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Journey Without Maps
How are we going to navigate this weird period in which we find ourselves? The greatest drama that many of us can remember is playing out just as a large share of the developed world’s population is forced to spend all their time indoors. Momentous decisions about the livelihoods of millions must be made often in claustrophobic conditions. Families become too close for comfort for some; and loneliness and isolation bite others. Those navigating, used to a place on the open deck and a telescope, find themselves cramped into the belly of the ship.
The financial navigation problem remains intractable because most everything depends on the efforts of the public health authorities to limit the damage caused by the coronavirus. Depending on their success, anything could be possible, from a mild recession that’s over by the end of the year to the worst global slump since the Great Depression. With so few precedents, quantitative asset managers used to charting their course with precision are suddenly left navigating using medieval sea maps decorated with sea monsters; they have sailed into the section that says “Here Lie Savages.”
What might offer some hope is that some of the numbers going around are outlandishly negative. James Bullard, president of the St Louis Federal Reserve, told Bloomberg on Sunday that the U.S. unemployment ratecould reach 30% in the second quarter. That is horrifying and would afflict the world in ways hard to contemplate. Meanwhile, Wall Street is beginning to revise GDP estimates. This one, from JPMorgan Chase & Co., suggests that the second quarter will be by far the worst since the war:
These developments are signs that a) the market is beginning to attempt to price in some very negative scenarios, and b) sentiment is already close to the bottom. For stock markets, and other risk assets, that is good news.
Beyond the imponderable issue of fighting the disease, the key question is whether we can fend off a financial crisis. We should have some clarity within days and weeks.
So as a navigation tool, I now offer a guide to our chances of avoiding a financial crisis, and then a guide to how the stock market is likely to deal with whatever results.
A Route Through the Credit Crisis
Could the public health crisis turn into a credit crisis? The crucial question, as one ETF manager once put it to me in terrible French, is: “Cherchez la leverage.” If there is leverage, then there is the risk of losses that cascade through the system.
Unfortunately, it isn’t difficult to find. As I detailed here, there is more leverage in the global system now than in 2007; banks have de-levered a bit, but governments and non-financial corporations have taken on huge extra sums. This chart, from Deltec, shows the increase in U.S. corporate debt, particularly at lowest investment grades, since 2008.
Further, U.S. corporate profits have stagnated for years — and even after-tax profits are drooping again after their boost from the corporate tax cut at the end of 2017, as SG Cross Asset Research shows:
So we have a clear solvency risk. If this is combined with a liquidity crisis, as investors try to retrieve money, then we have a full-blown financial crisis. As Deutsche Bank AG shows, there is indeed an extreme move topull cash from fixed-income funds:
Worse still, there could be plenty more where that came from, because money has flowed into investment-grade debt, and also into emerging markets debt, in recent years. The fact that high-yield funds had been relatively out of favor is, at this point, a positive:
Anecdotal evidence of problems with liquidity is accumulating rapidly. Perhaps most alarming, Bank of New York Mellon Corp. has stepped in to plug a gap in its Dreyfus Cash Management money market fund, investing $1.5 billion. Without this, it would presumably have “broken the buck” — or dropped below the price of $1 per share that money market funds try to maintain to give the impression that they can be compared directly with bank accounts. Following post-crisis reforms, money market funds had to choose between being “government-only” or concentrating on highest quality corporate credit. The Dreyfus fund was in the latter category. In the current environment, it is now deemed high-risk. Investors pulled out more than half the fund’s total assets in less than a week (as was first reported by Ignites, a Financial Times news service).
Goldman Sachs Group Inc. faced the same issue, even as the Federal Reserve started its effort to backstop money market funds once more. These events bring back memories of September 2008, when the Reserve Fund, an independent group that didn’t have a big bank like BNY Mellon or Goldman behind it, broke the buck and froze redemptions. It was holding Lehman Brothers bonds. That led to what was effectively an institutional bank run, and forced the Treasury to resort to the Troubled Assets Relief Program, or TARP, which was announced the next day. The fact that we are even talking about money market funds again — both in the U.S. and in Europe — suggests the risk of liquidity strains creating a financial crisis are high.
Another reason to fear a credit crisis is the speed with which investment-grade spreads — the extra amount in yield that they pay compared to Treasury bonds — have risen. As this chart from Deutsche Bank shows, this credit incident has happened far more swiftly than in previous crises.
