Wir sind alles Metallgesellschaft

An unhappy meeting of finance and industry

The behaviour of the price of oil in the last week was, to understate the matter, jerratic. A sharply negative oil price (the first time since 1870 at least) in the May contract served to illustrate how topsy-turvy the economic world has become (I hope some airlines hedged in negative oil!). Together with the relatively recent advent of negative interest rates, negative oil prices will convince many that something is not right in the engine room of the global economy.

I mentioned in last week’s missive that assets like oil that did not fall under the spell of central bank asset purchases gave a truer indication of the economic outlook than those assets that did.  

In this context, the signal sent by the price of oil, even today, should be a cause for concern. Of course, other factors conspired to push oil into negative territory – notably a shortage of storage, the convince of some hedge funds and traders as well as the side effects of financial engineering (exchange traded fund (ETF) structuring).

This upside-down oil shock is not over and the effect of low oil prices will continue to ripple through emerging and high yield debt markets, emerging market currencies and the dollar, as well as banks and the Texan economy.

In the greater scheme of things, it also brought to mind the case of Metallgesellschaft, a giant German industrial conglomerate which in 1993 ran up a USD 1.5bn (a lot of money then) loss on an oil hedging contract. Metallgesellschaft fell foul of the same effect we witnessed last week, contango, where the price of near dated contracts (i.e. May) dropped well below the level of later dated contracts (e.g. July).

The Metallgesellschaft case left a mark on the financial economic history of the early 1990’s and is widely taught in business schools as a case study in the dangers of mixing business and financial engineering.

The collapse of Metallgesellschaft came at an early point in the deployment of derivatives in markets and should have served as a salutary lesson to corporates, regulators and banks. That was not the case.

For instance, the lesson that Deutsche Bank, which had arranged the hedging trades for Metallgesellschaft, apparently drew from the blowout, was to aggressively expand its investment banking operation. Today, the share price of Deutsche bank is down 95% on the level it reached before the global financial crisis (without being too unkind to Deutsche Bank, David Enrich’s ‘Dark Towers’ is worth a look).

What the jumpy oil price and Metallgesellschaft have in common is an instruction on how the real economy and finance have become increasingly intertwined.  

From an economic and investment point of view, there is plenty to consider in this regard. I am tempted to say that there is one sector that does not rely on finance – technology – but the corornavirus crisis has turned tech from an industrial gargantuan into a stock market monster (Microsoft, Apple, Amazon, Alphabet and Facebook account for 22% of the market capitalisation of the S&P 500 index). Next week’s tech earnings results may bring a reality check for stocks, and see volatility pick up.

The two other sectors to consider are banks and private equity. In the light of the Metallgesellschaft discussion what is remarkable so far in the coronavirus economic crisis, is that no bank has keeled over (I may speak too soon).

Indeed, the balance sheet restrictions that have been put in place, and general focus on risk management, appear to have paid off. In many countries, banks are now part of the rescue mechanism, and there is an opportunity for many of them to repair their reputations. In Europe the price of heavy regulation has, made banks very cheap from a valuation point of view so that there may be some upside if a round of consolidation takes hold into 2021.

Unlike banks, private equity has for some reason not come under the intense scrutiny of regulators, even as private equity (and private debt) have replaced the role of banks in parts of the global economy (i.e. shadow banks).

A crunch is coming however. In the USA, private equity companies are heavily invested in medium sized enterprises, and in any cases have taken on large amounts of debt to do so. As the economic toll of the coronavirus deepens, the financial pressure on private equity will translate into economic pressure on companies (leading to cost cuts and layoffs), and social pressure on their workforces. Sadly, this may have a deeper human, economic and political effect than the drama of negative oil prices and deserves to be watched closely by policy makers as the summer approaches.

Have a great week ahead,

Mike

Roof

The Fed as protector in chief

Courthouses are fascinating places, and often help to shine a light on the deeper, darker layers of society. One example which sticks in my mind is the hosting some years ago by the London High Court of disputes between Russian oligarchs. The proceedings provided insights into the workings of Russian ‘capitalism’ and in particular uncovered the term ‘krysha’, or ‘roof’. Its essence is that individuals are given protection (roof) or cover from interference, in return for money or other obligations.

Whilst I know little about the darker corners of the Russian economy the phrase ‘roof’ struck me as a useful one in the light of recent central bank interventions. Regular readers of this note and those who have read The Levelling will know that I consider that in recent years central banks have encroached too far into financial markets, to the extent that they ‘own’ them, economically and psychologically. Amongst the many risks that this can lead to, is for investors to believe that risks in markets are uneven (i.e. the Fed will cover downside risks) and this may help to explain why it took markets so long to react to the outbreak of the coronavirus crisis in January.

