Writing a New Chapter for World History
By Chris Mark on The Capital
Markets have come under significant stress in recent weeks. We are seeing daily swings that are as large as the old monthly swings in many markets, and stock indexes are routinely locking against price limits. These are crazy turbulent times, but it’s always interesting experiencing them, and not reading them in a book, or watching them in a film.
In a short time, the spread of the virus affected financial markets worldwide, paving the way for a large number of rising uncertainties that can constitute a tangible threat for the economy if fear and all prevention measures stay in place for long.
From a financial perspective, this kind of event is a well-known type of risk (or at least it should) to which all investors are exposed. The risk I am talking about is a black swan, a rare and unforeseeable event with a huge impact, impossible to predict, and with uncertain consequences.
Recessions and financial crisis don’t happen by chance, they are the results of a chain of causes and effects. In the last decade or so, we saw a massive use of debt to boost economic output and foster economic growth.
The levels of debt (governments, companies and consumers) in all the developed economies exploded in the last decade, this has been going on since the global financial crisis, but the point is that it will inevitably leads to even bigger problems in the coming years.
HAVE THE “COMING YEARS” CAME TODAY?
Maybe, what we know is that using debt to stimulate the economy can be done only for a certain period of time. The fact is more debt works until it doesn’t work any longer. By definition, through the use of debt, we are pulling tomorrow’s prosperity into today, when the economy reaches a limit and can’t accept a higher level of debt the cycle reverts and works in the opposite direction causing a recession. We find ourselves with a monetary system either expanding or threatening to collapse, that’s why central banks do whatever they can to avoid any slowdown. While we tend to focus on the short-term news like the Fed announcements on interest rates, the number of new jobs created, international trade, the level of GDP, etc., we often forget to consider a long-term view based on how the economy works and how people behave.
The key question is: are you concerned with a market crash?
When talking about that, one should keep in mind that
- Financial markets are always cyclical and tend to be short-term focused.
- A recession will always happen, we just don’t know when and how.
A crash and a recession could manifest in 2020, or maybe the economy recovers and goes on for another couple of years, like Goldman Sachs points out:
However, for now, we’re about to witness the greatest debt expansion in history. For governments and central banks worldwide, the Coronavirus couldn’t have come at a more convenient time. COVID-19 is the ideal justification to reopen the floodgates of liquidity once again.
The Fed has undertaken a number of policy changes to promote the flow of cheap credit to businesses and households.
-The Fed funds target was reduced 100 basis points to 0.0–0.25%, matching its Great Recession low.
-The primary discount window rate was slashed 150 basis points to 0.25%, eliminating any penalty on banks obtaining credit in that way.
-Reserve requirements become zero percent on March 26.
-A coordinated move with the Bank of England, Bank of Canada, Bank of Japan, ECB, and Swiss National Bank to ” to lower the pricing on the standing U.S. dollar liquidity swap arrangements by 25 basis points, so that the new rate will be the U.S. dollar overnight index swap (OIS) rate plus 25 basis points.”
-The Fed over coming months will be increasing its holdings of Treasury securities by at least $500 billion and of mortgage-backed securities by at least $200 billion.
Whether all this stabilizes financial markets, in the long run, is far from clear. The shock that triggered the instability, unlike the events of 2007–08, isn’t one of financial market dysfunctionality. It’s not because of a housing bubble, neither of some derivative. It’s a blow to real economic demand, and real economic supply that above all else demands trusty leadership from the public sector, very broad fiscal stimulus, and a speedy containment of the spreading coronavirus.
As of today, the coordinated action between the Fed/BoE/BoJ/ECB/SNB/Bank of Canada to lower the price on the central bank swap lines, lower rates and provide as big a bazooka to guarantee the normal functioning of funding/liquidity channels by the Fed, has not worked. Old tricks won’t cut it anymore. The collapse in equities is the third biggest down day ever only rivaled by the Great Depression and 1987. The market has been clearly discounting the lack of effectiveness of such policies in mitigating the coronavirus-induced downside risks, which leads us to the next logical question. With a VIX closing at its all-time highs, and with concerns about the normal functioning of markets as cracks in liquidity/funding channels emerge, how long until a real circuit breaker? This could include coordinated global equity market closures within the next 1 or 2 weeks or targeted stock/corporate bond purchases by the Fed, following the steps by the BoJ. So far Fed is clear:
***Update 18 March: News: “Fed launches Primary Dealer Credit Facility (PDCF) which will accept stocks as collateral.” Fed will be buying equities, circumventing the law by calling them “collateral.” This is a very positive step to stabilize some companies that may be going under. So, instead of Fed buying corp bonds, they’ve reopened this facility to throw a lifeline.
