Political Decisions and Implications

Political decisions, not science, will be a “Cause” with important macro and financial “Consequences”.

• SUMMARY : As the Covid19 pandemic hit, the global economy was the most levered it has been with low reserves set aside.

• Governments have taken a political decision on mass quarantines and border closing - they could have taken other action.

• These political decisions (Cause) will have important impacts (Consequences) on economies, notably on the finances of corporates and households (HH). In the principal large DM economies, the former are highly levered and the latter have hardly reacted to interest rate cuts in the last 10 years.

• Central Banks have no normal policy tools left at their disposal. The small cuts available were immediately utilised, there was no scope for forward guidance, which left the inevitable action to undertake QE.

• It’s time to consider the unthinkable on a large scale. Central Banks could buy private sector assets. Governments will break fiscal rules and limits, not only to pay social dues in a climate of declining tax revenues, but also to assists HHs and corporates through direct payments, asset acquisitions and providing guarantees. Until there is clarity on how this will be done, which will allow the market to determine fair value prices, volatility on risk assets is likely to persist. Eventually value companies with good cashflow and strong balance sheets will be good buys.

• To fund this fiscal expansion, governments will issue large debt programs that will have to be bought by their central banks. This is because government debt levels are already high (thanks to the GFC) and there is limited capacity for the private sector to lend without raising real rates.

• Interest rates will continue to remain low for a persistently long period. This will have an important impact on the finance industry, including banks, insurers and pension companies. In the short term, the rise in real yields is a clear indication that central banks are not doing enough, which should mean continued asset price volatility.

• FX will be the pressure valve through which imbalances get measured, keeping a bid on the USD and Gold and an offer for deleveraging leveraged economies (e.g. SNACS) and EM.

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Financial markets seem to be moving from predictable revaluation trends with expected correlations between global asset classes, to volatile whipsawing changes in prices and a breakdown in cross asset correlations. This new phase seems due the market having to absorb the potential of much bigger than expected losses and bailouts, on a scale that has not been seen since the Great Financial Crisis (GFC), and all in the context of a global economy in a state of poor repair and with Central Banks with few traditional tools left to fight the consequences of the Covid19.

When Covid19 first broke out, there was little understanding of how it would impact populations and healthcare systems. There was a scramble to get experts’ opinions and their conclusions coupled with the events in China led to a quite natural risk sell off as the market priced in lower growth and profits. Analysts started modelling contagion and death rates, extrapolating what this would mean for healthcare systems. The initial reaction was to forecast “V shaped” recoveries and thus the recommendation to “buy the dip”. The ineffectual first 50bp Fed cut was a warning that the market was more spooked than what the consensus generally thought.

What has become clear in the last few days is that no country will be able to stop the contagion impacting them and serious questions have been raised whether you should mass quarantine or not your population. Should there be immediate lock down, or only when the heath system is full?

Whilst these debates have been moving forward, there has been a subtle move by politicians to use/hide behind expert scientist assessments to take decisions to quarantine entire populations and close borders to travel. This was not the only option available to them - they had two very different choices:

1) Let business continue as normal, which would mean a faster contagion with expected higher death tolls as health systems don't cope and recover all patients.

2) Lock down the entire population in order to reduce the immediate contagion, but at the same time lengthen it, thus hopefully reducing the death toll as more patients can be treated.

Whether one or the other path is right or wrong, and whether the numbers really add up is not the point of the discussion (I am not here to argue this question). The issue is that the decision to mass quarantine (CAUSE) IS a political one with very different impacts on the economy (CONSEQUENCES) to not doing a mass quarantine. Before considering those consequences, it’s worth remembering the state of the global economy as the Virus broke out.

