With regard to coronavirus, I am still very much focused on the economic fallout. But I do want to circle back around to the themes that inspired my post on market structure vulnerabilities amidst a coronavirus pandemic. What’s inspired me here is this post from the FT by John Plender on The seeds of the next debt crisis.
Here’s his view:
The shock that coronavirus has wrought on markets across the world coincides with a dangerous financial backdrop marked by spiralling global debt. According to the Institute of International Finance, a trade group, the ratio of global debt to gross domestic product hit an all-time high of over 322 per cent in the third quarter of 2019, with total debt reaching close to $253tn. The implication, if the virus continues to spread, is that any fragilities in the financial system have the potential to trigger a new debt crisis.
In the short term the behaviour of credit markets will be critical. Despite the decline in bond yields and borrowing costs since the markets took fright, financial conditions have tightened for weaker corporate borrowers. Their access to bond markets has become more difficult. After Tuesday’s 50 basis-point cut, the US Federal Reserve’s policy rate of 1.0-1.5 per cent is still higher than the 0.8 per cent yield on the policy-sensitive two-year Treasury note. This inversion of the yield curve could intensify the squeeze, says Charles Dumas, chief economist of TS Lombard, if US banks now tighten credit while lending has become less profitable.
This is particularly important because much of the debt build-up since the global financial crisis of 2007-08 has been in the non-bank corporate sector where the current disruption to supply chains and reduced global growth imply lower earnings and greater difficulty in servicing debt. In effect, the coronavirus raises the extraordinary prospect of a credit crunch in a world of ultra-low and negative interest rates.
That makes sense to me and I want to write about that. But, first let me give you a data dump on the economic impact before we go there. I think the economic impact has to be severe for a credit crunch to take form and be debilitating. So I would start there.
The hit to leisure
Let me start with this article from Cycling News because I am a cycling enthusiast.
Four riders reported to be positive for coronavirus at UAE Tour
Gaviria suspected to be one of 12 cases still in the UAE linked to the racehttps://t.co/C8nfsUYIb0pic.twitter.com/JeX3xVMpsM
— Cyclingnews.com (@Cyclingnewsfeed)
Why is this where I’m starting? Because it’s telling us the worst case outcome – that sporting events endanger not just spectators, but participants. Now, cyclists are bunched up next to each other for hours at a time on the road, in cycling team buses, at team meetings and at hotels. If one team member is infected, then it’s easier for others to become infected, both from the same team and even from other teams.
And if this spread can happen in cycling, it can happen in most any sport, at any sporting event, and in the Olympics too. The worst case scenario then is a mass cancellation of sporting events, not just as a spectator sport but period.
And, if the implications for sports are dire, then they are dire for every other leisure activity that involves large numbers of people in confined spaces like airplanes, movie theaters and so on. The hit to leisure is immense.
#Coronavirus is the biggest setback for the travel industry in almost 2 decades as tourists across the globe cancel bookings. Most at stake for tourist destinations like #Thailand, #Greece, #Portugal, #Spain or #Italy. Tourism accounts for 20% of Greek GDP https://t.co/weFe3iwQPYpic.twitter.com/Myd8fcfEmR
— Holger Zschaepitz (@Schuldensuehner)
The events business is getting hammered too.
Office work may change
A friend of mine told me he is part of a group tasked with his company’s response to the coronavirus. This is a company that employs 200,000 full-time, part-time and contract workers. So, it’s enormous. And what he told me is that there is likely to be a wholesale move toward work-from-home outcomes where possible and until the virus spread has abated. That’s not good for any business dependent on commercial real estate, like WeWork for example.
So, not only are we talking about leisure, events and transport here, we are also talking about the property market too.
The economic impact and response
The ripple outside of China has begun. And after the Fed cut 50 basis points yesterday, the policy response is going to hot up. With equity markets falling again, the Fed is now expected by many to add in another 25-50 basis points at the FOMC meeting in a couple of weeks’ time.
Other central banks will follow the Fed’s lead. Reuters noted today that the Bank of Japan’s Kuroda offered a bleak view on the economy, and warned of a big hit from the virus. He said the Bank of Japan is ready to take “appropriate action” to prevent the economy from a severe crunch. In Europe, for example, Bloomberg News is also reporting that “the governor of Norway’s central bank says a “significant” slump in trade triggered by the coronavirus might force him to reassess the outlook for interest rates.”
New Zealand, South Korea and the UK are all also in the spotlight, expected to ease. In Australia, traders are even talking about preparing for Quantitative Easing. And UK yields have fallen to record lows as bets the UK will cut rates ramp up (link here).
Policy focus
Is that what’s going to save us? You know I’m sceptical. Monetary policy is about interest rates, the financial system, and markets, not the general economy. And on the financial system, the real question is this: How long does this go on before we have severe liquidity problems, particularly at small and medium sized businesses?
Jonathan Ferro touched on this yesterday:
I love a dig at the Fed as much as the next person. But they set a threshold to move (material reassessment of outlook). We breached it. They cut.
Focus your frustrations on the lack of effort elsewhere now. We need to see measures supporting SMEs to get through this shock.
— Jonathan Ferro (@FerroTV)
The last thing we want is for otherwise viable companies struggling to the point they need to start laying off people.
Officials need to provide a bridge to get towards mid-year, to limit damage and maximise the chances the second half recovery is as smooth as possible.
— Jonathan Ferro (@FerroTV)
This is is where the problems now lie.
My View
I am heartened somewhat by the fact that, as Lisa Abramowicz put it, yesterday “high-yield bonds rallied, with spreads going lower & all-in yields dropping the most since Aug. 2019. Also, the biggest junk-bond ETF had its second-biggest one-day inflow ever, of $1.2 billion.” Plender’s story is about weak credits getting starved for capital and this leading to a systemic crisis. I think that’s right. Where we need to be focused is not on how much the Fed can cut rates but what policy makers can do to help otherwise healthy companies from going under due to a temporary shortage of liquidity and of consumer demand.
The coronavirus outbreak looks to be turning into a pandemic. And that is going to really wallop the global economy. And because financial fragility is back, with private debt levels globally at extreme levels, the makings of another financial crisis is there. Avoiding that outcome is what central banks should be focused on.