- The Big Conversation
- Episode 21: Here come the helicopters
Economic apocalypse: Here come the helicopters
Published on: March 24, 2020 • Duration: 16 minutes
This week we look at the government response to the shattering of global markets and economies. Will their response have an inflationary impact in the short or long term? Currently, they’re following the 2008 playbook, providing liquidity for financial institutions. On this occasion, they need to provide assistance to the real economy and that is a far harder task.
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[00:00:04] Because the moves that we've seen in markets and we're going to see in the real economy, central banks and governments are finally coming in with huge levels of combined support. This is effectively MMT, this is helicopter money. But what does that mean for things like inflation? What does that mean for us? That's what we're going to look at in The Big Conversation. This has been the fastest decent into bear market territory that we've ever seen. I think it's been about 16 days for the US markets. It's gone way beyond there. And so clearly now the question is, is this going to be recession? Normally, that's down 40 percent. We're not far off that at the moment. If it's gonna be a deep recession, equity markets usually fall about 60 percent in that scenario or depression, which is often more like 80 percent. Obviously, this matters because clearly it also depends or defines how long it'll take to recover. And I think as we've said before, one of the key elements to all of this is understanding the market that we had before this all blew up and what that framework was all about and whether that framework has now been damaged beyond repair. What we've seen so far, I think, has been two phases. The first bit was the economic shock and that sudden realisation that there was a problem. And that was that first sort of week and a half, two weeks. About two weeks ago, we said that this is now gone beyond that. This is now a deleveraging story. It's a funding story. It's a shadow banking story. And that really was a bit that drove that second leg down and is where we started to see bonds selling off, at least partly selling off and then not rallying much, even as equities continue to slide. We saw funding spreads blowing out and then we eventually started to see the dollar rise against pretty much every currency. The next question really is where do we go from here? We go from that economic shock to funding via deleveraging shock. But then we have to go to the economic reality and the economic reality being that if we're putting economies into a coma for an extended period, it could be one month, two months, maybe it's longer. People are talking 12 weeks minimum in the U.K. for older people to stay indoors. So how long are the supply and demand lines going to be out? And obviously this is a massive shock on both supply and demand. Well, what really matters here is what was the framework and has the framework been broken? The framework that's been in place since 2008 has largely been one of central banks being in the driving seat. Central bank liquidity, low interest rates. And they were providing lots of that liquidity, which effectively got into financial assets more than it got into the real economy. The key driver of all those years was that central banks suppress volatility. They wanted to keep a lid on realised volatility when it happened in the FX market, the bond market or the equity market or even commodity markets, which is what happened in 2014 2015. As of now, it looks like they've failed to suppress that. Clearly, the problem is that the whole of the financial framework was effectively predicated on the back of central banks controlling volatility. What do we mean by that? Well, this was effectively “yields will be lower for longer”. It also meant that GDP growth was very low. It was fairly constant. We haven't seen many real recessions over the last 10 to 12 years. We've seen some regional recessions. We saw some industry recessions. But we're never seeing a global wide impact and therefore a global wide deleveraging by keeping basically both growth and also volatility under check. It allowed people to build up into these effectively low volatility systems. And this is what we've basically seen the last 10 years. We've seen active managers bleeding their funds. Those funds have been disappearing from the active towards the passive, the rules-based, the smart beta, the risk parity funds. We think that the number of funds in that bucket, this is the rules-based bucket, overtook the active bucket sometime last year. And those flow of funds have been chasing very similar principles. And we talked about this before, how effective the whole market had been following the same investment principles. It's been looking for minimum volatility in stocks. It's looking for balanced portfolios, often leveraged into bonds on the assumption that bond prices would go up when equities sold off. And then when equities rallied, bond prices wouldn't go down as much. So overall, bonds went up and equities went up. So you won on both sides of the equation, whereas today is clearly a very, very different regime. And is this a regime that is now going to persist? Have we completely broken the old regime? And why does that matter? Well, the other element towards all of this is things like the share buybacks. Share buybacks are effectively corporate's. They were either reinvesting their profits into shares or they were leveraging themselves. And this was the important bit - leverage themselves in the corporate bond market to buy back shares. They didn't carry large cash buffers for a rainy day, which is the problem today. They didn't do much CapEx for future growth. This is always about effectively pushing the price of their shares higher. In the world today, the real world, those corporates no longer have any cash