STATE OF INDEBTEDNESS COMING INTO THE COVID PANDEMIC

i) Householders (HH)

Since the financial revolution in the 70s and 80s, when credit cards were issued and mortgages became more freely available at more generous conditions (less % deposit/longer duration etc), household debt has increased at a steady rate in nominal terms, as a % of income and as a % of GDP. European and Japanese HHs have been far more conservative in nature compared to US and UK HHs (and other smaller DM countries). HH leverage peaked in the 2008 GFC, which was followed by large scale deleveraging in the US and UK, whilst it flat lined in Eur and Japan. These new post GFC trends occurred despite very low interest rates (the first sign that a debt trap was indeed sprung on major economies). Against this deleveraging trend, the last 10 years has seen China and the SNACS countries (SEK, NZD, AUD, CAD and KRW) witness a large increase in HH leveraging (RHS). In summary, levels of HH indebtedness going into the Covid19 pandemic were extremely high on a historical basis, and trends were either deleveraging or flat lining (thus the recent low consumption).

ii) Corporates

There have been some major developments in corporate balance sheets over the last 30 years that has left the corporate sector in a poor position to withstand the consequences of reduced consumer spending shock (one of the consequences of the government induced forced quarantines): a) “Just In Time” policies in the manufacturing sector has reduced working capital to the bear minimum and reduced reserves against negative events. Globalisation has created distance in supply chains. b) There is evidence of a shift lower in the return on capital employed distribution curve with a rise in the extreme right tail as most companies are making less money and some companies are making a lot more (Orszag & Furman). This is the equivalent to a rise in inequality of corporate profitability as can also be seen in the rise in Household inequality. c) An increase in leverage for stock buybacks, including by those companies who are cashflow negative. Many in the market just take this as normal practice, not realising that this was illegal until 1982, as buybacks financed by debt were considered a form of stock manipulation. The very action of issuing debt to buy equity makes a company more leveraged. d) Very low interest rates and the flawed WRA banking model both contributed to a large misallocation of capital in the “hunt for yield”. This has taken the form of debt, the consequence of which has been that barriers of entry have been artificially low, supressing corporate margins through zombies artificially enhancing competition. The chart below (LHS) shows outstanding corporate debt as a % of GDP. Leverage is high, made worse by the poor serviceability of that debt. Already >25% of the Russell 3000 were making a loss before the Covid broke out, 83% of US IPOs in 2018 were loss making, whilst US Corporate debt as a % of gross value add is at 60 year highs (GMO – right).

iii) Government Finances

The sharp rise in deficits immediately post GFC led to a substantial and seemingly permanent rise in government debt/GDP for the main global economies (LHS), whilst the SNACS managed to limit their increases (RHS). Post GFC austerity programs halted the rise in Debt/GDP trends in the Eurozone and UK, whilst fiscal largesse in the US (Trump’s generous $1trn p.a. tax giveaway since 2018), Japan and China (to keep growth at 6%) have all resulted in increases in their sovereign debt levels. Of course, unlike the private sector, governments have unlimited capacity to issue debt, but with that privilege comes some important consequences.

CENTRAL BANK POLICY COMING INTO THE COVID PANDEMIC

Not only have Central Banks entered the Covid pandemic with low interest rate policies, but forward curves are also very low (below shows 1yr forward rates). This latter point is important because once the ability to cut rates is exhausted, the next tool is to use forward guidance to lower forward rates. You could argue that that forward guidance is now worthless as the market already prices it, which is perhaps why recent central bank interest rate cuts and talk of easier policy had little impact on financial markets. Talking of causes and consequences, the recent cuts and lowering of long-term forwards has led to more financial institutions entering the reversal rate zone where balance sheets will start deleveraging as cash flows turn negative and ALM breaks down. This leaves only one option available to Central banks – increasing its’ balance sheet through quantitative and qualitative easing

GOVERNMENT POLICY: HOUSEHOLD QUARANTINE AND BORDER CLOSING

As was seen all too clearly in China, the mass quarantine of householders leads to a rapid decline in consumption, industrial output and revenues. One thing that is becoming clear as the pandemic develops is that this whole event will last much longer than initially expected, and stock markets have reacting by severely downgrading valuations. The question is what can “the authorities” do and what will be effective?

