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This time is different

The saying goes that “This time is different” are the four most expensive words in finance! Well ignoring that – here goes – this is how we think the COVID19 crisis (the Great Pandemic perhaps) will be different from the Global Financial Crisis:

Much more synchronised globally. China locked down in late January 2020. The rest of the world has started locking down in March. This has provided for an incredibly synchronised global slowdown. By contrast, in the GFC we had asset backed security markets seize up in the US in Q1/Q2 2007, broader credit markets started to fail in 2nd half of 2007, Bear Sterns collapse in Feb 2008 and Lehman fail in September 2008 and then the eventual trough in markets in 2009. While it didn’t feel like it at the time, this was a gradual and evolving process of cascading contagion. Unemployment drifted steadily up over this period. By contrast, in this crisis unemployment is exploding (for example, three million new unemployment claims in the US last week). The good news, if there is any, is that as lock down conditions ease, this should provide for a spurt to growth as more of the economy is able to function.

Crisis starts with policy interest rates near zero. By definition this limits the effectiveness of monetary policy. While some regions (Europe and Japan) have gone down the route of negative rates, this has come at a huge cost to their banking systems. I think that the US (and also Australia) will be very keen to avoid resorting to negative rates if at all possible. Instead, if the crisis deepens, we should expect ever greater quantitative easing (that is, central banks buying government bonds). In fact, we shouldn’t be too surprised if central banks take QE well beyond government bonds into purchases and deep into corporate credit (way beyond high rated Investment Grade) and even equities (Japan is already there).

Supply shock as well as a demand shock. The GFC was effectively a pure demand shock as the seizing up of credit markets and enforced deleveraging drove a rapid fall in demand. By contrast, the COVID19 lockdowns imply supply constraints as well as demand destruction. Supply chains are being disrupted. The Trump Trade Wars triggered a reversal of globalisation. COVID19 will sharply accelerate this trend. There will be a sharp divergence in inflation. Some sectors will see sharp price rises because demand remains steady (or increases) and supply is constrained (and higher prices are needed to bring online new local higher cost sources of supply). Contrasting against this, some sectors will see massive deflation, as demand collapses (and supply is unconstrained). For example, consider the contrasting fortunes of face masks/food basics vs hotel rooms. Whether this crisis is inflationary or deflationary will depend on timing (it is deflationary at the start, but perhaps inflationary once the fiscal and monetary response arrives) and sector.

Many governments start the crisis in a very weak fiscal position. The US was running a $1 trillion deficit before the crisis. They have just passed a $2 trillion plus stimulus package. The US enjoys the privilege of being the world’s reserve currency and perhaps this means they can run whatever deficit they like. Time will tell. However, for countries other than the US, if they go into this crisis with unsustainable government debt and deficits, then their capacity to provide fiscal stimulus is constrained or the currency/interest consequences if they do is something to watch out for.

Fiscal policy will dominate monetary policy. Without doubling up on the points above, the GFC was about the dominance of monetary policy. This rewarded asset prices more than GDP growth – marking a sharp increase in inequality (which has in turn underpinned the rise of populism). I believe fiscal policy will dominate monetary policy in this crisis. As investors (aka asset owners) we need to keep in mind that this is likely to be fundamentally redistributive. Over the last decade asset prices outperformed GDP by a multiple, we need to contemplate the scenario that asset prices underperform GDP on the way down, as fiscal spending props up income and GDP growth, but not asset prices.

Investors more sensitive to illiquidity/credit risks. The old saying is that generals are always fighting the last war. One element of this is that super fund members and investors are going to instinctively assume that some of the patterns of the GFC will be repeated this time. For super funds, who saw a lot of member switching (ie members switching out of the balanced member investment choice into a cash or very conservative investment choice), it will happen again and in my view it will happen larger and faster. The newly announced early release of super provisions are likely to cause substantial additional liquidity problems for individual superannuation funds (those with low average balances and young members).

Similarly, having witnessed credit contagion in the GFC and how a sufficiently large problem in one sector (US sub-prime) can spread out and infect the whole system, will be quick to jump to the same conclusions again. During the GFC it was the freezing of enhanced cash funds that was the surprise. This time around, watch out for “liquid” credit funds. Many funds have offered the promise of much higher liquidity to their investors than really exists in the underlying assets (particularly in a crisis). It wouldn’t be a surprise if some open-ended funds were forced to impose a freeze on redemptions.

These are some of the key differences from our perspective. What else should investors be looking out for? Please get in contact with us by email to share your thoughts, if you like, we’re happy to share with the broader readership group (there will be no IP theft at Infradebt!)


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