Liquidity might not work this time – Part 2
A few weeks ago in part one of this series, we suggested that this was a unique supply side event where Central Bank liquidity couldn’t redress the major issues of a health crisis. We also estimated that when the lock down phase started there would be intense demand destruction. This hasn’t even officially occurred yet in Australia at time of writing, although many folks are self-isolating already.
This is one of the biggest moments of truth in financial market history. Will this week’s ‘low’ in risk markets hold? If not, a new era in the financial markets could be upon us, something none of us have ever managed before (unless you worked in Japan in the early 1990’s).
The economy is forever changed already
This is not hyperbole. Business and consumers are facing unprecedented cashflow shocks with intense credit implications which will take years to work out. We are trying to flatten the curve to save people’s lives and the medical system − but the longer we remain in isolation the greater the structural economic damage and credit problems.
For now, the clear and present danger is that so much credit exists outside of the financial system, so Government stimulus may not get to the right places in time. For example, take a small business that sells building products on credit to trades people. Trades people cannot work, they cannot get paid, they cannot pay. Credit and cashflows form complicated chains which are only as strong as their weakest link. With so much credit provided outside the banking system, it is very difficult to implement a system-wide payments freeze which ensures all obligations are simply rolled over.
Each day we remain in isolation, travel and tourism is closed, restaurants and bars are empty, movie theatres, building sites are shut, wages are not earned, productivity is lost, it all compounds. Every day is that little bit longer, and, at some point, Directors’ must wind up insolvent businesses. We have simply never seen anything like this before.
Markets are losing confidence in central bank policy response
Central Banks and Governments are going “all in” to keep financial markets from falling further. They have effectively done everything they can, cutting rates the world over and pumping massive liquidity into the system. This better stimulates risk markets to hold around this week’s low. If risk markets continue to fall, effectively there is little more that can be done. They can try to invent more programs, but they have already fired their most potent weapons.
Many will argue that the US Federal Reserve (the Fed) should buy corporate bonds and/or equities (and in the end they may try this), but this requires Congress amending the Federal Reserve Act, as it is currently illegal for the Fed to do this. Considering Congress only just passing virus relief which took days (and felt like weeks), this will not happen fast enough. Simply put, if this huge rate cut and liquidity injection does not work, the central bank “put” no longer works. You are on your own.
Every day of compounding is critical to survival
Margin calls will force involuntary continued liquidation. It is a very scary picture. Yes, this virus-driven economic collapse is temporary, one or two quarters of deep negative growth perhaps, but the risk is very real that long-lasting damage is being done that will hamper the economy for years via the credit mechanism and forced bankruptcies. Every day of compounding is critical. We simply have to get to the peak of the virus for our own physical and economic survival.
We expect all markets to remain highly volatile, and there will be plenty of significant counter trend rallies. If you are a speculator, there is plenty of tradable volatility ahead. For long term investors, deep consideration of what lies ahead is required. Recency bias suggests you should buy the dip, but what can be expected of the economy if we move through the peak of the virus? That requires a lot of thought. In our opinion this cannot be ‘V’ shaped now (your opinion may differ strongly here), ‘U’ shaped is the best we can foresee which requires immediate virus peak. ‘L’ shaped is possible. An ’I’ shape is also possible, where markets cannot recover for a long period. In the case of Japan, its Nikkei stock index went from circa 39,000 to 15,000 and stayed, and has never risen above 25,000 again, with most of that time since spent below 20,000. 30 years later those lofty levels have never been seen again after its own bust in early 1990’s.
To answer the question of where this all lands, we need to know when the virus will peak. None of us can answer that right now, but every day in a compounding world of credit pain and forced bankruptcy, this matters greatly. Find the peak, and we can collectively work out which letter the future investing environment may bring.
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Charles is a co-founder of Jamieson Coote Bonds (JCB) and oversees portfolio management of the Australian and Global High Grade Bond and Dynamic Alpha investment strategies. Prior to JCB, Charles forged a career as a seasoned bond investor from...