As the above charts show, main economy HH leverage has been flat lining for years – it was also peaking in SNACS countries over the last 18 months. It should not be controversial to say that the usual monetary policy tools to stimulate HH credit demand, and thus growth, stopped working in 2008 for the major economies. With many HHs now impeded from consuming due to quarantine measures, it is hardly going to work now. That said, one should expect higher government spending on social security to help sick workers and those made unemployed by the effects of the decision to mass quarantine, against which income and value added/sales tax revenues will decline.

Added to the lower internal consumption will be poor tourism, business travel and a reversal of globalisation as borders get raised for people (not goods or services). Monetary policy will obviously have little effect to reverse this.

Thus, the direction for real government expenditure is likely to be rescue corporates, especially those who are highly leveraged with negative cashflows. This should come through government guaranteed bridging loans, deferred tax payments/tax cuts, and grants. The issue arises on who to allocate assistance to, by how much and in what form (debt/equity), and the initial sums being thrown around are huge. If 2008 is any guide, then expect a substantial increase in Government Debt/GDP as both sides of the ratio move in opposing directions. This will be the cost of the political decision to have HHs enter lockdown.

GOVERNMENT POLICY AND CENTRAL BANK ACTIONS: IMPACT ON FINANCIAL MARKETS

Experience of previous economic cycles shows the first Central Bank reaction is to cut rates (where there was room to cut), and when this did not stop asset price declines, then to expand balance sheets through direct QQE, QE or “not QE”. These are the actions that CBs have recently undertaken when asset prices started reacting to the Covid19 pandemic. To date this has at best slowed the bearish momentum on risk assets but not brought any sort of meaningful rebound in prices, or supressed volatility. Very recently correlations have started to break down and systemic risk indicators have started to flag. The market is becoming unpredictable, which suggests a requirement to start questioning what authorities will do next as much more is needed to shore up asset prices.

“Backwardation” is a human trait to make them feel better when they don’t understand something. We apply an answer to a problem even if it is an incorrect one, pretending to ourselves that we knew something all along when in reality we did not. If we did not do this, we would have some serious brain pain! This is a very dangerous trait when mixed with consensus/group thinking.

Two examples of this are our understanding Japan and Money Printing. There are now many people who profess that they understood what was happening in Japan when the debt bubble inflated and then bust, which cannot be true given it took 8 years for 10year JGB rates to decline from c. 8% to 0.8%. Lessons were not learned, evidenced by the fact that other central bankers subsequently allowed their own debt bubbles to inflate. With regards to money printing, most market participants in 2008 did not even have the slightest suspicion that Central Banks would enact QE, Tarp, Tarn etc programs, i.e. expand their balance sheets to buy government bonds or private sector assets. This is what EM countries did, not developed counties, as all the historical evidence was that Central Bank balance sheet expansion was nuclear waste wrapped up in toxic rubbish.  And yet, that’s what Central Banks did, hoodwinking many, calling it QE and saying it was “temporary” in nature. The Fed’s mask dropped in the 2013 taper tantrum and 2018 balance sheet unwind as market disturbances forced immediate policy reversal.

Understanding the Japanese debt trap and how it has been repeated elsewhere has been important in running the theme of lower rates for longer in the last few years, whilst ignoring the temptation to be bearish on stocks. Understanding the ability of Governments to intervene and buy private sector assets whilst Central Banks circumvent economic thinking and legal constraints to buy debt is also very important to try and determine what happens next.

It should not come as a surprise if either Governments or Central Banks intervene directly and buy private sector assets (debt and/or equity) and issue guarantees to banks to lend to corporates on a very large scale. If governments undertake this action, as seems very likely, then the consequence will be a very large increase in debt issuance, which absent QE would mean a rise in real rates. But for sure Central Banks will ensure real rates will not rise (which would further damage deficits and tighten monetary conditions). Alternatively, Central Banks might just directly buy private sector assets under the guise of “Qualitative Easing” or to ease “market liquidity”. I am sure there are many reasons why many would immediately cast this aside as impossible or improbable, but then again in 2008 people did not expect the FED would buy Treasuries, the ECB to buy GGBs, Btps and Corp Bonds or for the Japanese to buy equity ETFs.

