2008 all over again? Probably not, but it feels that way
There are three aspects of uncertainty to the current market crash, which are distinct but inter-related.
- The ‘coronavirus’ and its virulence;
- The economy: company bankruptcies, lost jobs, and loan defaults;
- The financial markets: positioning, leverage and how do inter-related assets affect each other.
In times like this, markets crave certainty. Breaking down each of these three segments we see that there is still no certainty on any of them.
On the face of it China is back to ‘normal’, as pundits on television judge from the ‘Apple stores re-opening’ to statements by the government. Though, the news out of Italy is inconsistent with China’s figures. Italy is facing a mortality rate of over 5% and their number of deaths is far surpassing China’s at a much earlier stage. It is likely that the markets won’t fully feel like it understands this virus, until it gets figures from a more reliable government than the Chinese Communist Party. Some suggest that this uncertainty will subside only after the peak in the US. No doubt more astute analysts will take their lead from other countries with data considered to be reliable.
Further, the secondary question about whether or not, and to what degree consumer behaviour will change after the virus is also unclear. It is entirely possible that some industries will change forever. Disease has unique psychological effects, as historically it kills more than human conflict, and so the fear associated with it is somewhat irrational.
It follows from the uncertainty about the Coronavirus and separately the unknowable impact of the virus on a deeply interconnected and globalised economy, that the implications for the real economy are also worrisome. Much like how the economy of the period running up to 2008 relied on credit, we have enjoyed record low interest rates for the better part of a decade, resulting in a potentially highly leveraged economy. The IMF estimated that in a shock half as bad as 2008, 40% of companies will have interest payments that are higher than their profits - so called ‘zombie’ companies - basically only alive due to low interest rates.
The ‘oil crash’ could be categorised as an example of economic uncertainty. Whilst Russia and Saudi are involved in some complex game theory applying strategies to maximise their benefit from the sudden and precipitous collapse in demand for oil, their actions were brought about by sudden unexpected changes in asset prices. These secondary effects to the economy are virtually incalculable. The oil derivatives defaulted on by failing airliners are some examples of secondary, tertiary and even quaternary or quinary, impacts.
If the real world drives cash-flow, then the financial markets are dependent on valuations. Entities, that rely on leverage, whose terms are linked to the value of underlying assets constitute a potentially fragile eco-system. Threats to cash-flow impact valuations and the more complex the build up of inter-woven layers the more the uncertainty as to the consequences of their unravelling.
The ‘everything bubble’ perspective
From Albert Edwards to Peter Schiff, there are a great many proponents of the idea that our lowering of interest rates (the trend for four decades), is contributing to an asset bubble. Following that school of thought, the ‘Coronavirus’ is just the ‘pin’ pricking the ‘debt balloon’, and mirroring Japan’s experience of the ‘80s. The problem then is that our underlying economy is too leveraged. The erratic moves of markets support this thesis to the extent that large numbers of people and companies do not seem to have ‘savings’ to deal with shocks. Despite the common understanding that within three months we should have seen the worst of the virus, markets are too uncertain about how badly those three months will affect balance-sheets and solvency.
To have some sense of the other end of the ‘savings spectrum’, you can contrast this to the Italians and Greeks in the pre-Euro eighties (or even Emerging Market states today), who lived in inflation prone economies, and commonly had ‘cash under the mattress’ to make it through longer and maybe tougher periods. I.e. if savings and debt move cyclically, then this current state is an extreme lack of savings.
The solution, based on this thesis, is to raise rates and ignore asset prices. Those who are ‘left behind’ and unable to save enough cannot be helped by monetary stimulus, but rather need political change. ‘Zombie’ companies that are sustained solely by low interest rates, need to be allowed to go bankrupt, whilst new companies, with different business models evolve. Thus monetary stimulus is a problem, prolonging the rot in society, not allowing markets and people (including governments) to do their respective jobs, of giving price transparency and implementing change.
What does this mean for now?
Staying clear of the markets, likely makes sense for the short, perhaps even, medium term. Despite the US finally acting (on Friday) and Central Bank stimulus over the weekend, markets are opening in the red today (Monday 16th March).
It seems markets are looking past the Coronavirus, toward concerns of leverage (starting with High Yield and Corporate debt) and the wider economy. Banks appear to have stress tested for many things over the past decade, but not for pandemics. Presumably, that’s why it’s defined as a ‘Black Swan’.
The market price action is dreadful. Bulls (from Larry Kudlow to the Trump family, and even the more serious market gurus, like Ray Dalio, with his ‘cash is trash’ statement) were optimistic at the start of the year, and the ‘common sense’ until last week was to ‘buy the dip’. The reasoning, that the ‘Coronavirus will be over in three months’ and ‘20% from the top’ is great value (ignoring the fact that there is no fixed percentage formula that tells one when to buy).
This morning the market is contending with panic in many European and US cities as people hoard goods and worry about their livelihoods. Rothschild famously said ‘buy when there is blood on the streets’, which probably made more sense in a time when money was linked to metals, you didn’t have to contend with the implications of the ‘everything bubble’ (i.e the notion that markets fall like a house of cards)..
It would appear that participants, or at least those acting rationally and not throwing in the towel, are now looking past the Coronavirus, to the Oil shock and other unknowable shocks to the economy, and subsequently the financial markets, ala 2008. Stepping out of the way as the ‘bulls’ stampede for the exit, seems sensible.
The good news, is that unlike 2008, Central Banks have a formidable arsenal of tools at their disposal. In 2008, Central Banks needed special legislation to halt the crisis. Today a more omnipotent (at least when it comes to buying financial assets) central bank, means the ‘everything bubble’ will likely be perpetuated, which means asset prices will recover.
Keep your powder dry and look for the right signals.