Thoughts through the cycle: W4 March ’20

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  • The intensity of the current pandemic, the mania that has accompanied it, and the financial crisis that has resulted from it make days seem like months or even years. With offices closed, many are working from home for the first time, which only adds to the sense that there has been a fracture in our way of life beyond the ‘usual’ crises we have experienced in the past. While it may be comforting to think forward to things getting back to normal and whether the recovery is V-shaped or U-shaped (or the shape of another letter on one’s computer keyboard), it might be more profitable to start considering what has changed and why.
  • Of all places, an article on supermarkets the Financial Times provides a fitting eulogy to the age past and a picture of what is to come: “UK households started stockpiling in the final week of February, according to the data firm Nielsen. The surge – which could not be foreseen by algorithms used to set stock levels – has prompted supermarket chains to ration items and manufacturers and distributors to find ways to increase supply.[1]
  • For those who have witnessed at first hand the turmoil in the financial markets in recent weeks, the fact algorithms could not foresee events provides cold comfort, and ought to lead one to conclude that the ‘A’ in ‘AI’ really stood for ‘Alleged’. Much of the extreme volatility and aggressive price movements have been caused by the unwind of highly-leveraged systematic-trading strategies such as risk parity and commodity trading advisors (CTAs). As with the collapse of Long Term Capital Management in 1998, it turns out that very clever minds often think alike, and that underpinning all their assumptions is the fallacy that because prices are numbers, they obey mathematical rules, principally those relating to mean reversion and standard deviation. A cursory glance at manias of the past such as the Dutch tulip bubble of the 1630s or the California gold rush of 1849 ought to disavow any market participant that reason and abstract mathematical logic underpins financial transactions.
  • Itself the child of low rates, the build-up of corporate debt and automation within the financial industry, the iShares iBoxx US investment-grade exchange traded fund (ticker LQD.US) can be seen as the poster child of what is happening at present. As the graph below shows, excluding dividends, the LQD has fallen 20.5% and in price terms has surrendered 10 years of gains in barely a few weeks. The Fed may have been mistaken that there was no asset bubble.

[1] (‘Soaring demand stretches supply chains to limit’, FT, 21/03/2020

Source: Bloomberg, 21 March 2020

  • The Fed is not providing stimulus at present – that is not the correct description of a central bank cutting rates to zero on a Sunday night while also announcing $700b of quantitative easing (QE) and extending dollar-swap lines to all the G7 countries (but critically not to China). The Fed is in panic mode, aware that the leverage built up in the financial system, particularly amongst the largest hedge funds, as a result of its low interest rate policy, risks a disorderly market melt-down (yes, we haven’t seen that yet…). After its shock-and-awe announcements of Sunday 15th March, the Fed also then underwrote the commercial paper market, added more dollar-swap lines with central banks and finally on Friday 20th March, guaranteed short-dated municipal paper in the US. It has all its cards on the table. The Fed put has been exercised in full.
  • One need only look at the rise in size of the Fed balance sheet and the price of the S&P 500 to see that something quite different is happening now. Since QE was resumed in Q4 2019, the S&P has steadily tracked higher with the Fed’s balance sheet under the ‘old’ logic that QE makes shares go up. While supermarkets may be struggling to deal with customer demand, the decision of the world to lockdown and to send the working-age population home and to close schools has shattered the demand side of the economy. Goldman Sachs on Friday 20th March suggested that US Q2 2020 GDP will fall 24% as a result, although with a sharp rebound later in H2[2].

Source: Bloomberg, 21 March 2020

  • The decision in developed world economies to send workers home to prevent the spread of a virus is unprecedented in modernity. The language and metaphors of war are becoming more prevalent at government press conferences and in the press. War is ultimately a calculus between blood and treasure on the one hand, and a political outcome on the international stage on the other. This current situation is a little different. This is a choice between blood or treasure. The UK has been particularly clear here. Based on a study by Professor Neil Ferguson at Imperial College London[3], the British government is working on the basis that left unchecked, Covid-19 would kill 510,000 in the UK. The ‘herd immunity’ approach of quarantining just the old would allow economic continuity but would result in 250,000 deaths and would critically see the healthcare system overrun. By deciding for lockdown, the British government has decided to sacrifice the economy to save the people.
  • It is not the job of investment analysis to make an ethical judgement here. In fact, there is no judgement to be made. The same logic which saw the banks bailed out in the global financial crisis required the lockdown in 2020. As argued by the late Roger Scruton, in a political system which has elevated the protection of the rights of the individual to the sacrosanct, the ‘precautionary principal’ demands that everything is saved and nothing is risked. In 2008, the banks were bailed out to save the economy. That the 1% gained and the 99% lost out is a consequence of the way it was done (QE) not a reflection of the original purpose of the government action. It is critical to bear this in mind when assessing the impending tidal wave of fiscal intervention from governments.
  • With much of the service industry closed, unemployment levels are about to sky-rocket. This is a human tragedy to which governments are rightly responding. Back in 2006, then Chairman of the FOMC Ben Bernanke talked about the helicopter drop of money in a crisis. This event is imminent in the US, and with workers sent home by the state, it is necessary as a consequence of how the fight against Covid-19 has been decided upon. This is people’s QE as talked about by outgoing British Labour party leader Jeremy Corbyn. That such a policy is being announced by a Conservative Chancellor of the Exchequer (formally employed by Goldman Sachs and the hedge fund TCI) shows the extent of the social and political earthquake currently occurring.
  • Modern monetary theory (MMT) is a topic which has gradually shifted from the esoteric to what is now not quite mainstream but not quite fringe (Democratic Presidential candidate Bernie Sanders’ economic advisor Stephanie Kelton might be considered as the ‘high priestess’ of MMT). At its heart light lies the idea that money is the tool of the state, and as such ought to be used for policy outcomes such as growth and full employment. The means employed involves central banks buying government debt issued for growth and employment projects. There ought to be no limit to this unless inflation starts to rise above a certain, unhealthy level.
  • When one sees governments such as the British one announcing plans to guarantee up to 80% of furloughed workers’ wages (up to £2,500, and for an undisclosed length of time) as well as offering loan guarantees up to £330b while at the same time the Bank of England cuts rates to 0.10% and adds £200b to QE, then it is clear that the age of MMT is here. The monetary and fiscal have fused. That there is also talk of debt holidays and mortgage write-offs is almost unprecedented – no different in fact to the debt jubilees of ancient times. Such is the revolution that is currently happening.
  • One can control the cost of money, or its amount, but not both. The price for the UK’s fiscal largesse and monetisation can be seen in the precipitate fall in the pound against the dollar in the graph below (The dollar is soaring, but this a separate and far more complex and important issue relating to the Eurodollar market and China’s reliance on the dollar). For a country such as the UK with primary and current-account deficits, the risk of stagflation is high. Welcome back to the 1970s? Perhaps, but with a lot more debt – this is the key consideration for UK investors going forward.

