The bull market is dead, LONG LIVE THE BULL MARKET!
This fucking virus, man.
I’m not an epidemiologist or virologist, so I’m just going to focus on the market impact here. Cities around the world are effectively shutting down in an effort to contain COVID-19. Aside from the loss of life, these measures are also presenting real challenges to the short-to-medium term viability of the global economy. Credit is freezing up, equity investors are getting hosed and the real economy is suffering from reduced spending. So, what’s going on here?
The credit markets are shutting down, a la ’08-’09. Anyone that lived and/or worked through the GFC knows this all too well.
The first major problem is the commercial paper market. At a high level, this is where corporations come to finance their payroll, accounts payable and other short term costs. Essentially, a company will issue a short term note (usually for a few days but no longer than 9 months), issued at a discount to the par value of the note, in exchange for cash now. The notes are issued at a discount to par which then becomes the investors’ return upon repayment. Since we’re talking unsecured notes, the credit quality of the companies issuing commercial paper is relatively high quality. This is a very mature market that normally functions incredibly well.
Enter COVID-19. As citizens around the world hunker down to “flatten the curve” of new virus cases, the obvious concern for investors has become the implications of what it means to shut down the global economy and how that impacts the liquidity profile of companies. We should even be discussing whether certain companies will be able to operate as a going concern in the future. Worries about liquidity have forced the hand of commercial paper investors: if they’re not sure whether you’ll be generating enough free cash flow through ordinary operations to pay back the notes, then they’re also not sure they’ll lend you the money.
Were the entire market to seize up like it did in the GFC, the effects on both the real and financial economy would be devastating. You’ll see companies struggle to make payroll and pay their bills, which will lead to lay offs and plummeting share prices as equity investors try to assess what it all means for profitability.
The second major problem we have on the funding side is the repo market. This is where banks and financial institutions come for short term financing (similarly to the commercial paper market for companies). A borrower will sell high grade paper (usually government bonds or agency-backed paper) to investors, with a contractual agreement to repurchase the collateral from the investors at a slightly higher price in the future. The repo market is massive, trading anywhere between $2 trillion – $4 trillion EVERY. DAY.
There is an immense amount of friction within the repo markets at the moment. Banks see that a recession (possibly depression) is now inevitable, and there will absolutely be some corporate casualties. They’re becoming more and more skeptical of lending to each other and any market analyst worth their salt knows this is always the kiss of death. The Fed has implemented a handful of programs in excess of $2 trillion to keep the repo market open, but the impact of even those efforts has so far been, muted. If you need just one example of how exacerbated the issue has become, look no further than the mREIT space.
While most people are familiar with the equity REIT space (buying properties and profiting from rents and/or capital appreciation), mortgage REITs (or mREIT) are a bit more opaque. Their business model is to borrow in the repo market at 4-5x leverage in order to finance the acquisition of mortgage-backed securities or originate whole loans themselves. Here’s a one month look at what happens to a highly-leveraged repo participant’s share price when the market starts to freeze up:
That’s not great! The equity market is essentially looking at these companies and saying, “Yeah, we’re gonna wake up one morning and one of these guys won’t be able to open for business” (read: bankruptcy). If the repo market completely dries up, there will be another Bear / Lehman event. The banking business is entirely built upon borrowing short to lend long, so any material interruption in that business model will prove absolutely fatal for some of the more highly-leveraged financial institutions.
But here’s my number, so call me maybe…
Equity markets are plummeting. Gold was rallying but then fell off a cliff. Bonds rally and sink every other day. Oil isn’t remotely putting up a fight. Even fucking bitcoin looks like shit. Everything is selling off. How can that be? Where are the safe havens? Oh, that’s right:
SELL IT ALL! The ultimate feedback loop. Markets spiral > PMs sell to cover margin calls > forced selling tanks markets further > PMs sell more to cover more calls.
The stock market has been on an 11 year tear. The economy has been on fire, juiced (perhaps irresponsibly) by the Trump tax cuts. Credit has been pretty loose in a post-GFC era. It’s not difficult to imagine why portfolio managers around the world borrowed money to buy stocks and, to be fair, I don’t think you can ask a PM to hedge for pandemic-related exposures, either. After all, they don’t make a derivative for that (paging all structured products desks).
That said, none of that matters in this moment. The leverage in the system has exacerbated the equity sell off we’re seeing now, and it’s impact is going to be felt not just by fund managers, but by anyone with a 401-k, IRA or brokerage account. Those are real losses that are going to trickle up into the economy via reduction in consumer discretionary spending.
C.R.E.A.M.
The dollar is absolutely ripping, no surprise. There are a few reasons for this outside of the traditional safe haven trade.
The first is that since the U.S. capital markets are so dominant in the global economy, international investors have a lot of U.S. exposure. Typically, they’ll hedge their FX risk by selling USD and buying their local currency in their portfolios. The problem is that when U.S. markets start collapsing or fund managers begin selling, they’re left with hedges that are notionally too large for their overall U.S. equity exposure. This leads the international fund managers to scramble for the dollars needed to pare down their USD shorts in their portfolios.
The other reason, which hasn’t been in the headlines yet, will end up being the Eurodollar market. A Eurodollar is essentially a USD-denominated bank deposit that lives outside the U.S. financial system. The purpose of this market is avoiding U.S. capital requirements. In a Eurodollar transaction, an international bank will issue a short term deposit instrument to investors that will be denominated in USD. The deposits immediately become a USD-denominated liability on the bank’s balance sheet. This is all well and good in prosperous times. However, the rapid ascent in the value of onshore dollars during a crisis has a devastatingly deflationary effect on the international bank’s USD-denominated liabilities. Every time the USD increases in value, it costs more money for the international bank to repay the deposit instrument (their liability). This will likely force the international banks to go to market and purchase dollars as quickly as possible to avoid any more losses, akin to a short squeeze:
Combine the traditional safe haven trade, a general unwind of FX hedges and a Eurodollar squeeze, and you’ve got the recipe for a global dollar funding shortage – better known as a good ol’ fashioned liquidity crisis.
Where do we go from here?
The pain is likely to just be getting started. As quarantines become more prevalent, so will their impact in the economy. Institutions will continue to have difficulty funding their operations and share prices will continue to fall. Aside from markets imploding, however, there will be real human costs to this crisis.
There are thousands of restaurants and bars across the country (and millions across the world) that will never open again. Those people will lose everything and so will their employees. The supply chain is going to become increasingly strained as borders shut, likely inducing shortages of some goods. People are going to lose their savings, and that will take an indescribable toll on some.
Who knows what the next 12-18 months holds in store for everyone. All I know is that it’s getting weird out there and I’m not sure I have enough wine stockpiled. All we can do is sit back, go cash and enjoy the show.
Waiting for the coming recession is going to be like ordering an UberX: you know it’s going to be a terrible ride, but you won’t really know just how bad until that black Camry with seat protectors pulls up.