The latest moves by the Federal Reserve, in particular that to support the high yield bond market, are redolent of ‘roof’, though ‘floor’ might be a better term. In doing so the Fed distorts market prices, offers one sided ‘bets’ to speculators and helps out reckless investors. Apart from curbing market disorder, some of the Fed’s actions will have very limited economic impact at a time when small businesses and many households in the US are struggling.  

For some, this will create the impression that the Fed is beholden to Washington and more Wall Street than it is responsive to the broader American economy. What is more troubling is that the Fed’s activism will allow a stock market centric president (see my January 19 note ‘Peak Stocks, Peak Trump’) to claim a sense of ‘mission accomplished’, whilst ignoring the deeper economic and public health carnage of the crisis.

In markets, what is noticeable is that assets that do not have ‘roof’ appear to be underperforming those that do. Emerging market debt and fx have been weak, as have energy prices and copper, whilst small cap American stocks (Main Street) have underperformed the Nasdaq (Wall Street).

In this climate, the non-protected (non-roof) assets, or rather those that are not under the spell of big central banks, will likely continue to offer the best steer as to where the global economy is going – in that respect these assets (copper, oil and EM currencies) point to ongoing stress in the global economy. If this continues to be the case it will create a two-tier investment world where investors trade baskets of ‘roof’ (Fed sensitive assets) and ‘non-roof’ assets (economy sensitive assets) against each other.

In Europe, the propensity of the ECB to offer ‘roof’ is constrained by the political-economic divide between northern and southern economies. While the ECB has nonetheless been relatively speedy and generous in its actions, there has been something of a market backlash against periphery bonds (Italy in particular, and also Spain and Portugal). To one end, this strikes me as investors indulging in a habitual trade in that they expect every market crisis to become a euro-zone crisis.

One interesting rebuttal to this is that the US is beginning to look more like Europe. Note that US state governors (like EU state prime ministers) are enjoying a level of prominence they have rarely had and are beginning to form inter-state ‘pacts’ in the same way that countries within the EU are forming coalitions (i.e. France/Germany, the Hanseatic League 2.0). Financially, there will be greater market focus on municipal debt, the variability of real estate prices and mortgage debt across the US (a la Europe). So, Eurosceptics might well look to the US for their next trade.

As a final point Europe to reiterate the sense of recent comments of the French President, needs to give itself ‘roof’. Endless squabbling about debt mutualization is not the way forward here. The best approach is bottom up harmonization of processes – such as setting up a business, corporate governance and capital markets, not to mention harmonization of ‘emergency’ protocols for crises like the coronavirus crisis.

A more profound solution is to do what Europe has not done in a sincere way since its foundation – a strategy to grow its economies together, that goes beyond wordy plans and empty unenforceable commitments. That is the great challenge for Emmanuel Macron and those (myself included) who want the EU to thrive in a post coronavirus world.

Have a great week ahead,

Mike

League of Nations

Soon as competitive as the Champions League?

If the defining characteristic of the coronavirus crisis is its speed, then equally, one of its defining effects has been to expose the vast disparity in in the way countries have been affected by and dealt with the virus.

Though it is very difficult to have a true sense of numbers of infected as well as deceased, there are remarkable differences in fatality rates (per capita) if we say compare close neighbours – Ireland to England, Germany to France or even Norway to Sweden.

Whilst there are also some stark inter-state differences across the USA (Kentucky v Tennessee for instance), countries are still the best lens by which to view the effects of the coronavirus because they capture differences in laws, customs, social cohesion, institutions, political leadership and so on.

On balance, countries with good levels of human development, institutions and where the state is competent, seem to be doing a good job of containing the crisis. They are aided in this by largely obedient and well informed citizens, though the Easter weekend will test how obedient those citizens are.

So far, the crisis (beyond China) has centred largely on what we regard as the developed world (Europe, the USA and many Asian countries like South Korea and Singapore), but it is now picking up in developing countries.  

Amongst the big emerging economies (China apart), Turkey and to a lesser extent Brazil stand out in terms of the onset of new cases. By and large, the emerging world has appeared to be be spared the scale of tragedy that has struck Spain and Italy, partly because testing is done sparsely (India has done 121 tests per million people compared to 13,000 for South Korea), and partly because these countries are less intensely connected to China and other international hubs.

