"This Time It Feels Different" - What If It's Just Begun?

Authored by Bill Blain via MorningPorridge.com,

“That about sums it up for me..”

There is an amusing piece on the FTs’ Alphaville listing 20 things investors should look for when trying to work out who will be the next Wirecard. You don’t need to be a financial genius to work out which company they might be talking about… It’s a basic wake-up call. In periods of economic darkness, its all-to-easy to be persuaded as to the efficacy of snake oil. If something over-promises, makes lots of noise while underdelivering, and is basically a personality cult – then it’s long-term unlikely to be a particularly successful investment.

Back in the real world…

We are nearly half-way through 2020. Although we’ve been shocked, surprised and buffeted by the Virus, and buoyed by the swift and effective intervention of Governments to support companies and mitigate job losses while Central Banks have calmed markets with the opium of QE Infinity, I can’t help wonder if the real earthquake is yet to come. 

I am still bullish about long-term recovery as we adapt to the virus and it spurs a new tech development age. But I can’t help feeling deeply uneasy about current markets and the resilience of global financial systems. 

This crisis is unlike anything I’ve experienced before. Normally a market crash is explosive event – it occurs when something in the financial sphere breaks; like confidence in housing and financial systems in 2007, or valuations in the Dot.Com crash, or faith in credit constructs like during the European Sovereign Debt crisis in the 2010s. In each of case of financial mayhem I’ve experienced since the Great Perp Crash of 1986, the initial shock and horror gradually lessens as the market discounts the shock, shrugs it off, and carries on. 

The Global Financial Crisis of 2007-2008 has some similarities to current events – it was slow. It took more than a year from the gating of Bear Stearns structured credit funds, through the collapse of commercial paper markets, the run on Northern Rock, till we got to the collapse of Lehman in September 2008. As banks were bailed out and rescued, there were around three months in 2008 when it felt like financial markets were irreparably broken. Of course, they weren’t – governments and central banks nursed them through. Stock markets were extremely volatile – but were equally swift to arbitrage that support – triggering a rally that lasted 12 years! (Largely on the back of markets being distorted by ultra-low rates and QE.)

This time it feels different. The crisis started off with a meteor strike – the virus. We’ve never seen anything impact the real economy so dramatically. Normally – it happens the other way around:  financial crashes impact the markets and only then does the pain trickle down into the real world. This time it’s real jobs and production that got hit first. That’s fundamentally different. 

I’m not convinced that markets really understand that difference. The effect on the real economy of financial failure is felt in terms of the flow of capital to businesses. If a bank blows up – it will impact savers and borrowers. This time we’re looking at how will crashing earnings and diminished rental incomes will hit the financial markets - but they are behaving as if it’s just another round of QE Infinity for the markets to arbitrage. As we all know markets are completely delinked to the real world at present.

Yet, the damage the real world is going to inflict on financial markets is going to be huge – but that’s not what I see the banking regulators and authorities preparing for. They’re pushing financial institutions to participate by easing lending and supporting confidence. You can understand why – yet they also know a crisis coming. Just read the dissenting statement by Fed Governor Lael Brainard after she stepped back from the Fed’s decision to allow bank dividends: “many large banks are likely to need greater loss absorbing capital to avoid breaching their buffers in adverse circumstances next year.”

The bottom line is global central banks know a financial crisis is possible/probable. 

There are many issues here. Is the market pricing in a major financial systems crisis – to a limited extent. What if rising real world problems trigger a massive NPL crisis? Effectively the whole financial system now sits on financial assets (stocks and shares) which are underpinned by government support. How sustainable is that?

For instance, In the UK we know commercial landlords have received less than 20% of their rental incomes on the last 2 quarter days – the day tenants are supposed to pay the next three months rent. Property “experts” expect landlords will recover much of that rent in the aftermath of the virus. That will be interesting – how many more names are likely to disappear from high streets and how many more shopping malls will fall into receivership as folk keep shopping from home? 

Companies failing to pay rents or dividends is no longer just a banking problem. Risk is now far more widely spread across the whole financial system: insurance companies and sovereign wealth funds own most City offices. Fund managers that rely on dividend income are likely to be sadly disappointed as incomes dry up as a result of government fiat or on the back of the dismal earnings season we’re about to experience. 

The path for markets will depend on what surprises us next. In previous crisis I’ve watched markets roiled by a massive shock before falling in a predictable path: the daily news becomes less shocking, the markets become less volatile, and start to seek opportunities. 

This time I don’t think the real financial shock has yet occurred. The dominant issue remains the virus. The market news creating the current RO/RO (risk on/risk off) volatility is all about how COVID-19 is slow burning its way across the Southern US stats, triggering renewal lockdowns, and spooking the markets. The sheer size of the US is one issue, but lax lockdowns and early re-openings in states that hadn’t reached anything close to a peak infections is another. 

  • The virus is going to remain a massive threat, but real economic and political issues are going to emerge in coming weeks. Dismal corporate earnings and stories like the collapse of Gas fraker Chesapeake energy, or Boeing struggling to re-launch the dismal 737 MAX will dominate the news flow. 

  • Geopolitics ranging from the deepening China/US standoff, to the EU fighting battles on Brexit, the Poor South and the democratic challenge from the East, are likely to remain negative. 

  • And lets not forget domestic politics. An increasing number of fund managers list the US November Election as their biggest fear. Few would admit to being Trump supporters, but there is clear fear of a Biden presidency achieving a clean sweep of both the Senate and Congress. Meanwhile, Macron’s drubbing in French local elections, and the hopefull pro-European vote in Poland highlights voters unhappiness with current regimes. 

As I said – I’m bullish… but selectively, and there is a lot of noise coming our way.