, if we look at the economy as a whole, it adds both the top part and the bottom part of the K. If the bottom stays weak, so will the total. And if we stay lower than where we were [pre-COVID], then even if the economy is growing, it still feels like a recession to a lot of people.”

A structural shift in workers from flat to growing sectors looks likely and if the bottom part of the K continues to drag, Poloz said the natural conclusion is that inflation will stay low. This could even become deflation in a long, drawn out scenario, a prospect that weighs heavy on the bond market.

This points us to the scenario beyond COVID-19, when hopefully vaccines are widely available. With the IMF expecting global government debt to move above 100% of global GDP this year, this is similar to the level of government debt after World War Two.

Low interest rates mean government revenues will grow faster than interest payments to help the debt burden. However, Poloz said the way governments spend this money during the fiscal expansion will affect the sustainability of the debt, creating a balancing act between investing in infrastructure and increasing the labour force, and printing money to create inflation.

Poloz said: “We have what looks like an inflationary policy today. But that's only because it must counter a huge deflationary shock. It's as if a bomb has gone off in our economy and a gigantic crater has opened up in front of us. The question is, how do we move forward?

“One way would be to walk down into the crater, cross it and walk up the other side. That's a process that could take years and would amount to what we did during the Great Depression of the 1930s. Now, instead, central banks have filled the crater up with liquidity, meaning we can row our boats to the other side.

“At the moment, it takes an inflationary policy to counteract deflationary forces and the future depends on the balance between the two.”

Unsurprisingly, Poloz believes central banks will get this transition right but he warned there are multiple scenarios where things could go wrong. The biggest risk is politics; Governments have an incentive to inflate and, in turn, highly indebted households have an incentive to vote for it. Populism, therefore, carries a risk, especially as it’s often driven by widening imbalances in income distribution.

Portfolios should be built to understand and insure against both deflationary and inflationary scenarios, he said, adding that there is also a worrying third scenario where inflation and unemployment rise at the same time.

Poloz said: “Consider the trend towards deglobalization, which is clearly in place. Deglobalization will raise costs everywhere and will slow economic growth everywhere, therefore raising costs and most likely prices at the same time of slowing the economy.

“Secondly, income supports or guaranteed incomes and those kinds of policies have a tendency to raise costs for firms, constraining labour force participation at the same time. There are other structural policies that one can take to counteract those things but this, initially, can have a stagflationary consequence.”

As well as backing people’s innovative ability to recover and survive, Poloz also said governments are right to set out highly targeted fiscal policies and backs central banks to succeed with this reflationary effort and prevent an inflation outbreak.

He also believes the fourth industrial revolution, the deployment of AI across wide swaths of our economy, will be accelerated by the pandemic.

“We're going to look for more and more deployment of AI and automation. This, along with the removal of government policies that restrain economic growth, are the key to a full and complete recovery and one that will allow us to pay for the fiscal overhang that we're creating.”