Investment Institute
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Dark Days

  • 20 March 2020 (5 min read)

As we all isolate and get used to home video conferences and virtual lunches, there is much to reflect on. In markets, there will be permanent changes. Some financial products will disappear. Some ways of managing money may not survive. There will be permanent losses in wealth for some. Like it or not, central banks will have more influence on markets than ever before through the impact of their huge asset purchases and credit facilities. Their actions have hopefully prevented more disorder and greater economic damage. Time will tell how quickly this feeds into asset prices, but it will. De-risking will come to an end and there will be victims from this. The good thing is there will be new opportunities for investors. Keep calm and look for value.

Worse than anything

This has been a most extraordinary week. The public health threat from the COVID-19 virus got much more real and much closer and more personal for many more people in many more countries. The numbers from Italy and Spain are particularly shocking and the way in which life has changed is quite astonishing. Actual and virtual lockdowns, school closures, mass cancellations of events and closures of businesses are things that we never thought we would see. Life has changed beyond belief and our priorities have shifted to safety and security in the most fundamental way.

Lessons unlearned?

I remember from 2008 the shock at discovering just how much leverage and financial engineering had made the global monetary system so vulnerable to a shock – back then, it was the collapse in the US housing market. The unravelling of leverage and risk exposed the endogenous inter-dependencies within financial markets and between institutions. The phrase, “the plumbing got clogged up” did not do justice to the way in which the markets seized up back. Today I am asking myself whether we actually learned anything. The amount of central bank intervention that has been announced this week tells us that the financial system has been just as close to total collapse as it was back then. There appears to be lots of leverage in the system and hedging strategies that add up to a great “Ponzi” scheme that only central banks printing money can deal with when it falls apart. Regulation might have made banks safer, and I am sure they are, but what about financial products that rely on leverage and the risks taken by a range of investors who have been made complacent and greedy at the same time after a decade of super low interest rates. The Great Financial Crisis saw the back of some of the most egregious financial products. This time will be the same. There will be a moment when the reckoning is done and when the wealth losses are totted up. I venture that people will look very differently at the passive versus active debate, at the liquid versus alternatives debate and the short-term versus long-term approach.

Peak virus

In the immediate future the outlook remains dependent on the progress of the virus and the impact of the policy initiatives that have been announced over the last two weeks. Western European countries are largely still on the upward slope of the epidemic curve. I have seen modelling that suggests the peak infection rate will come in the final week of March or in early April – as long as the public health policies put in place are successful. There also seems to be evidence that lock-down policies are working. Yet the weeks ahead will remain difficult. The same research suggests that up to 90,000 in the big five European countries will eventually be infected and that also means a devastating number of mortalities. For the US the peak is likely to be later. However, better news on the epidemic remains a necessary if not sufficient condition for some return to normality in everyday life and in the financial markets.

The policy put is huge

I won’t go through all the policy steps that have been announced across the world. Needless to say, it is massive. The global economy suffering a huge hit and policy makers are doing the best to plug the gap. Monetary policy officials have provided facilities that should prevent financial markets becoming even more disorderly as they deal the massive winding down of risk. But they are also proving credit backstops for the private sector and giving governments space to expand fiscal policy which is more directed at supporting aggregate demand. This is important as investment and consumer spending collapses in the face of supply chain disruptions and rising unemployment. Additionally, and importantly, there is a social welfare aspect to this as well. If we believe that the virus will pass anything that can be done to minimise the disruption to employment, incomes, and people’s fundamental needs such as housing are both morally and economically necessary.

Buyers of last resort 

All of this adds up to several percentage points of GDP. The ECB’s additional policies announced over the last week alone are estimated at 11% of Euro Area GDP. Most countries have announced fiscal stimulus of 1-3% of GDP with contingent promises adding up to a whole lot more. Rates have been slashed to zero and will remain extremely low for a very long time. Never has the term “lower for longer” been more appropriate. Central banks will end up with balance sheets that range from 25% to over 100% of GDP. The renewed increase in central bank money creation should eventually have an impact on financial markets. The day after the Bank of England announced an additional £200bn of QE, the Bank said it would buy £5bn of UK government bonds from the market. You have to think about who will be selling those gilts and what they will then do with the money. After all, central banks already own a lot of government bond markets. The deployment of the additional £200bn in Bank of England QE, if it all goes to government bonds, would represent another 12% of the market that the central bank would own. Eventually this will find its way to credit markets and lead to lower spreads and higher equity prices.

Watch the plumbing unblock

The short-term focus will be the impact of this new QE. For signs of markets returning to some kind of normality there are the usual risk indicators to watch. The VIX index of US equity option prices closed at 65.67 on March 19th. On February 19th, the day the S&P peaked, it was at 14.38. This needs to come down. The European crossover CDS index closed at 635bps on March 19th. It was at 214bps on February 19th. This needs to come down. We need to see less stress in funding markets and in the price of borrowing dollars. The price of leveraged loans has collapsed. This needs to recover to suggest a lower risk of default in the wake of the policy steps. The dollar probably needs to reverse its recent super strength. The central bank put needs to work first by stabilising the markets and cutting off an even more extreme left-tail event.

US high yield

If it does and when the time is right, there will be interesting opportunities. I have been looking at one of my favourite asset classes, the US high yield market. This is a high beta fixed income asset class with performance highly correlated to equity markets and comprised of leveraged companies with speculative grade credit ratings. The fundamental picture is likely to evolve with credit events becoming more prevalent, including a greater number of defaults as the US economy suffers a sharp recession. It also has the oil shock to deal with. So far this year, the total return from the high yield index has been -18.3%. In 2008 the index suffered a peak to trough loss of 34%. On March 19th the index closed with a yield-to-worst of 10.67% and a spread over the government yield curve of 982 basis points. In late 2008 that spread peaked at 2147. So, the bad news is that there is potentially worse to come in total returns and spreads moves. The good news is that, historically, buying the market at these kinds of spreads and higher delivered exceptionally strong subsequent 1- and 2-year returns. A bullish view would be that the policy response has been much quicker than in 2008 and that the economic shock might be much more short-lived. Also, and as I mentioned last week, the hedged returns in Euro and Sterling will be much closer to US dollar returns going given the collapse in foreign exchange hedging costs.

Forever changed

Global wealth has taken a huge hit over the last month. It will take a long time to recover and there will be permanent losses in some of the avenues and cul-de-sacs of the financial markets. There have been many people calling for a purging of excess valuations in markets for some time. This might be it. But the recovery depends on how bad the eventual economic damage will be given the devastating impact of the virus and the huge policy response. What we know is that borrowing costs will be super low for a generation now and that a large part of our economy and financial markets will end up being socialised. I for one would rather have this pragmatism and survive than capitalist purity and fail.

Oh, and I do miss the football.

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