In the near term, there is a growing need to tend to sharply rising poverty in the developing world, and a need to ensure that they are also well served in terms of medical supplies and knowledge.

When the crisis is over, emerging economies will have much to think about in terms of the resilience of their currencies (i.e. Rand), structure of labour markets, the patterns of migration and most importantly, urbanization and the role of public health systems.

This is a time when the rise and fall of nations is being accelerated and offers countries with scope for structural growth (i.e. Bangladesh to Ethiopia) a chance to stop and rethink their paths forward. They might also rethink how they are served by the dominant world powers and by international public goods.

In a context where institutions like the World Bank and World Health Organisation are being drawn into the geo-political rivalry between the USA and China (for example, the US President has threatened to cut funding to the WHO) there is an opportunity for emerging nations to speak out and to claim the best parts of these institutions for the developing world.

One suggestion might be to move the headquarters of the World Bank to Africa, which is the one region of the world that continues to need the expertise of the Bank. Locating the experts and executives of the World Bank in Africa will arguably make them more responsive, and better informed of the economic challenges there.

Equally, the expertise of the World Health Organisation could be harnessed for a post-corona crisis wave of public health education across emerging countries and an embedding of the health lessons of the crisis into urban and economic development planning.

There is also a greater strategic consideration at play. The developing world is still condescended to by the dominant economies and in the style of Thomas Pakenham’s influential book ‘The Scramble for Africa’. For instance, the crippling debt burden associated with the One Belt, One Road project will become more clear in coming months (e.g. Sri Lanka).

Given the way in which the crisis has exposed supply chains, there is potential for emerging countries to take stock of their strategic assets – an ability to produce some pharmaceuticals and healthcare equipment cheaply, and in certain cases, they are critical producers of food.

In a word order where national identities and borders have been reinforced, emerging nations may look to strike a tougher bargain with wealthier ones in terms of their hold over agricultural commodities. If they do so, they can become part of the levelling out of geopolitical power in the post coronavirus world.

Have a great week ahead,

Mike

Sitting quietly

Blaise Pascal – for how long can he sit quietly?

At this stage in the coronavirus crisis, many of us consider ourselves experts on pandemics and biology. The speed of the coronavirus through our world is paced by the speed at which our concern and curiosity is fuelling a quest for information.

One thread that has become evident to me, is that historically epidemics have not always been greeted with calm and grace. In periods when medical knowledge was not as well developed as it is now, and when democracy and public health education were fledgling, epidemics were often met with violence and disorder.

For example, in the early 1830’s cholera spread across Europe but efforts to contain it in countries as diverse as Scotland, Prussia and Russia were greeted with public attacks on doctors, nurses, and quarantine officers. At times, anyone in a white coat was a target. The general fear was that authorities were using the cholera epidemic to poison people so as to reduce the burden on the state or that doctors simply wanted cadavers for anatomy schools. We trust experts more today!

Compared to the nineteenth century, what is remarkable today is the degree to which populations – mostly in Asia and Europe so far – have followed the lockdown guidelines. In general, adherence to the lockdown has been highest in countries where trust in government (and perhaps fear in some cases) is greatest.

The next stage of the crisis, coming over the next two weeks, will severely test this trust. Whilst I am now tired of reading commentators quoting Blaise Pascal’s ‘All of humanity’s problems stem from man’s inability to sit quietly in a room alone’, millions of people across the world will face severe stress in terms of how they sustain themselves. This much was made clear by last Thursday’s initial jobless claims figure in the USA. At the height of the economic pain of the global financial crisis (March 27, 2009) the jobless number hit 665,000. Last week’s figure was ten times that.

With the number of coronavirus deaths per capita, per day, in the US now higher than during the US Civil War, the pressure on the US economy and its healthcare system will grow. The same will be true of many other countries, and though part-time or partial work schemes in economies like France and Germany may lessen the economic uncertainty, it will still weigh heavily. For instance, the past week has already seen food shortages in Italy, mile long queues for food banks in Pennsylvania. In many cases, loans, compensation and government payouts in the US will not arrive in bank accounts for weeks.  

As this urgent, difficult stage of the coronavirus crisis develops, obligations on governments will grow. In Europe, there is an opportunity for what we might stereotypically call the ‘Northern’ countries to repair the diplomatic damage to the idea of EU solidarity of recent weeks (I am thinking of the Dutch in particular!) and undertake to ensure that food and basic staples can reach parts of the EU where they are needed.