Deutsche also points out that the move has been far more aggressive in the U.S. than in the euro zone, which is probably due to the European Central Bank’s efforts.
This suggests that there is a case for the Fed also to take more aggressive action. Meanwhile, emerging market and high-yield debt are showing even greater signs of strain.
The template for what could happen next was provided in 2008. If investors continue to withdraw from the markets in search of something more liquid, we could reach the point where banks and other lenders are forced to realize losses, and where it becomes far harder for borrowers to raise finance. That could have a negative impact on the economy, even if the human cost of the coronavirus proves contained.
Bereavement in the Stock Market
There is little point attempting to estimate where the low will come for indexes. There are too many unknowns, several of which should become knowns before too many more weeks have elapsed. Valuation misses the point.
We can, however, try to map the course. It is more than a century since the last global pandemic, but we do have a good repository of knowledge of how market shocks and sell-outs progress. And we know how far we have fallen. At this point, the S&P 500 is down almost 32% from its high of a month ago. Globally, stock markets have lost $19 trillion in market value since the top, as this chart from S&P Global shows:
Putting it into perspective, several sell-offs in the history of the S&P 500 have been greater. This league table was produced by Harry Colvin of Longview Economics Ltd. in London. Stocks fell a bit further Friday but this sell-off’s historical ranking is unchanged:
This is already above the median for all significant corrections (of 10% or more). But there have eight worse drawdowns in history. If the economic impact of the virus is as severe as currently looks likely, it is reasonable to assume that there is more damage to come. Markets in such situations behave much as though they are bereaved. The schema, to use Longview’s words, is: Panic, followed by Relief, followed by Demoralization or Resignation. These phases can take weeks or years, and Longview suggests the base case should be a “short, sharp shock.” Markets should be able to return to normal quite quickly, as after the Black Monday crash of 1987:
This relies on the assumption that we avoid a serious financial crisis. In 1987, after a few terrifying days and weeks it became clear that the collapse in share prices had not led to the falling of other financial dominoes. Longview’s second-most likely scenario, if the risks of a full-blown financial crisis come to fruition, would be the sell-off that followed the bursting of the dot-com bubble in 2000. In that case, the selling went on much longer — although again the stages of panic, relief and demoralization are clearly visible. There were two attempts at relief rallies, in early 2001 and again after the 9/11 terrorist attacks, and a prolonged period of demoralization at the bottom that ended with the U.S. invasion of Iraq:
Personally, I am not sure either of these should be the central case, as both were primarily valuation events after markets had become very overblown. This is a response to a major external shock that threatens to bring a serious recession in its wake. For now, I am inclined to agree with Dec Mullarkey of Sun Life Investment Management, who argues that the pattern may well be closest to 2008, after the Lehman bankruptcy. As we can see, there was a clear early panic phase after Lehman, which ended at about this point in proceedings. (To see the effect on me of the fourth week after Lehman, when stocks fell 20%, watch this video). Once that was over, life in the trading rooms never again felt so scary — though there would two further lows before the recovery began.
At this point, it looks to me like the moment of maximum panic is close at hand. If a Fed governor says U.S. unemployment could rise to 30%, and we discover that Angela Merkel has put herself in quarantine while the mayor of New York begs for help from the army to stop people leaving the house, that sounds like a traumatic low in confidence is close, if it is not here already.
It is reasonable to expect that some kind of relief rally will get underway in the next few days. It is also reasonable to expect that the final low is still a ways off. The bottom comes when all hope has been lost, and resignation sinks in.
Again, the analogy with bereavement is useful. Ian Harnett of Absolute Strategy Research Ltd. in London pointed out that one of the most successful timing measures for market lows was developed for the Episcopalian Church, and used the advice of clerics on how long people typically take to deal with bereavement. The answer was from 11 to 14 months. The so-called Coppock Indicator amalgamates the percentage move over these periods. When this figure is negative and starts to rise, it is generally a great time to buy the market, as this chart from Harnett shows:
The problem, clearly, is that the Coppock Indicator is still positive. The chances are that it will be months until this process of financial bereavement, which is linked to an all-too-real sense of human bereavement, moves far enough for a lasting recovery.
This column does not necessarily reflect the opinion of Bloomberg LP and its owners.
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