Can Central Banks Stop the Bankruptcies? | The Big Conversation | Refinitiv
The gap between Main Street and Wall Street has never been more acute. Many financial assets are soaring, whilst the average consumer is struggling with debt that has been brought into sharp focus by a loss of income. But is the current mix of monetary accommodation once again distorting the long term outlook for the economy? That's The Big Conversation. In March, Spain experienced a 9.4 percent surge in bankruptcy rates amongst its small businesses, that was according to a report by Thomson Reuters. And considering that the crisis was probably at its deepest in April, we should expect these numbers to rise dramatically. And this won't be an isolated experience either, other regions have been hit equally hard, although measures in UK and Germany plus the difficulty of entering filings during a period of lockdown, have meant that bankruptcies in these regions have actually fallen. In Japan, on the other hand, Reuters reports that coronavirus has pushed 141 companies into bankruptcy since February, mainly in the travel and leisure sector. Now the sort of level of balance sheet impairment to the household, corporate and government level will be one of the key drivers of economic growth over the next few months. So far, risk assets have already experienced two of the three classic phases of a major economic bust. The deleveraging phase and then the hope phase. But as the reality phase kicks in, a key concern will not be about the monetary inflation of central banks, which is all this money printing which we discuss further in The Whisper, but it's about the potential for monetary deceleration i.e. the velocity, not the amount of money. According to the St. Louis Fed velocity is, "the number of times one dollar is spent to buy goods and services per unit of time. If the velocity of money is increasing, then more transactions are occurring between individuals in an economy". Or simplified even further - when there is an increasing amount of economic activity taking place, velocity will be rising. I prefer not to use equations, but a simple formula for the velocity of money is that V is equal to the price of goods multiplied by the quantity of goods. And then all that's divided by the money supply. So velocity = price x real expenditure divided by money supply. And what's money supply? Well, the M2 money supply is often used, which is checking, savings and deposit accounts, plus money markets and mutual funds. Therefore, an even more simplified version of velocity would be to divide gross national product GNP by money supply such as the M2 just outlined earlier. In this chart showing the central bank balance sheet versus the velocity of money, we can see the economic fragility that has persisted before the coronavirus. Velocity had been in a sharp decline because money supply was increasing at a faster rate than GNP growth. What that means is that each new unit of so-called stimulus was having a lower and lower return on growth. So if we now roll onto today's environment, we know that the numerator of GNP or GDP, i.e. the economy is collapsing whilst the denominator of M2 money supply is accelerating. Therefore, velocity will fall much further because corporates will offset lost revenues and start to hoard cash in anticipation that their future revenues will fall. Households will start to plug their own shortfall in savings and try to offset the debts that they had built up over the preceding years. And all this is going to be deflationary. In this chart, we can see the relationship between the year on year change in CPI and the year on year changes in the velocity of money. It implies that US CPI is going significantly lower, perhaps even as low as we saw in 2008. Even if peak economic contraction is now behind us. Now to avoid deflation, governments need to stimulate aggregate demand to levels that are above and beyond where they were prior to the virus. Raising asset prices is not the same thing as raising economic activity, and we saw that for the last 10 years. Cash flows from governments to the private sector, that's corporates and households, are merely filling the void, helping to stabilize, but not to stimulate the economy. Because that real economy of businesses and households is preoccupied with firstly plugging the immediate liquidity crisis, such as paying today's mortgages or rent, and then secondly, hoarding cash in anticipation of future solvency issues such as a decline in income revenues. Meanwhile, the outlook for U.S. bankruptcies looks shocking. Expectations for a V-shaped recovery appear increasingly unlikely simply because the lockdowns have dragged on from Spring and into Summer. And even as economies edged towards normality, it's going to be via a series of baby steps rather than a straight line release. This following chart shows the potential magnitude of the risks. Here we plot the US unemployment rate against Chapter 11 bankruptcy filings. Even if we adjust the size and speed of the rise in unemployment with an expectation that jobs will return much faster than expected, we should expect bankruptcies to rise dramatically. In reality, I think it's fair to assume that within the leisure and hospitality industries, the return to work will be a drawn out affair with restrictions of some sort in place throughout the Northern Hemisphere's Summer. The hope is always that the US consumer will come good. And over the last 40 years, the consumer has proven remarkably resilient. The consumer is therefore key. But it's the consumption part of the economy that has been taking the hit from coronavirus this time around. And what is the likelihood that the consumer behavior will return to normal afterwards? U.S. consumers were not in a robust position prior to the crisis. Despite the recovery in the aftermath of the great financial crisis in 2008, 45 percent of Americans have close to zero cash in their savings account. And that's according to a survey by GoBanking Rates in December 2019. Auto and student loans are also at record levels. We can see in this chart how auto loans have soared past the previous peak prior to the great financial crash of 2008. Credit card financing costs have also risen, despite Fed funds that are close to zero, pushing credit card delinquency rates to a 20 year high. And that was before