In the USA, the past three years have seen a hollowing out of expertise in government. Consider that in 2017 and 2019 the Pentagon and White House economists respectively developed studies to plan for a coronavirus like pandemic, but the executive did very little to prepare for such an eventuality. In the longer-run, the state of healthcare and the fragility of the US labour market should become major political issues. In the meantime, I expect that both corporate America and the military will play a greater logistical role in meeting the needs of this next phase of the crisis in the US.

As this occurs, the debate on the marginal usefulness of the lockdown (in terms of its contribution to lives saved versus its economic impact) will grow. It has already been marked by what I call the ‘cure is worse than the problem itself’ brigade.

Two more weeks of lockdown in Europe will test the sanity of its citizens (though will I hope also show the value of this strategy) and business people. At very least, political leaders will have to outline some kind of roadmap to normalisation – the continued isolation of vulnerable members of society, wearing of masks, a gradual return to normal working patterns for example. Balancing this will be incredibly hard to do, and control. At this point, market volatility may give way to a pick-up in social and political volatility.

Have a great week ahead,

Mike

Why did nobody notice it?

Not amused

During a visit to the London School of Economics in November 2008 Queen Elizabeth II demanded about the debt bubble, “Why did nobody notice it?”. She might ask the same about the onset of the coronavirus crisis, particularly of her prime minister and her eldest son. The defining characteristic of the coronavirus crisis has been its speed. For example, markets have fallen by the same magnitude as during the dot.com crisis, but this time the fall took 16 days not 16 months.

The speed is explained by the sudden restriction placed on human movement by the crisis, and the fact that in general we are used to dealing with single set piece economic or financial crises (market bubble, classic recession, regional – EM or EU – crisis) and not five overlapping crises at the same time. The speed and drama of the crisis is heightened by the fact that it is breaking things – diplomatic relations, investment funds, political careers and economies.

The policy response has not, as I have outlined in previous mails – been well coordinated between fiscal and monetary policy, nor between nations. That so many policy makers repeat Mario Draghi’s mantra of  ‘do whatever it takes’, betrays the fact that the magic of those words is vested in Draghi himself.

Still monetary and fiscal support has come thick and fast and will help stem market pain. My worry is that given we are at the late stage in a very long expansion, it will be harder for policy to significantly boost trend economic growth. Of the other policy measures – the quest for vaccines and treatments is the most exciting, whilst Russia and Saudi Arabia’s adherence to their oil price war is the most disappointing.

From here, I see three scenarios.

Easter: Under this optimistic case (25% likely) the fruits of isolation in Europe begin to show, the race for treatments and vaccines is promising, while central bank liquidity dampens market distress. As such, workers, companies and governments begin to get a sense as to the parameters around the crisis and some visibility as to when and how it can be managed. A slow return to ‘normal’ then begins in Europe and the US in late April. Stock markets hit new highs in October and Donald Trump stays in the White House.

Summer: ‘Isolation’ is increasingly debated on ethical, economic and political grounds. It proves hard to enforce across America and harder still to prosecute in emerging economies. Under this ‘main’ scenario (55%) the second derivative in infections and macroeconomic indicators only begins to significantly improve in mid-summer. As a result, many businesses close or are near to ‘broken’, despite fiscal support. At the same time, investment in ‘newer’ industries – data (5G, AI, Cloud), healthtech and digital finance is accelerated. Still, high unemployment and low trend growth are significant policy issues into 2021.

Winter: Under this ‘pessimistic’ (20%) scenario, much of the world’s workforce is disrupted by the virus, and second waves become the norm. Social unrest, political disunity and a breakdown in diplomacy between nations (US and China for instance) are some of the resulting side-effects. Monetary and fiscal policies cannot contain the full effects of bankruptcies and unemployment, to the extent that central banking ‘accidents’ crop up. The 1930’s is the nasty template to follow here. Property markets and alternative asset classes like private equity are hard hit.

While broad scenarios are useful for framing problems, they are often overly simplistic. One distinction to draw here is between the short to medium term return to normal in terms of end of isolation and return to work, and the enduring long-term imbalances that result from, and are exacerbated by this crisis.

Ideally, following a two-month period of isolation in the US (taking us to mid-May) a return to normal might be in sight.

However, under the surface of the world economy the following trends will have been deepened by the crisis – the end of globalization and the resulting multipolar world, the biggest debt load since the Napoleonic Wars and central banks who are running out of effective policy measures. In the alphabet soup of U, V,L and W shaped recoveries that forecasters talk about, we might well have a cyclical V, followed by a structural L.