flow. It has disintegrated. It's not quite zero, but in real world sense, it's close to zero compared to where we were historically, even through the financial crash of 2008. Now, these companies may get bailouts, but those bailouts will be for workers, will be for maintaining production lines. It will not be for buying shares. So the biggest bid in the equity market is no longer there and is unlikely to come back before the cash flows are fixed by governments and that could be six to 12 months. With volatility where it is, we know that the rules based funds are also going to have a problem, which is often the equity allocation was dependent on realised volatility being, let's say, in the equity space (this is the amount that the S&P would move each day) would be around about a 16 vol, but we're way above that on a three month basis. These are all way above the levels where these funds are now sellers of equity. If you take the pension fund industry itself, what happened on a daily, weekly basis is that people worked, got paid and some money got put into a pension fund which would find its way into bonds and equities. Well, we now know that for the next two or three months, a lot of people are not going to get paid. There's an expectation that the initial jobless claims in the US this week will hit well into the million mark. Well, some people actually argue it could hit 3 million compared to a peak initial jobless claim of around about 700,000 over the last 30 or 40 years. If people aren't earning money, they're not putting them into the pension funds. Those pension funds are not going to be the bid in the market. So they're out as well. And then you have within the pension funds, the makeup of people having probably too much equity, which will come on to. So in many senses, we've seen a shift in the whole fabric. But I think the longer term impacts can be seen just as some of the examples that I've experience myself and we're reading in the press in terms of pensions. So the pension crisis is something that has been festering away underneath the surface for many, many years. Future pension and pension liabilities in the future are in the tens., some people say up to 100 trillion dollars. This is the underfunded pensions. Now with equity markets that are falling and with bond yields providing very little support, either those liabilities will be increasing. But in a very real sense today there has been an expectation, at least at the beginning of this move for a lot of people in the pension industry, a lot of private wealth advisers who are saying, look, by the dip, by the dip, you always buy the dip, the markets bounce back. But what we're now seeing is that, for instance, in the U.K. in 2015, people were able to move into self-invested pension plans. SIPPs. This is where they took the money and looked after it themselves. Many people were encouraged to take more equity exposure because bond yields were so low. Now there are examples of some key income funds in the U.K., down 40 percent, in line with the U.K. market. The problem is that also the dividend yields are being cut. So in the way that corporate buybacks won't take place in the US, dividends will be cut. The yield may stay roughly the same. But because the capital has fallen by 40 percent, the income has fallen by 40 percent, in some cases more. So many pensioners who are relying on these equity pots and their dividends for their income are now going to see their income decline. We know that the economy is not going to recover in two or three weeks or two or three months. And we also know it is very unlikely that equity markets will have the V-shaped recovery that we're used to in 2015, 16 and 2018. So it's a very real decline going to happen for a lot of pensioners. And this is not just in the U.K. it's all over, particularly the developed world where pension plans were put in place, but particularly the US and the UK where equities were too large a part of those pots. My own experience is that I've been consistently been tapped to put more money into equities as the market has sold off. And each time I've been saying no. But this is probably the advice that's been given out to many, many people over the last two or three weeks to encourage people to go into the equity market on the assumption that we'd bounce back. But we'd only bounce back if the structure and the framework that's existed for 10 years is not broken. But at the moment, I think we'd have to say it probably is. So therefore, what is the response and what is the response that we're going to get from central banks and from governments? Now, this is obviously key because before it was all about liquidity. We've mentioned this before, the repo market. The funding market, the shadow banking market. People who had leveraged themselves up and were now deleveraging couldn't get hold of cash. I think that phase has now been onsets over, but I think they've targeted the liquidity into that part of the market. But this is the financial assets market, the one that's benefited from this whole process over the last 10 years. But what they now need to do is start dealing with the real economy, the fact that wages are going to zero at least for a month, maybe two months for many, many parts of the economy and recovery phase, maybe, maybe a lot longer than normal. So the liquidity now needs to target the real economy. The central banks, well not central banks……. governments need to give effectively capital directly to workers, to street cleaners, to painter decorators, to bartenders, many of whom will no longer be in work. Liquidity is not going to be for the financial market in the way that it has been over the last 10 years. It's going to find its way into the real economy and is going to struggle to find its way into the real economy. Effectively, what we have here is a massive pit that had just been dug, into which the liquidity is going to be poured. Now the