Key highlightsAre markets already enjoying a V-shaped recovery by discounting a V-shaped economic recovery?
“I think the the notion of V shaped recovery is actually an after the fact attempt to explain what's just happened in financial markets. People are looking around for a reason and saying, the stock market must be predicting a recovery because when we look at the actual data, for the virus or for the real economies, we're not seeing too much in the way of good news. We've had the great news that the virus is pretty much eradicated in New Zealand, Malta, Iceland, many of these small economies, most of them islands that have locked down and seal their borders early. They are eradicating the virus and that's great to see. But for most of the larger economies in Western Europe and across North America, who didn't lock down so quickly, who let the virus get onto the exponential part of the infection curve, we're seeing more mixed news. Germany has made some progress, although even they've had a setback in the last few days. Rates of infection are down in Spain and Italy, but it's not even back to where they were a month ago. And the US is still adding 90,000 cases every three days, the UK is still adding 14-15,000 cases every three days. Yet we're seeing a lot of pressure to release lock downs. But that's more because of the health effect of the lockdown is beginning to match the the number of lives saved through having the lockdown, with people missing treatments or their illnesses going undiagnosed. we know in the UK that fewer people are turning up to the emergency room with suspected heart attacks than would be normal. This is going to mean a very long tail in relaxing restrictions, particularly in Europe in the US. And then there is the economic data, which I would argue is actually getting worse. We're seeing some real signs of stress in places as far apart as Brazil, United States and Europe. I think people were lulled into a false sense of security in the early part of the year because the closure of China in February actually provided a trade boost to many of its competitors. So that February, early March data was actually quite strong. The virus effect doesn't really kick in until the latter part of March. We're only now getting through all the March data, and it doesn't look too bad. But the economic shock is in April. And the limited amount of data we have for the early part of April looks pretty shocking. We've had big falls in confidence indices. But more importantly, world trade looks like it's down by a third, corporate revenues in China down by between 30 and 50% year on year, and air travel down 80%. Now we're seeing signs of a credit crunch in many of the world's corporate sectors, which is what's driving the big rise in unemployment in the United States and elsewhere. So the economy picture has actually been really quite miserable. And yet, of course, we've had financial markets, the equity market, technically in bull market territory.
So is the recovery in markets then all about monetary stimulus?
“I think there's, that's very much the case and we're getting a fairly consistent picture now that the Federal Reserve panicked round about the 12th of March when the equity market was starting to fall so strongly. From round about that date onwards, the Federal Reserve has instituted of QE have completely unprecedented proportions. It outweighs anything we saw in QE one or QE three, or it just blows them away. a back of the envelope calculation suggests it was 40 times as powerful as what we saw during QE two, which of course, was always held up as the as the big one when it came to the US response to the GFC. And just the numbers are mind boggling. In a four week period. The Fed purchased $1.6 trillion of treasury bonds at a time when there was relatively little issuance. Now a couple of weeks since that day, we've seen a bit more Treasury issuance. But in the last six or seven weeks, the Fed has reduced the supply of treasury bonds outside the US banking system by about 1.24 trillion US dollars. So that means investors will have received about a trillion dollars of cash in a four to five week period, which is completely unprecedented, and that money will have burned a hole in their pockets is why they've pursued equities with it, they pursued the credit markets, particularly with the Fed trying to underwrite some of the credit risk in the system. This amounts to a 5% of GDP equivalent injection of cash in a matter of days, no wonder markets have been on a tear. As I say we've seen absolutely nothing like that at any point in history. And I do think it's a reflection of the Fed panicking.
So what is rage downside to this?
The Fed has done so much quantitive easing, it's raised the amount of liquidity in the economy so much in such a short space of time, it's actually managed to gum up the banking system. So all that money the Fed gave to investors they spent it on financial assets and ultimately, it ends up on the balance sheet of some investment bank. That cash will be deposited by the fund that sold the Treasury bond to the Federal Reserve, then the money ends up in the banking system. So we've seen big banks have massive deposit inflows from big investors and most of this money is in short term deposits. It’s not operational deposits, so the banks can't do very much with it. So really all they can do with it is to put it on deposit at the Federal Reserve. So their reserves go up, but it is not really money they can lend out. But more importantly, because their balance sheets have grown 15%, in some cases 20%, in a matter of days, most of them end up in breach of capital adequacy rules, they end up in breach of their own internal leverage rules, and that forces them to adjust the rest of their portfolio. So if you think of a banking system that's trying to keep its capital adequacy at 12% of risk weighted assets, suddenly it's got 10 and 20% more assets, but it hasn't got any more capital. The only thing it can do at that point is lower the risk weighting on its other assets so that it remains compliant. And you have to take risk out of the rest of the portfolio to accommodate the growth in the total portfolio. And what does the US bank do then? They don't stop lending to their favorite companies that they've had a long term relationship with who have existing credit lines. But maybe they don’t lend to that small company that really needs the money and is quite risky and has a high risk weighting. And they won’t provide money to the brokerage arm that attracts a high risk weighting either. So that adds to market liquidity. So any buying doesn't find many sellers. There's no inventory that the brokers can pull back on to meet orders. That's tended to amplify the rally in the market. But it also makes the market quite narrow. But the big casualty in all of this with the banks trying to reduce their risk weightings is in their lending to the rest of the world. You don't lend to some emerging market or some financial center. So the rather ironic part of what the Fed has done is they've dumped more than a trillion dollars into the financial system and they've got a great equity rally on the back of that. But they've rather effectively and completely inadvertently managed to crowd out small companies, medium sized companies, companies that are maybe lowly rated, and certainly the rest of the world that needs to borrow dollars. So the fed by panicking in the way that it's done, has actually created a credit crunch in that real part of the global economy. Financial systems have done really well out of this or at least the domestic one, and that's reflected in the equity market. But you can see the impact the credit crunch in the SME sector in the US is having by the fact that new unemployment claims are rising by a full million every week, we're heading to a 30 million increase in unemployment, a 20-24% rate of unemployment in the US because there's credit crunch. We're seeing in many of the emerging market currencies in virtual free-fall due to a real shortage of Dollars. And we're heading into a period where there's big emerging market economies, including China that need to roll over Dollar debts and who are also facing a credit crunch. So it's a very complex system. The Fed has has really done something unprecedented here. And to be honest, I don't think they thought too hard about what they were doing. They've created an equity rally, but they've created some very big problems out there in the real world.