With three of the G7 leaders now in quarantine, world political leadership is under strain. It has two battles to fight – beating the virus, and then resolving the end of globalization in as constructive and imaginative a way possible.

With best wishes

Mike

Quid Pro Quo

No Quid Pro Quo?

Otto von Bismarck, 19th century Germany’s Iron Chancellor, is reputed to have said ‘laws are like sausages, it is better not to see them being made’. With the benefit of very recent experience, the same is true of economic and monetary policy. The lightning speed with which a public health crisis has morphed into a deep, financial crisis has resulted in chaotic policy brawl where bouts of market volatility are met with new initiatives.

There is little sign yet of coordination across nations and regions, and between monetary and fiscal policy authorities. The US, Europe and China are all guilty here. In the short-run, the flow of policy moves will likely eventually swamp market volatility. Policy makers, be it in the Treasury, White House or the Fed may sigh with relief when volatility dies down, but they will do well to focus on the potential of their actions.

While the speed with which the coronavirus has morphed into a deep financial crisis has humbled policy makers, it has also revealed the faultlines in a deglobalizing world.

For instance, world debt to GDP is the highest since the second world war, labour markets have been hollowing out, and instead of investing in capital spending many American companies have deployed cashflow to buyback shares (Boeing, which has spent tens of billions of dollars on stock buybacks and is now seeking a bailout of sorts is an example).

The relevance of share buybacks here is that they have pushed up earnings per share, the choice benchmark for CEO pay.  So, with two-thirds of CEO’s being paid according to rising earnings per share, playing a ‘financial’ trade rather than say making better products (e.g.  Boeing) has been attractive for executives.

Yet, having debated ‘stakeholder capitalism’ at Davos in January, the corporate world is now entrenched in ‘survivor capitalism’. The risk now is that in treating the fallout from these faultlines, that has been catalyzed by the coronavirus crisis, policy makers paper over bad economic behavior that has contributed to unimpressive productivity over the past decade, and growing wealth inequality.

In this context, policy action needs to have a ‘quid pro quo’. The phrase entered the lexicon of American politics through George H Bush, and more recently in the President’s impeachment case. The notion of a quid pro quo should reign over policy interventions, in potentially, a range of ways that will produce a more sustainable and resilient economic model.

A first suggestion is that though the USA has no corporate governance framework in the same way that the UK does, a ‘quid pro quo’ skeleton framework can be introduced in return for policy support. For instance, it should tie executive pay more closely to underlying profitability and an array of measurable goals, rather than earnings per share. Tax and securities laws can make overly enthusiastic share buybacks and excessive debt loading less attractive.

Second, many businesses that will require assistance – such as airlines and energy companies – are vital cogs of the economy but also contribute to climate damage. One brief upshot of the now worldwide coronavirus quarantine is that the skies over China have cleared of pollution and the waters of Venice have a healthier hue.

Here, financial assistance to companies should come with the rider that as a quid pro quo they change business models to become more environmentally friendly – that can entail more investment in green sources of power and raw material, less investment in extractive industries and an acceleration in the adoption of a ‘green’ approach to urban develop.

Then, while medical studies suggest that the human cost of the coronavirus can be severe – one scenario in an Imperial College London study points to over 2 million coronavirus related deaths in the US – the coronavirus crisis, like the global financial crisis, has laid bare the vulnerabilities of American society.

At a time when life expectancy in the US has been falling and where healthcare is a locus of inequality, and when tens of millions of workers are vulnerable to layoffs, this crisis presents an opportunity to rethink the US healthcare model and to fashion a more resilient labour market. If this is not done now, there will be a severe political backlash.

The idea of a ‘quid pro quo’ is to encourage policy makers to stop and think about the faultlines that the coronavirus has exposed, to mend them and to steer industries and society towards a more sustainable path.

Otto von Bismarck also said that ‘politics is the art of the possible’, now is the time for policy makers to grasp this by matching urgency with foresight.

Have a great week ahead,

Mike

Friday 13

Lagarde, Merkel

In the current panicked environment, it will not have escaped the attention of most people that last Friday fell on the 13th of the month. Friday 13th is typically seen as an omen of dark things to come, though its origin is more interesting than many will suspect.

Friday 13th October (1307) was the day that King Philip (le Bel) IV of France launched a lightening raid against the Knights Templar, imprisoning their Grand Master Jacques de Molay and many others. Philip was in debt to the Templars, whom he also feared for their military power and the clout of their pan-European financial network (they in many respects, invented banking as we know it).