Source: Bloomberg, 21 March 2020

  • In a world of MMT, one needs to look closely at the mechanics of central bank debt buying to see whether it has limits. The Fed cannot buy directly from the Treasury by law, but through repo to primary dealers (which last week saw collateral quality standards lowered substantially), this issue can be bypassed. The Fed can print all it likes, and it will. The dollar will weaken at some point, and it may in fact need devaluing against gold for a number of reasons, not least that it could in an instant save much of the US oil industry by raising the value of all commodities (including oil) against the dollar. For now though, the dollar is rocketing higher. Dollar-swap lines have been extended to a number of countries, easing pressure for offshore dollar funding and normalising the cross-currency basis in what has to be seen as a policy win for the Fed.
  • The only G7 country to which the Fed has not offered dollar swaps is the most important one, China. China effectively uses US monetary policy as it has a closed capital account. While Fed cuts and falling oil prices clearly help China’s thirst for dollars, its economic shut-down and credit crunch is occurring in a highly leveraged economy and one with systematic under-reporting of bad debt. Tensions between China and the US are rising: China abhors President Trump calling Covid-19 the ‘China virus’ and expelled all US journalists as a result. The risks of a monetary event such as a major Chinese devaluation ought to be high on investors’ watch lists. China has so far resisted massive monetary and fiscal intervention. This may yet change, especially when everyone is back at work.
  • With respect to the ECB, Christine Lagarde has made a shocking debut. The arrival of Mario Draghi and the confident assertion of the ‘whatever it takes’ doctrine saw a major turning point in the Eurozone crisis in 2012. Lagarde’s fumbling response about the ECB’s job not being to control Italian bond spreads at the ECB press conference on the 11th March saw Italian debt lurch lower in price. The puny €20b-a-month increase to QE has since been replaced by a Pandemic Emergency Purchase Programme of €700b. Such an enormous volte-face in under a week hardly inspires confidence over the central bank’s competence or leadership.
  • Buried within Lagarde’s op-ed in the Financial Times on Friday 20th March was a fatal admission. “While the benchmark allocation across jurisdictions will continue to be key to the capital contributions of national central banks, purchases will be conducted in a flexible manner[4] . The capital key is still being enforced, and the market will be free at some stage to test this out, especially in the Italian government bond market. Germany and Holland were apparently opposed to further QE. While the European Commission has approved temporary exemptions to budget limits, this is a long way short of the single fiscal policy approach needed, not least with respect to euro-bonds or bank deposit guarantees. With the ECB as a supra-national central bank, it’s ability to monetise debts is also institutionally and legally limited. A return to the Eurozone crisis beckons.
  • The first ever G20 meeting occurred in London in April 2009 and in some ways marked a turning point in the global financial crisis. With the US and China at each other’s throats, with Russia and the Kingdom of Saudi Arabia descending into an oil war, with central banks acting in a quasi-simultaneous but largely uncoordinated manner, it seems the chances of the world coming together in a time of crisis is low. The closing of borders to non-essential travel is symbolic of this. With fiscal policy appearing to merge with monetary policy, and with national self-interest seemingly trumping coordinated, multi-lateral action, many of the rules and trends which have characterised the age of globalisation and of the post-1971 fiat money era appears to be at risk. The rules of investment, if they exist as such, are about to become very different.

[1] ‘Soaring demand stretches supply chains to limit’, FT, 21/03/2020

[2] GS economics daily, Jan Hatzius, 20/03/2020

[3] https://www.imperial.ac.uk/media/imperial-college/medicine/sph/ide/gida-fellowships/Imperial-College-COVID19-NPI-modelling-16-03-2020.pdf

[4] ‘The ECB will do everything necessary’, FT, 20/03/2020

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