question here is, isn't MMT going to be inflationary? Isn't this the reason why bonds are struggling because it's so much liquidity is coming to the market. If so much printing is going to happen where governments spend money on the real economy and then basically sell bonds to finance, is providing a large amount of issuance and then the central banks through QE will buy back these bonds and therefore hopefully keep yields relatively static. But isn't there a risk that that that this increased liquidity is going to push yields? Well, yes, there is. Is there a problem that this could create inflation? Well, if this had been done last year when the framework was still intact, then everybody would have said the chances are the fiscal impulse will be an inflationary impulse, because it's a fiscal impulse on an economy that is growing at 1 percent. But it's a little bit loose around the seams today. It's cracking. It's breaking. In fact, maybe it's broken. So it's going to be put into a bottomless pit. But there is still a risk for inflation. And the risk on the inflation side is simply that if you're going to give money to a workforce whilst telling that workforce that they can't work, then you're going to create demand, but you're not going to create supply. In the U.K. we can see this a little bit. Some of the supermarkets are already starting to put up prices. Now, what they're saying is that they're taking off their 3-for-2 deals because many times we are limited to buying only two items in the supermarket. My own feeling here is that in the short term, those hits to pensioners and pensions, income, the hit to the real economy, the fact that this is a bottomless pit, corporates are drawing down their credit lines. All of that suggests that I still think governments will be behind the curve in terms of providing sufficient liquidity to offset the impact on the real economy. But nonetheless, in specific areas of our economy and same in the U.S., when these deals and these packages start to come through, then again, we've still got to be concerned that certain elements of the economy may see the sort of inflation that we've not been used to. And it will be debilitating inflation cause will probably probably be on the very things that we want to buy whilst the overall longer-term economy remains relatively under duress. So how will this play out with these governments providing liquidity? It's not like 1987. 1987 was an equity story where equities got overvalued. But once it was done, it rebounded pretty quickly. It's not in 2000 to 2000 is again an equity story. It had a bigger impact because the whole global economy leveraged into the dot.com concepts, which obviously was a bubble, which created a belief within the equity market, a deflationary impact. But the liquidity provided by central banks through through lower interest rates allowed other parts of the economy to take off in 2008. Again, there's a large part of the economy now with the whole credit space that got levered. But when that blew, once they worked out how to fix the banks in particular, then again we moved on. Now, obviously, we didn't get great growth from there, but at least it fixed what was quite an exaggerated move in that finance space in the world of bank banks and mortgages. Even 2012 within Europe, once they worked out where to target bond buying and where to target the real issues around the periphery, at least plastered over the cracks in the short term. Today, we don't have that same scenario. This is global. Something like 137 out of 193 countries currently have coronavirus. I'm sure it be all 193 before we finished. So it's clearly not going to be a quick fix like we've seen before. And in some ways, 2008 and 2009 was a remarkably quick fix considering the widespread impact that the access of credit had had. But today, the very fabric, the very framework is the bit that's under pressure. But in the meantime, central banks will continue with MMT, with helicopter money. It may be inflationary in the longer term, but in the short term, this is still going to be fixing the whole fixing the problems that we have. So taking all that together, where where are governments here? So governments have probably fixed in the very short term the deleveraging of the shadow banking system. I think that was a story a couple of weeks ago. They've got nowhere near to dealing with the de-leveraging or the debt issues in the real economy. They're starting that as we speak. But this will have to play out over many months and will require a lot more financial accommodation. So think about this in the very much the longer term, don't think about this as necessarily being the V-shape. It's very, very unlikely. That was a story when the framework was intact. The framework is no longer intact. Central banks and governments are combining to deal with the problem that we have today. But that means that we're going to be in a completely new framework, probably in a year's time. And therefore, think about what positions you have considered. This is currently pricing for a recession, not a deep recession. And yet nearly everything that we're seeing suggests that this could have far wider reaching impacts than we've seen in our lifetimes. And therefore, put your positions accordingly. Think of your positions accordingly. If you're a trader, maybe now is the time start for a short term bounce in particularly now that hedge funds have switched from being long and starting to play on the short side, that could give some decent bounces. But you've really got to be a trader to do that. For an investor. You still got to look about protecting capital. Yes, it will be some opportunities once dividends have been cut and you can start looking at those. But we're still in the dividend cutting phase and the balance sheet reduction phase at the corporates in the real world. This is still time to play safe and not try and catch the falling knife.