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Panic has no bounds

Mar 16, 2020

• Panic in the financial markets prompts policymakers to accelerate their efforts to support the global economy
• Fed cuts rates to near zero and provides $700bn of further liquidity – but equities are limit down
• Governments will need to expand fiscal policy substantially to replace the collapse in economic activity
• Global growth collapse could be greater than the 2007-9 – every major country is affected
• Credit markets are key to bringing stabilisation
• Hope from the doctors not just in terms of a vaccine buy older drugs that could mitigate the symptoms.

The world is in a panic, and the financial markets will suffer further unless there is a massive improvement in leadership in some of the largest economic blocs. Medical solutions will for sure take time. In our view, we are far away from stabilisation. The Fed is accelerating policy with a cut to zero and further QE, but a US stock market indicated limit down shows that even US policymaking is still not ahead of the curve.

The panic is evident. For businesses, every counterparty is a potential failure in the network of supply and demand. Every bank is a potential source of a failed backer in a crisis.

We live in a world of massive uncertainty. We need certainty. Policymakers have got to give us guarantees. They cannot guarantee control of the virus, but they must provide assurances of our economy. Just announcing a pile of cash to be deployed is not tangible to households or companies.

The global picture is not helped by a dysfunctional G7/G10/G20. The US is not talking to anyone. Each country in the eurozone is acting independently rather than as a coordinated bloc. The chair of G20 is currently at war in the oil market with Russia.

If we cast our minds back to the events of 2008, we can characterise the financial meltdown as happening in three stages: First, there is a breakdown in bullish sentiment. Second follows a severe liquidity contraction, with finally a credit event with systemic implications. Arguably, phase one is past us. If the popular media is to be believed every significant stock market in the world has now entered a bear market. The second is at risk of playing out. Number three could follow if phase two is not short-circuited quite soon.

Central Banks in action
To beat the liquidity meltdown is where the policymakers have a chance of being the heroes. Stepping in now and safeguarding the integrity of the system is what is required. To get this done is easier said than done. The Fed has made a start. On Sunday night, rates were cut to near zero, and there is a significant injection of liquidity. The Fed has also expanded quantitative easing through $700bn of bond buying. They are renewing buying of mortgage- backed securities – recently US 30-year mortgage rates had risen from 3.55% to 4.12%. The Fed’s policy will only be seen to be effective if it reverses the marked rise in corporate credit spreads in the coming days. Emerging market bond spreads widened 100bps just last week. The Fed’s rate cut allows other central banks, particularly in the emerging markets, to cut very soon.

All is not so well in the eurozone. The brief but violent reaction of Greek and Italian government bonds to the Chair of the ECB, Christine Lagarde’s gaffe about not being tasked to keep spreads in check was not all helpful. First, there is evident policy incoherence. After many years of “doing what it takes” to shore up the eurozone, it should be common cause by now that the ECB will not abandon the weaker credits by making access to liquidity harder.

Second, the scale of the yield spike in both countries’ debt was indeed violent: almost doubling in both cases, over a period that was not too much longer than the news conference took to finish.

Fiscal policy will need to move from defending a situation to the attack
Next up, we need to see a significant boost to budgetary spending. However, in many parts of the world, fiscal policy is severely constrained by sizeable extant budget deficits. The eurozone, in particular, faces structural problems in the promotion of a significant fiscal boost. Germany will have to relent and allow countries to break the rules.

Gauging the growth slump
A V-shaped global economic recovery is still a pipe dream at present. There is little confidence that a medical solution is near at hand or government/central policymaking will be sufficient to turn the situation around particularly quickly. Governments have succumbed mainly to trying to mitigate the impact of the virus on the welfare of the nation rather than keeping it under control.

The current situation is graver than the slump in the global economy in 2007-9 in one critical regard: virtually every country is impacted. And at almost the same time. The World Bank database shows that in 2008 only 24 out of 222 countries had negative growth in 2009, only 104 countries had negative growth. China’s growth in 2008 and 2009 was above 9%!

We appreciate that many economists will still hold out hope for a second half rebound which can’t be dismissed entirely. However, we find it difficult to see that in late March with the restrictions that governments have put in place that the world will be clear from its problems. Unless the virus is beaten, the world will be nervous; decisions will be delayed, spending curtailed.

Watch for scale of job losses
Much will depend on how many jobs are lost and how many businesses go to the wall. JPMorgan calculates that every recession since the second world war in the United States has led to an average 1.9 percentage point rise in unemployment. Research in 2018 showed that 1 in 5 jobs in the United States was held by contractors/freelancers compared to 10.1% in 2005. Indeed, the study found that 94% of the net jobs created between 2005 and 2015 were these sorts of impermanent jobs. Current economic conditions will test how permanent these jobs are and whether there could be a more significant rise in unemployment as employers rush to cut costs.

Stress in ETF pricing
Another factor the move in spreads is the clear problems of liquidity that the market ran into last week, and even before. Retail investors have been thoroughly spooked and are trying to run out of the exit, post-haste. The rush has caused selling that challenged the market’s ability to cope. By some observer’s estimates, a discount to NAV has opened up in some high yield bonds or even investment-grade paper ETF’s with as the underlying asset. In the physical gold market, there is a significant shortage pushing prices higher. In contrast the Exchange Traded Commodity for gold is trading at a discount to the physical price.

Medical Hope
There is medical hope. Unfortunately, a vaccine is probably still at least 12 to 18 months away. However, some expectations existing drugs may prove useful in alleviating the situation in some way. A very useful article in Der Spiegel outlines the pipeline of drugs that could at least mitigate the impact of the virus on some elements of the population. Remdesvir that initially developed for the treatment of Ebola has been going through trials since February. Results should be known by late April. However, it has to be administered intravenously, which limits how extensively it could be used. Around 85 trials are ongoing on COVID-19 patients. Doctors are also trialing a combination of HIV/AIDS medications lopinavir and ritonavir. A decades-old anti-malaria tablet chloroquine is thought to inhibit viruses penetrating the human body – the drug is currently on trial in China.

Gary Dugan
Johan Jooste
Bill O’Neill (Consultant)

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