What can move the needle?
There seem to be two central topics on what may ultimately act as the circuit breaker if that’s still conceivable 1: Coordinated global equity market closures within the next 1 or 2 weeks ( I find it not fair as what is allowed to go up must also be allowed to be sold. Liquidations are wealth destroyers but healthy as they get rid of all deadwood even if we are in an era where too many are exposed to fail vs the GFC’s too big to fail). 2: Targeted stock/corp bond buys by the Fed (essentially turning the Fed into a BOJ, called ‘japanification’ of the policies). For that to happen, Powell needs to first manage to cut a deal with Congress.
Japanese government has allowed the BOJ to support the stock market with additional ETF purchases, and Australia recently announced an $11.4 billion stimulus package, providing cash flow assistance to small and medium-sized businesses. Emerging markets are also joining in: South Korea has issued a six-month ban on short-selling equities, Thailand has issued a 400 billion Thai Baht stimulus package to support low-income workers, and Hong Kong has issued each citizen with a credit of $10,000 HK dollars.
These are truly ‘untested times’ as an interdependent globalized world economy is brought to a standstill.
THE CRASH
The NYSE Index is down 32% from its all-time highs just two months ago. As a reference point, the index fell a total of 35% over the course of the 2-year long bear market in 2000.
It took the stock market sixteen trading days to drop by 27% from the all-time highs to Thursday’s lows. We have never seen anything close to that in history. The closest we’ve ever been in history was 1929, when it took 42 days to get from the all-time highs to a 20% correction. The speed in this decline is unprecedented, and major hedge funds like Bridgewater, BlueCrest, H2O, and Renaissance Technologies have come unstuck to say nothing of the funds nursing large losses we still don’t know of.
As BofA points out, “the current bear market (which took 21 days to reach a 20% decline) is so far the fastest bear market in history since 1929”. This is quite something:
This chart from BofA shows that this market peak to 20%+ decline has been one of the fastest in history. “This selloff has been one of the sharpest declines in history, with more indiscriminate treatment of stocks vs. prior selloffs,” she went on to say.
BofA notes the historical context of SPX bear markets since 1929, writing:
- Median peak-to-trough price decline of ~30% (we have seen 26.7%)
- Peak to trough trailing P/E compression of 18x to 12x (we are at 13.9x)
- Bear market historically lasted about a year and a half (it has been just over 3 weeks)
- Peak of market has generally preceded an economic recession (if one occurred by three quarters).
- EPS peaks have varied but have occurred on average two quarters after the market peak.
- EPS recessions (which have not occurred in every bear market) have seen an average ~20% peak-to-trough decline.
The level of uncertainty is even beyond what we saw in 2008 immediately after Lehman Brothers collapsed.
And when we are talking about fear, it’s helpful to see these real indicators to determine what is happening, not by looking at P/E ratios and stock prices. Below is the restaurants’ performance at the country level from OpenTable.
Companies with the most leveraged balance sheets have been getting hit the hardest. This list from BofA shows the top 30 S&P 500 companies with the most refinancing risks.
Ray Dalio says:
“What the world needs, focusing on the US specifically, is a big fiscal stimulus but has reservations of the impending risks that governments will handle it poorly. I’m seriously concerned by what I see, which is that a number of companies and industries will have debt problems that will likely lead to restructurings”
One should expect a cascade of companies going under and with it a multifaceted bailout program to keep certain industries running or nationalize them. A $50B aviation bailout is already being negotiated, but that’s just the tip of the iceberg. It is projected that the US deficit will balloon by $2 trillion at least.
You may have heard about the CEOs of US airline companies asking for a $54bn government bailout. Now, it’s understandable that airlines, one of the hardest-hit industries from this virus, would need some financing to help them weather the storm. But…at the same time, maybe US companies need to learn to keep a rainy day fund for such exogenous shocks. Instead of, say, spending “96% of free cash flow” over the last decade to buy back their own shares — which, just so happens to boost said CEOs takehome pay.
