Mind the Gap…

To re-state the obvious, we are in the midst of the Great Cessation and Yearning-to-Re-open, in which both the demand and supply sides of the economic equation have been significantly impacted. As a result, debate is re-surfacing about what the nature and extent of the “output gap” will be once the world, or at least most of it, starts clawing its way back to something resembling normality- even if it is to the “new normal”.

In basic terms, the “gap” is the difference in an economy between its actual output (or GDP) and its potential output (or GDP). This gap matters, because it is linked to many other factors, such as employment levels and inflation.

In an ideal world, governments and their central banks want there to be as small a gap as possible between the demand and supply side consistent with a low and stable rate of inflation (and people’s expectations for it) and low unemployment, with most developed economies having what is seen as a sustainable level that allows GDP to grow in real terms over time.

In the case of the pandemic, the starting assumption is that GDP growth will recover relatively quickly to its former trajectory, with “quickly” meaning something like “within a year to 18-months”, rather than the 10 years it took output to catch up with potential in the wake of the GFC. However, this assumes that both available capacity and sustainable demand have not been impaired, which seems less and less likely the longer the Great Cessation continues.

Unfortunately, the longer economies are stalled, the greater the likelihood there will be permanent damage to businesses that supply capacity, which reduces the rate at which an economy can grow, assuming the demand is there, and represents a significant opportunity cost.

Conversely, it seems likely that the nature and scale of demand will also be impacted, especially when no longer propped up by governments’ fiscal stimulus- and that assumes that individuals will spend, rather than save because of the “psychological scarring” they have just suffered.

All this amounts to the introduction of even greater levels of uncertainty into economic forecasting and business planning. Does a manufacturer, say, re-tool and adapt, or wait to see what the “new normal” may be? What if service businesses have to try to function in a way that constrains that service, or suppresses demand?

And what of inflation? Is it kept in check because the output gap remains wide, or given a shock to the upside because of both money supply growth and unexpected tightness caused by greater than expected supply destruction?

In this context, with the only certainty being uncertainty, Awbury continues to be prudent in sourcing, analyzing, structuring and pricing risks based on ensuring a margin of safety and on building and testing a thesis which will survive extreme downside shocks and volatility of the sort which we are all now witnessing. Any risks that do not meet our “prudential test” will continue to be discarded, because one cannot be paid adequately for them.

The Awbury Team

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