Covid struck. It's clear that many US and many European consumers have been teetering on the edge for years, living paycheck to paycheck. Now, with paychecks abruptly postponed and in some cases canceled, many households will be missing rental, mortgage and credit card payments and also skipping on health care, setting in motion the dominoes in which their credit scores will be impaired. And banks who are already hoarding cash will be reluctant to lend. Government handouts will be used to plug the holes in today's cash flows, or they will be hoarded in order to offset a decline in future revenue or wages. And in many cases, it will be used to pay down debt. We can already see that the US savings rate is now at the highest level since the early 1980s, and that creates a vicious spiral. If households are hoarding, then corporate cash flows will be impaired. Corporates will therefore also hoard against a drop in future revenues and they will cut jobs and cut wages. Household balance sheets will therefore be impacted further, forcing more retrenchment in cash hoarding by companies that are fearful of future revenue losses. And then the banks will hoard. Their capital will be kept aside and they will only lend to the less risky corporates because consumers are exacerbating that dynamic. Now, let's be clear, we're not talking about a complete collapse in consumption. In fact, the next set of headlines will probably be about how economies are returning to something like normality. But it's what happens at the margin that matters. It only takes a small percentage of consumers to stay away from restaurants and leisure facilities to push a profit into a loss. If fixed costs are inelastic, it only takes a few weeks of the new normality with slightly smaller customer bases to push companies into insolvency. Many industries have wafer thin margins and consumption patterns aren't likely to return to pre-Covid levels, even if economies rapidly reopen, because the crisis has revealed the underlying balance sheet fragility and may now trigger a desire to de-lever. And that would be deflationary. The question is then if consumers retrench, can central banks print at a fast enough pace to offset the decline in demand? Now, Jerome Powell is backing the Fed as he should. But the experience over the last 10 years of unorthodox accommodation is that central bank's efforts actually make matters worse. In the 1970s, they didn't try and create inflation, but they got it. Over the last decade, they didn't try to create disinflation, but they got it. Today they are trying to create inflation and history suggests that they won't get it. But they might get an even greater disconnect between the equity market and the underlying economy between Wall Street and Main Street. There's a lot of chatter about the performance of the U.S. equity market when compared to the outlook for the broader economy, in particular the consumer, as we've just discussed. The Nasdaq 100 has rallied back to within about 4 percent of its all time highs with both it and the S&P making new recovery highs on Monday. So although the NASDAQ is signaling what appears to be a healthy recovery, there are many other signals from the market that are indicating a less robust outcome. So how should we interpret these mixed signals? Firstly, as mentioned in the main section, it's key to understand that the equity market is not necessarily representative of the economy, and that the US equity market is not representative of global equities. Arguably, the US equity market, which has been outperforming most other major global benchmarks for the last decade, has not been trading on fundamentals for some time, but has been trading on flows. These flows would be buyback flows, 401K pension flows, and even inflows from foreign capital. Assets had already migrated from active managers to passive managers who have a concentration bias into the largest names by market capitalization such as those in the S&P 500. And this has helped keep valuations on the S&P 500 at elevated levels for a very long time, even prior to the Corona crisis. Since the crisis, these flows have been concentrated into an even smaller handful of tech names, mainly those with a significant global online presence. And this has helped elevate the Nasdaq to its highs. The S&P 500 has also benefited from these flows, although the rally in the S&P is still very much in line with the other bear market rallies, at least at this stage it is. So far the S&P has recouped 62 percent of its initial decline and that's a classic Fibonacci retracement level. And it mirrors numerous historical examples in which we first see an aggressive liquidation phase or deleveraging, followed by a significant rebound. And this is what happened in 1929. A liquidation phase followed by a big rally of around about 50 to 60 percent before the market rolled over. The same pattern was true the Japanese Nikkei 225 after its equity bubble peaked at the end of the 1980s, followed by a sudden decline before bouncing to recoup 50 percent of its losses and then rolling over again as reality kicked in. And then more recently, the sell off at the end of 2018 also saw a 62 percent rally before the index rolled over to make new lows. Clearly, the S&P, like the Nasdaq, could break above the 62 percent retracement level, which has been testing this week. But at this stage, it is still perfectly in line with numerous historical examples of how a market might perform through a classic equity bust. The Nasdaq itself is not a play on the macro economics, but on the performance of only a handful of stocks. But when we look around the rest of the world, the dominant performance of large cap US markets is clear. Ignoring the volatility in March, the S&P 500 has continued to move higher versus the German DAX, the UK's FTSE 100 and Europe's EuroStoxx50 index. Many of these markets, such as the UK's FTSE100, have struggled to hold the 38 percent retracement level versus the S&P at 62 percent, and the Nasdaq having almost recouped all of its losses. Many global equities remain entrenched in long term bear markets. The Japanese Nikkei 225 has failed to regain the highs made in 1989 and the EuroStoxx 50 has failed to regain the highs made in early 2000. The U.S. market reflects the dominant flows of corporate buybacks in the years preceding Covid-19, followed by