For now, the major corporations around the world halting their share buybacks as they believe stocks are looking grim at this time. If they think that things are heading downward, they’re not going to buy into it. The biggest buyers of these stocks are gone, so what do you think that’s going to do to stock prices?
LIQUIDITY SHORTAGE
The Treasury market became very dysfunctional in the second half of last week. It looked like all markets were being liquidated: You had stocks declining, bonds declining, commodities declining, gold declining, and you even had a US Dollar shortage since everybody was running into the Dollar. The indisputable strength in the USD at a time when the Fed has exhausted all its monetary weapons by making liquidity available like we haven’t seen in years, is still keeping the USD bid. This clearly tells us there is a continuous scramble to amass USD no matter what the Fed policy and the USDs in circulation.
What we are seeing is the credit risk of banks increasing; that means banks want to hold USD more to sure themselves up. Much of the world’s credit infrastructure is based on the dollar, and in periods of stress, people flock to the USD as they understand that it will be the preference to do business in.
“Everything was being liquidated. So the Fed, recognizing this problem, stepped in on Thursday afternoon with the announcement of $5 trillion of repo operations over the next month. On Friday alone, they offered $1 trillion in repo. To put that into perspective: We are talking about the size of QE1 — that was the first quantitative easing program in 2009 — done in one hour.” Bianco Research
IS THE WORSE STILL TO COME?
The Central Banks went all in. They fired all of their ammunition and they’ve got only one goal in mind: They have to stop the decline in financial markets. This started late last week with the Fed’s giant repo operation. Central Banks need to stop the stock market from falling through last week’s low (see Phase 3 below).
“If stocks make new lows we’re at a real risk of financial markets being closed. The Fed and other Central Banks have fired all their ammunition and if markets crash through last week’s lows, there’s nothing left. The Fed can’t buy equities outright without a change of the Federal Reserve Act. It would take weeks for Congress to do that. Even if Congress moves with lightning speed it will take them at least a week, and it will be over before that.” Bianco Research
We experienced the Phase 1 of bear market with an overreaction of massive selling. In Phase 2 some people decide that it is time to buy “Buy the Dip”, where potentially many people agree with this. What remains is to see Phase 3 which is when the stocks actually decline a significant portion which might extend over a period.
Why is it so important to stop this crash?
“If it continues, you will get margin calls, involuntary liquidation. Markets will lose their ability to price securities, especially things like high yield bonds and emerging markets securities. Funds in those areas will be unavailable for people to redeem because they won’t have any prices. There will be trapped money. Also, you will get broken covenants in the corporate debt area, and that will force changes of control or restructurings. But the biggest damage will be that pensions will become underfunded. Companies will be forced to pony up billions of Dollars to get their pensions back into funding.” Bianco Research
“This is unlike anything we’ve seen in our lifetime. What’s going on in financial markets today exceeds the financial crisis of 2008, it exceeds 9/11, it exceeds the tech peak, and it exceeds the 1987 crash. Maybe 1929 is still bigger, but few of us were alive then. We’re writing a new chapter for American and world history textbooks. We’re only a few pages into it, and we’re not sure how it will end, but our grandchildren will one day learn school about the great pandemic of 2020 and what it meant for world history.” Bianco Research
There’s been a paradigm shift, but we’ve been lulled by recent history into expecting this dip to be bought too. I don’t know, maybe these brave bulls will end up being right, and the market will be making new highs in a few months, fueled by the Game Masters firehosing liquidity into the system, and we’ll look back at this period and laugh about how panicked we all were. History tells us that all the policies the authorities are implementing lead to an unfavorable outcome, so its anyone’s guess as to which policy causes the least long-term damage. Although QE infinity, whether that’s supporting asset prices or not, will improve financial conditions in the short term, any kind of money printing will prove to be an ineffective long-term solution.
The end game for global authorities, however, is not to consider the future consequences of inflating the bubble further. It’s to do whatever it takes to curb the effects of COVID-19, saving the global economy from a total collapse, and maintaining the stability of an already broken global economic system.
Originally published at www.trading-manifesto.com