The Templars were subjected to years of torture, the techniques of which prefigure the worst of the Inquisition and recent wars (i.e. water boarding). At the end of some seven years in captivity, Jacques de Molay was arraigned, and upon declaring that his only mistake was to renounce the Templars, he was carted off to be burnt at the stake (there is a memorial to him at the end of Ile de la Cité in Paris). Before dying, he cursed Philip and the Pope, both of whom died within the year.

While this tale is a good diversion from the ups and downs of the Dow, and to scare you the death of de Molay was followed thirty years later by the bubonic plague, it has made me think of the the link between torture/pain and one’s view of the world.

In de Molay’s day, torture quickly made the Templars recant their views, and in markets the same is true today. My first thought is of ECB President Christine Lagarde, who having been born in Paris should be familiar with the plight of the Templars.

On Thursday she stepped into the fire of markets by declaring that it was not the job of the ECB to close bond spreads. It was a brave statement, delivered at exactly the wrong time. Regular readers will know that I often rail against the ‘morphine’ that central banks have provided to economies and markets, and of the need to curb the oversized role of central banks. Lagarde, wisely I think, agrees and she has also expressed the view that European governments (especially Germany) need to be much more fiscally active.

By choosing to express this near heretical view, Lagarde risked monetary martyrdom, and disarray on the periphery of the European bond markets. I suspect that the pronounced and prolonged market volatility will produce a more generous and less thoughtful policy response from the ECB. We should expect a rate cut, more QE and liquidity intervention and I suspect more joint communiques with the Federal Reserve.

Lagarde is not alone in having her feet held to the fire of the market’s ire, Angela Merkel may be next. If there is a time for Germany to engage its borrowing power and fiscal surplus, it is now. Berlin needs to quickly communicate a plan to stimulate the German and by extension the European economy. This must also include ambitious structural objectives such as the need to a unified pan-European capital market, banking consolidation and a common approach to business start-ups across the EU.

If Merkel doesn’t act now, her career will be marked by banking collapses and rising unemployment. Like the network of the Templars, the future of the Union is at stake.

In the same way, the future of Donald Trump and the American approach to capitalism is also at stake. His administration is not the exemplar of the kind of big, responsive and diligent government that is necessary to defeat this crisis. Neither is big, responsive and diligent government something that can be conjured up in the short-run.

As market pain persists, I suspect that the Trump administration will increasingly turn ‘socialist’, and ask the private sector to take the strain of the coronavirus crisis (i.e. organizing testing, work from home and a less aggressive approach to layoffs), and will push for new monetary measures such as ‘helicopter money’ from the Federal Reserve. As the unfortunate Jacques de Molay found, pain can motivate great inventiveness.

Have a great week ahead,

Mike

Recession Rehearsal

Powell troubled by low rates

The last week has seen many different expressions of adaptive behaviour. First, the Democratic Party establishment and organisation have rallied around Joe Biden, and helped to push him to stunning turnaround in the Party’s campaign for President.

Then there has been widespread adaptation to the coronavirus – people have stopped shaking hands, travel only when necessary and it seems, lead incrementally more healthy lives (though a half-marathon I had entered was cancelled). In some cases however, stoicism wins out – the London Tube is as packed as ever.

In markets, investors – a great deal of whom are unsentimental robots – are adapting to extreme volatility. It has been one of the most extraordinary weeks in markets as investors try to position around the uncertainties introduced by the coronavirus. If and when we get it, a mid-twenties reading on the Vix volatility index would suggest that what might be described as ‘normal’ trading is getting underway. 

Then, policy makers have also been adapting, slowly. My sense is that to a large extent the policy reaction to the coronavirus is a rehearsal for how the next recession is met. So far, it has been a shambles. 

Jerome Powell, in making a 50 basis point cut in interest rates revealed that he is beholden to both equity and bond markets, and it seems, to politics. His action underlined the existence of the Fed ‘put’ – that the central bank will ride to the market’s rescue in times of turbulence.

The delivery of the rate cut was poor.  It focused insufficiently on the sense that this move would provide ‘insurance’ and on the ways it might combat the economic panic (e.g. risk of bankruptcies) associated with the coronavirus.

With the idea of a ‘rehearsal’ in mind, Powell’s move contributed to a feeling that when the ‘real’ recession comes, the Fed will have relatively little monetary ammunition and may, like the ECB and Bank of Japan (BoJ), have to resort to extraordinary measures like negative interest rates. 