the concentration of flows into the winners such as Amazon over the last couple of months, plus both the explicit support of the US Federal Reserve for certain asset classes such as investment grade corporate bonds, as well as the implicit support for equities by the threat of further intervention, such as we saw over the weekend from Fed Chairman Powell. However, there are still areas within the US equity market that are a closer reflection of the underlying economic malaise. The small-cap Russell, 2000, has retraced 50 percent of the initial de-leveraging, but remains 20 percent off the highs, even after Monday's huge rally. And even within the S&P 500, which is around 12 percent off the all time highs when we filmed this piece, if we excluded the top five or six performing tech names, then the rest of the index would be down closer to 25 percent. The market cap of the top five or six stocks is equivalent to the bottom three hundred and twenty five or so names, which is one of the greatest concentrations that the index has seen. Digging deeper still, we can see the performance of the banks has massively lagged the performance of the broader equity market. Although the role of banks in the economy has diminished since the financial crisis of 2008, partly due to regulation and the need to rebuild their working capital, they are still integral to the performance of the real economy - and that's the economy of businesses and households rather than the financial assets such as equities and bonds. The BKX, the bank index, managed only a 38 percent retracement of the initial selloff, and has again been within a whisker of the recent lows. The ratio of the bank index vs. the S&P 500 last week made a new all time low. Banks are clearly indicating that the economy remains in limbo, even as we contemplate a reversal of lockdowns and another rally in the Nasdaq 100. In Europe, the picture is even worse. The eurozone banks made a new intraday all time low last week, hobbled by a backdrop in which the eurozone and EU leaders are again showing during times of crisis that there is no union, even though there has been a rescue package announced this week. And this performance in banks is repeated across the world. The Australian Bank Index only managed a rebound of 23 per cent of the original decline that happened in March. So whilst the Nasdaq and to a lesser extent the S&P 500, are highlighting the strength of a handful of stocks, the banks are reflecting the reality that the rest of the economy is experiencing. For smaller businesses lacking the technology or the clout, insolvency is an issue which is on the immediate horizon. Lower or negative interest rates were already a challenge for banks. The potential wave of global insolvency is clearly being reflected in both their relative and absolute prices, even whilst a handful of stocks, at least in the US, give the impression that the economy appears to be anticipating a rapid rebound in activity. Between Friday of last week and Monday of this week, at one point, silver had gained 10 percent. But silver still remains a laggard versus gold. Monday's squeeze higher in precious metals was in response to US Federal Reserve Chairman Powell's weekend comments on the US show 60 Minutes, in which he outlined the policy tools at his disposal. In many ways, we shouldn't be surprised that his enthusiasm for printing, this has become enshrined in many central banks emergency rule books. The interview also came hot on the heels of an address earlier last week in which he outlined the headwinds for the U.S. economy. Basically playing good cop/bad cop. When the presenter of 60 Minutes Scott Pelley, asked him if he had flooded the system with money during the crisis period, he said, "Yes, we did, that's another way to think about it." And when asked "Where does it come from? " He answered, "We print it digitally. We have the ability to create money digitally." When pressed further, the key passage was "Has the Fed done all it can do?" And he replied, "There is a lot more we can do. We're not out of ammunition by a long shot. No, there's really no limit to what we can do with these lending programs." Many risk assets, particularly those pricing inflation, sprinted higher on Monday. So after money printing in 2020 was at a rate that dwarfs 2008, especially when we look at the growth on a year on year basis, the Fed is prepared to do yet more. Precious metals took a leg higher in anticipation of the bigger bailout that Powell was suggesting, although gold did retreat off its highs when real yields started rising. But for silver, there is still some considerable catching up to do. Silver has many industrial uses, and when liquidations impacted all risk assets in March, the precious metals with industrial uses were particularly badly hit. And even gold was impacted by margin calls. But when we look at the price action, we can see that silver's performance has also lagged gold over the last five years. And with that underperformance being particularly acute over the last few months. And when we look at the longer term chart, we can see how extended the current period of underperformance has become. And yet on those other occasions when precious metals rallied, silver eventually outperformed gold, as it did in 2011 and also in 1980. The Corona crisis has added a further dimension by impacting a large number of silver miners who've temporarily had to mothball their operations, thus creating some of the supply chain bottlenecks that will put upward pressure on prices. And given the small size of the market, and the potential size of interest from institutional investors, prices could move quite quickly. And if we think that this period of money printing is going to be far in excess of other periods - and Chairman Powell has implied that they have a lot more ammo, then that environment should be excellent for the precious metals complex. Precious metals perform well in a period of deflation. And in order to avoid deflation, central banks will print more money in order to try and create inflation. That should also be good for precious metals, so therefore the path to inflation, If we can ever get there is paved with both silver and gold. Silver is coming off a very slow start, but history suggests that once it gets going, this is a supercharged precious metal that everyone begins to chase.