By Steen Jakobsen, Chief Investment Officer at Saxo Bank
The virus outbreak has set three major macro impulses in motion: a global demand shock, a global supply shock and an oil war that has forced prices to multi-year lows. This final development will result in an enormous destruction of capital and, soon, structural unemployment.
In over 30 years of doing this job I have never seen three simultaneous blows to the economy. I am again reminded of 2008, where small events like BNP Paribas closing their high-yield fund, Bear Stearns closing redemptions on its hedge funds in 2007 and ultimately the failure of Lehman Brothers catapulted markets into a fitful, systemic meltdown that quickly disrupted the economic backdrop as well.
The markets were extremely difficult to trade in this period, just as it was difficult to comprehend all of the moving parts of the broader economic fallout. This current disruption has already eclipsed the 2008 chaos in some markets, as we suddenly find ourselves in a period in which some markets can move up and down more in one day than they did in an entire year. A bull and bear market can happen inside of a week. The behaviour of markets this year is completely without precedent and reflects how illiquid markets are after having suffered this triple whammy of shocks.
The volatility is a symptom of the worst-nightmare for traders and market makers: when prices become ‘discontinuous’, or gap viciously from one price to the next like an airliner hitting air-pockets. The bid-ask spread goes from some orderly path of 5-10, 6-11, 4-9 to something like a jump from 5-10 to 25-35 to 45 bid- but where is the offer? 70? 90? This tests trading systems on the chaos of inputs. But even more importantly, it forces many financial investors to deleverage as P&L swings become too violent and counterparties send out a flurry of margin calls.
In an environment of panic deleveraging, the ‘cash is king’ mantra arises. Funds, banks, investors and even companies suddenly see not only a dramatic mark-down of asset prices, but wild swings in correlations across portfolios and swings in P&L.
Central banks, meanwhile, try to move in quickly with ‘support’ in the form of rate cuts and liquidity provision. For a company or fund relying on credit for some portion of its operations, this may help in terms of the future cost of financing liabilities. But it does not help the price of the equity or credit on the asset side. Here, the ‘crowded theatre with a small exit’ metaphor applies, with everyone selling to deleverage across the board. And, often, that selling is of assets that are highly illiquid even in the best of times.
This cycle is even worse than past cycles because the current era of low and negative yields has seen a ‘reach for yield’ that forces market players further and further out on the risk curve and into super-illiquid financial assets such as private equity and high-risk corporate credit.
Markets always become most vulnerable when we are operating with discontinuous price structures. The shakeup we are seeing here in Q1 will change the landscape of investment and risk tolerance going into 2021. But it will also change the long-term allocation model away from a 60/40 bond/equity allocation — or similarly heavy-fixed income-weighted risk parity principles — to proper hedging through commodity exposure (inflation protection) and long volatility (fat tail-discounted price action protection).
If this happens, then investors will be in a better place going forward. The popular idea that the spectrum of asset allocation only stretches from some mix of bonds/equities to the riskiest 100% long equities has always been flawed, but the illusion of safety was measured in returns, not in risk. Now risk has come back to bite.
The Economic Outlook
The triple whammy to the global economy almost guarantees that 2020 as an economic year is lost, with policymakers needing to pull out all of the stops to address a real, global recession.
Classically the policy response has been to lower the price of money. But with the Fed effectively zero bound before Q2 even gets under way, we already have all of the major world’s major central banks at that level (and even beyond in some cases with NIRP). The ability of monetary policy is at best constrained and, at worst, directly detrimental to the ability of economies to respond — as a low velocity of money dictates lower inflation and in the process less net lending demand.
There is now a demand gap, supply gap and an energy sector scrambling to survive as their 2020 cash flows point to major losses for the strong and bankruptcies for the weakest producers.
The market is on the brink of spinning out of control as credit, which is everything in today’s market, has dried up — such that US mortgage yields are rising even though 30-year US treasury yields have collapsed. In other words, the market is tightening terms on credit even as the Fed tries to ease by cutting rates.
With the central bank policy tool box empty, we think we are on the verge of full Modern Monetary Theory (MMT), as politicians take the reins from obsolete central banks and expand spending without constraint from debt issuance (true money printing!).
The UK budget was an early indication of this and was drawn up even before the coronavirus impacts began to crystallise. And the concept of the government filling the gap left behind on demand is now even accepted in Germany, which issued its own form of Mr. Draghi’s 2012 ‘whatever it takes’ speech in vowing infinite support to German businesses large and small through the KfW or government development bank.
Think of the Marshall Plan after WWII, where the US issued infinite credit to war-torn Europe in order to create demand and help the destroyed continent rebuild. In economics, this is Say’s law: the idea that supply creates its own demand. And that will be the solution here because failure via debt-deflation and a credit implosion is not an option. Governments will create money far beyond any on- or off-balance sheet constraint. Note how Germany used a government entity, not its budget this week.
Is the system so broken, or unbalanced, that it needs to get worse before it gets better? We will leave that for others to speculate on. But we have full confidence that when we leave 2020 the policy measures taken will prompt strong inflationary forces that even point to the risk of stagflation.
Our allocation will focus on adding long inflation and long volatility to our portfolios. The era of low volatility we saw since the global financial crash was due to financial repression and central banks lowering interest rates. It has now come to a close. We are in an environment of more price discovery, which will mean significantly higher volatility and with it a cleaning out of models for the valuation of private equity and other high-risk assets that are predicated on low interest rates, central bank intervention and a somewhat naïve assumption of multiples that can go up forever.
The global economy has become a financialised super tanker fuelled by credit and low interest. It was heading for The Port of Deflation, but this new crisis has the super-tanker changing course as quickly as it can — which is not very quick, and seas are heavy — toward a new destination called The Port of High Inflation. The global bull market of 2009-2020, the longest in history, just died of coronavirus. In its wake, we have the weakest economic and political structures since the 1930s.
Buckle up, it’s going to be quite an adventure — one like none (save perhaps for the very oldest of us) have seen in our lifetimes.