MARKET IMPLICATIONS

The reality is that one way or another Central Bank balance sheets are going to expand tremendously – this is the natural next extension of the long term credit cycle, one that Japan started in 2011 with its QQE. The unpredictability is how it will happen (CB or indirectly via a state’s treasury or agency), the aid instrument (debt, equity, guarantee), the terms and conditions, the timing, and the efficacy to a company’s cashflow given the short term consumption slowdown and risk of long term changes in which business is done. This leaves a lot of uncertainty over how to price the value of lesser quality risk assets, but this should lead to an outperformance of less leveraged assets with good cashflows.

With regards to future interest rates, a further large rise in government debt should convince most sceptics that debt traps are in place for the most important large economies. The existing gross and net supply profiles, as well as debt interest servicing trends, show clearly that this is already the case. This was confirmed when problems arose in the 4Q18 when real rates rose 100bp. It’s worth bearing in mind that Japanese rates have been low for 25 years necessitating the change in the expression from “lost decade” to “lost generation”.

Despite the heightened risk of lower rates for lower, the prospect of a flood of new issuance in the short term is rightly putting upward pressure on real yields, whilst inflation breakevens remain supressed at low levels (red and blue respectively in charts below). The real yield rise has almost eradicated all of the nominal yield gains made during the risk asset sell off. This is a clear indication that the market is not satisfied with the central bank announcements to date, which is a red flag for all assets. Given that Central Banks will have to supress real yields through balance sheet expansion, this should eventually turn out to be a buying opportunity.

The least fuzzy road ahead in a foggy market environment is surely FX and precious metals. The market knows about the excessive USD borrowing by institutions without USD cashflows to service those debts. Deleveraging should bring a continued USD demand from USD debtors as well as from foreign governmental institutions that need to help their corporates with USD debts. This month’s DXY gyrations tested and held the long term 20month ma support – prices below which were bought - keeping the upward momentum intact. For the moment there is no indication that the developing bull trend in place since 2018 is over. 100 will be an extremely important test to the upside, which if broken would open further gains to the upside.

In the last month the SNACS currencies have all behaved as expected, devaluing to different degrees. They have the most to lose from the Covid19 given their recent post GFC leverage – they all have experienced asset bubbles and the banks are ill prepared. They have their own GFCs ahead of them, which means the future should hold much lower forward rates and weaker currencies.

EM currencies have nowhere to hide. Having cut rates tremendously in 2019 to support growth as inflation was muted, there really is little carry protection for investors for fx losses. The JPM EM Currency Index recently broke the key 18month support at 60, and has been declining ever since. The last time this happened, in 2018 (which we played via an INR short), the EM index fell 13% - to date the EM FX Index has dropped 8.5%. Whilst the market looks “oversold” (RSI at 16), note how long the RSI index can be oversold for (2014-2015 and 2018). Given the leverage, exposure in some cases to commodities, valuations of equity and bond markets, and exposed nature of EM countries to border shutdowns, it seems further fx devaluations ahead until there is meaningful aid in DM that will be seen to have a knock on effect to help EM.

The final comment has to be on Gold. This first came onto the horizon in 4Q18 when buy signals appeared that coincided with Trump’s fiscal largesse and the Fed’s about turn on its balance sheet policy, reversing its’ contraction to expansion. After a decent 2019 appreciation in price, this year Gold initially behaved as per the correlations seen in 4Q 2018 (negatively correlated to the SPX), but has over the last two weeks been violently sold. Many reasons have been given for this correction, but the reality is that some damage has been done to price momentum on the weekly and monthly charts (see RSI divergence below). Perhaps currently there just is not the money to buy Gold (a bit like USTs being in corrective mode).

Whatever the case, given just how much Central Bank balance sheets are destined to expand over the next years to support corporates directly or finance large increases in government debt issuance, there is a strong chance of a marked appreciation in the price of Gold. To this end the trends of the 2008 25% depreciation and subsequent 2009-2011 85% appreciation in the price should prove to be a good guide to what could happen going forward.