If that is where the Fed is headed to, then the lesson for them from the likes of the BoJ, ECB and Riksbank in Sweden is not a happy one. The rush towards very low to negative rates in those monetary jurisdictions undercut banking sectors – a key reason why Europe and Japan have had weak recoveries, and also why to date US banks have outcompeted their international rivals. Sharply cutting rates, in tandem with a compressing yield curve, undercuts the balance sheets of banks, and in some cases can deepen a downturn. The Fed needs to study this carefully.

The second issue with the political response to the economic side-effects of the coronavirus crisis so far, is that despite G7 conference call and very general statement of intent, there is little apparent leadership and coordination.

The fracturing of international politics has made sincere collaboration difficult in practice (America might for example have announced a moratorium on sanctions on China). Moreover, the absence of a serious fiscal response in countries like Italy (the support measures announced come to only 0.3% of GDP), and the notable lack of open thinking on how deregulation might serve to boost business, is worrying.

I may be a little too critical here, but the sum of the week’s policy activity highlights depleted economic arsenals. Debt is too high and few countries have a decent fiscal surplus. Those that do, like Germany, don’t have the will to spend it.

It also points to a depleted international policy community – where the goodwill, leadership and force of mind that existed in the 1980’s or 1990’s (I am thinking of the likes of James Baker or Robert Rubin) is no longer visible. In Europe, Christine Lagarde has been strangely quiet.

There is now a need, an opportunity and hopefully time for someone like Kristalina Georgieva, or even departing Bank of England boss Mark Carney, to so a postmortem on the economic policy response to the coronavirus crisis. With world debt to GDP at its highest level since the Second World War, the next recession will be for real.

Recession rehearsal

Powell under pressure

The last week has seen many different expressions of adaptive behaviour. First, the Democratic Party establishment and organisation have rallied around Joe Biden, and helped to push him to stunning turnaround in the Party’s campaign for President.

Then there has been widespread adaptation to the coronavirus – people have stopped shaking hands, travel only when necessary and it seems, lead incrementally more healthy lives (though a half-marathon I had entered was cancelled). In some cases however, stoicism wins out – the London Tube is as packed as ever.

In markets, investors – a great deal of whom are unsentimental robots – are adapting to extreme volatility. It has been one of the most extraordinary weeks in markets as investors try to position around the uncertainties introduced by the coronavirus. If and when we get it, a mid-twenties reading on the Vix volatility index would suggest that what might be described as ‘normal’ trading is getting underway. 

Then, policy makers have also been adapting, slowly. My sense is that to a large extent the policy reaction to the coronavirus is a rehearsal for how the next recession is met. So far, it has been a shambles. 

Jerome Powell, in making a 50 basis point cut in interest rates revealed that he is beholden to both equity and bond markets, and it seems, to politics. His action underlined the existence of the Fed ‘put’ – that the central bank will ride to the market’s rescue in times of turbulence.

The delivery of the rate cut was poor.  It focused insufficiently on the sense that this move would provide ‘insurance’ and on the ways it might combat the economic panic (e.g. risk of bankruptcies) associated with the coronavirus.

With the idea of a ‘rehearsal’ in mind, Powell’s move contributed to a feeling that when the ‘real’ recession comes, the Fed will have relatively little monetary ammunition and may, like the ECB and Bank of Japan (BoJ), have to resort to extraordinary measures like negative interest rates. 

If that is where the Fed is headed to, then the lesson for them from the likes of the BoJ, ECB and Riksbank in Sweden is not a happy one. The rush towards very low to negative rates in those monetary jurisdictions undercut banking sectors – a key reason why Europe and Japan have had weak recoveries, and also why to date US banks have outcompeted their international rivals. Sharply cutting rates, in tandem with a compressing yield curve, undercuts the balance sheets of banks, and in some cases can deepen a downturn. The Fed needs to study this carefully.

The second issue with the political response to the economic side-effects of the coronavirus crisis so far, is that despite G7 conference call and very general statement of intent, there is little apparent leadership and coordination.

The fracturing of international politics has made sincere collaboration difficult in practice (America might for example have announced a moratorium on sanctions on China). Moreover, the absence of a serious fiscal response in countries like Italy (the support measures announced come to only 0.3% of GDP), and the notable lack of open thinking on how deregulation might serve to boost business, is worrying.

I may be a little too critical here, but the sum of the week’s policy activity highlights depleted economic arsenals. Debt is too high and few countries have a decent fiscal surplus. Those that do, like Germany, don’t have the will to spend it.

