Settle in for a long crisis

In the space of just a few short weeks, governments and central banks globally have thrown absolutely everything at the COVID-crisis. The trillions of dollars of support, both monetary and fiscal, is absolutely unprecedented. No wonder then, that Charlie Jamieson, Chief Investment Officer at Jamieson Coote Bonds, said in a recent webinar that this “is one of the biggest moments in any of our careers.”

The big issue that we face now, is that with everything that’s happened over the last few weeks, governments and central banks lack options from here.

“By throwing absolutely everything at this there is really very little more of substance that they can do. They've fired their biggest weapons and that now needs to filter through the system,” he said.

He says that consumers and businesses face an unprecedented cashflow shock, which will surely have significant impacts on credit. Despite some expectations of a ‘V-shaped recovery’, he believes that this could take years to work out.

Since the GFC, a large portion of lending, particularly to SMEs, has occurred outside the financial system. While this could be positive for bank stability, it also means that it’s harder to identify where troubles exist and address them.

Signs of what’s to come

The US saw a huge spike in unemployment claims last week. Probably the best depiction of the scale of the job losses was that of the New York Times the following day (see below).

But Jamieson warns that this is just the beginning. Neither the US nor Australia are in full lockdown yet, though that could be coming in the next few weeks. He cited videos circulating on social media of “substantial military hardware being moved up from the South”, saying that it looked to him that martial law could be imposed.

Markets were complacent

As news of COVID-19 was beginning to spread, there was “tremendous market complacency”. It wasn’t until significant outbreaks were discovered in Iran and Italy that equity markets begun to take the issue seriously. In February at one point, COVID-19 was not even in the first 10 pages of the US newspapers, which were entirely focused on the Democratic nominations.

The team at JCB was watching the situation though. With some staff in their Singapore office having experienced previous outbreaks such as SARS and Swine Flu, they were wary that thing could get worse.

While Jamieson believes markets have had “their initial panic moment”, he said this is set to be a pretty long crisis.

“This probably is a long and drawn out exercise in terms of trying to find an identifiable market bottom. In the GFC, it took 17 months to go from the all time highs down the lows.”

With markets only a month into this crisis, he says it’s too early to assume that a low has been found.

Why a ‘V-shaped’ recovery is unlikely

The thesis of the ‘V-shaped’ recovery seems to be based around the idea that when this is all said and done, people and businesses will be able to get back to normal fairly quickly. But far too much damage has already occurred in credit systems, according to Jamieson. He expects to see substantial problems in high yield loans, CLOs similar risky debt products.

Adding to this is Russia’s move last month to ramp up oil production in the face of falling demand. He described is as being like “a metaphorical 747 into the heart of the energy industry in the United States.” The move saw the price of oil fall to levels rarely seen in the last 40 years, which he said would be a material market risk at any time but is particularly concerning in the current crisis. Oil producers make up a big part of the US high yield index, so any issues for them is an issue for the market.

Given the financial risks, he still thinks a ‘U-shaped’ recovery is possible – if we get through the virus peak quickly. But increasingly, it looks like the virus could be with us for a long time. The longer it sticks around, the more likely we experience an ‘L-shaped’ outcome.

In parts of Asia that had managed to contain the virus, policies have recent begun to be lifted. However, he says the virus has begun to spread quickly again once containment measures were lifted. He cites the example of Singapore, which recently had to raise alert levels again as new cases rose above 100.

“Once we open our front doors and go back out into the world, the virus comes with us unless it's 100% eradicated. The longer we stay in this environment, which certainly looks likely, the more compounded damage that is occurring.”

The importance of oiling the gears

What started as a health crisis is now also becoming a credit crisis. In recent years, many investors have moved towards lower quality or less liquid credit investments – the much publicised ‘search for yield’. This was great when credit conditions were benign, but once you reach a “seizure point”, Jamieson says they are “incredibly problematic.”

Some credit funds have massively increased their buy/sell spread costs in light of the lack of liquidity in the underlying markets. Some are now charging up to 200 basis points (2%) to redeem an investment.

“How much toxic stuff is really in those funds if they need to charge you 200 basis points to get out?”

He called credit markets the financial lubrication that allows companies invest and operate. But with those markets seized up, it will soon create bigger problems. He likened it to the situation nearly 10 years ago in Portugal, Italy, Ireland, Greece, and Spain, where investors refused to roll over debts when they came due, making it impossible for them to be repaid.

Complicating the issue is that New York is the epicentre of the virus in America. Many trading rooms are completely empty, with traders and staff working from home, in quarantine, or potentially even ill themselves. He said it was more like September 11^th, when trading rooms were inactive due to the attack.

“Clearly the market making functions are impeded; trading floors rely on information exchange.”

He doesn’t expect those market making functions, and therefore normal levels of liquidity, to go back to normal for a while.