It also points to a depleted international policy community – where the goodwill, leadership and force of mind that existed in the 1980’s or 1990’s (I am thinking of the likes of James Baker or Robert Rubin) is no longer visible. In Europe, Christine Lagarde has been strangely quiet.

There is now a need, an opportunity and hopefully time for someone like Kristalina Georgieva, or even departing Bank of England boss Mark Carney, to so a postmortem on the economic policy response to the coronavirus crisis. With world debt to GDP at its highest level since the Second World War, the next recession will be for real.

Globalization crashes

Coronavirus has spread internationally

That a rugby match in Dublin between Italy and Ireland can be cancelled because of a virus that germinated in a market in a Chinese city, may be a chain of events that appeals to amateur chaos theorists.

In my view, the panic caused by the coronavirus illustrates how easily interconnected the world has become, how fluidly people move from one location to another, and how national infrastructure and policy systems are still so very different.

Having written about the coronavirus a few weeks ago (‘Humanity and Adversity’, Feb 2, https://thelevelling.blog/2020/02/02/humanity-and-adversity/) I thought that markets at least would quickly work through the implications. That it has not been the case owes much to another form of sickness – overexuberance in financial marketplace. The catalysts provided by the coronavirus are now treating this (in the short run the sell-off is nearly complete, and we will rally mid next week).

Ironically, in an age of machines, and where social media companies are dominant in many senses, markets are responding to the risk that humans will have less physical interaction with each other and will enjoy less physical forms of consumption (travel, shopping and consumption).

As I write, it appears at least from official numbers that the virus is somewhat contained in China, and globally the number of cases looks to have peaked. Here though, the risk is that the Chinese authorities rush people back to work and, like the Spanish flu in 1918, there is a bigger second (and third) wave of the virus.

The passage of the virus across the world has, even at what might be an early stage, revealed and further provoked a number of changes in our world.

The first relates to trust. There is widespread suspicion inside and beyond China that the authorities there have not been upfront about the true extent of the virus. Some, like US Senator Tom Cotton even believe that the virus is man-made. To that end, while China’s handling of the crisis will on one hand reinforce the sense that it can marshal huge swathes of its population, on the other the trust of outsiders in the Chinese authorities will diminish. The Belt and Road Initiative may be a casualty here. Distrust can also channel itself in other ways. If in the future China has a debt crisis, investors are likely to sell first than wait for a true picture to emerge.

Within China this episode has clearly damaged the Communist Party, though it is very hard to see how this will play out in public life, or even through social media discourse. My sense is that the Chinese authorities will react in at least two ways. One is a fiscal stimulus made up of tax breaks, support for small businesses and an acceleration of infrastructure programs.

The other more interesting one is to take what has been done in the domain of social control and social credit scoring and apply this to healthcare. I can envisage a sharp rise in self-diagnosis, tech based medicine and a related set of incentives for people to allow their health data be monitored by the state. If it happens, many in the West would consider it insidious, though given the fear created by the virus, many Chinese might acquiesce.

The second effect of the coronavirus crisis is that it is yet another event that makes visible the arteries of globalization and leaves them atrophied. That there has been little to no coordination between nations speaks to a sense of a fractured world, and the performance of the WHO reinforces the view that like the WTO, its time has come.

There will be a sharp short-term hit to world trade from the coronavirus (hotels, airlines are the obvious ‘victim’ industries though I think that ‘elite’ forms of travel and healthcare will continue to thrive), but in the longer-term it will also reinforce the sense in governments and some companies that security of production is increasingly important.

To that end, the rise of national champions and the relocation of production to ‘home’ countries (pharmaceuticals is an example) will continue. In many different ways, the coronavirus, like the 2019 trade war, will force a rethinking of globalization by corporates.

Other megatrends may also be rethought. India and many parts of Africa are the only parts of the world where urbanization rates are still relatively low, though where the rate of urbanization is now picking up. The coronavirus crisis is a very clear reminder of ‘smart’ urbanization is terms of the health, data gathering and communication implications, and in this way the lessons for Wuhan are yet to be learnt. For example, it is only emerging that 40% of the coronavirus cases in Wuhan were transmitted in hospitals – and the same may be true of both Italy and Iran. 

As this adjustment process happens, there will likely be one constant, which is the vogue of central banks to meet any threat to growth and attendant dip in markets with more liquidity. Liquidity provision and rate cuts will not solve the process of adjustment away from globalization, and in the long run they may channel this process down the wrong path because cheap money increases the risk that investment decisions are badly made.

Have a great week ahead,

Mike