Economic Strains from Covid 19

Liquid is Key

We are over two months into the crisis in Europe. One thing this has pointed out to me, that I remember when I finished school in Ireland in 2009, at the height of the euro-zone crisis. I looked at a brand new petrol station having the pumps taken away, and over the street next to it, a boarded up coffee shop. It doesn't matter the situation, cash is king! 

A financial crisis is like a heart attack. It hits the pump of the economy hard and the organs, as the blood stops pumping cannot support the body, as they do not have sufficient liquidity. The defibrillator is the central bank, which is the key to getting trust restored and applying the voltage funding to kick start the heart.

A depression on the other hand, is a much more difficult patient. Serious organ failure, complimented with underlying health conditions; a quadruple blowout. There is no clear solution to get this patient out of the coma. More important, is how the economy is sustained during coma and its slow recovery; as it is very easy for the large corporates to eat up their solvent but less liquid competitors.

There are right now, three tiers of balance sheet a business could be.

1. Solid cash generation on hand, few illiquid assets i.e. tech companies.
2. Easy access to capital markets, with a higher cost of financing due to the demand.
3. Cannot access credit and capital impairment probability is high. SMEs and capital-intensive industry.

The final pillar will be the major part of the life support. The ECB and Fed injected over $3 trillion between themselves, with bond buying. However, this is a macro move. Governments have taken their turn in supporting their central banks, but must step in quickly, consistently and effectively, to support the small domestic economy. Caution should be exercised carefully in the aid to large industry, as it could be throwing Semtex at itself or rattling the sabre of next door neighbours. 

Germany is facing serious scrutiny of unfair advantage. As the EU relaxed its law on state aid due to Covid-19, the German ministry filed the largest proportion of state-aid claims to the EU, as it helps to prop up big industries, most notably the airline industry. Though, this has hit hard with less wealthy EU member states left to see their home industries put at a negative advantage.

Cheaper than Water

Being a producer of black gold in 2020 will be remembered as not the best time in the world, being the owner of an empty mine shaft on the other hand.... Oil traders have scoured the globe to find empty Scandinavian salt caves, to unused rail tankers to fill the glutted supply of unwanted crude.

In late April, Brent fell below zero from the mid-seventies in value of long-ago January, for the first time in history, causing an interesting phenomenon of a contango. As the spot price fell below zero, future prices overtook in value. Traders had the unique ability to buy and sell back deliveries on the futures market at a reasonable profit complimenting an additional surge in storage demand.

Cheap oil has the incentive of attracting a quicker rebound to the global economy. However, this comes with its downside when too low. OPEC is seen sometimes as a group of spoilt children, fighting over the lion’s share of production. But it plays an important stabilisation role of its members economies. Rural communities in Nigeria are highly dependant on the sale of oil as a source of income, as are most mid-African and middle eastern nations. However, with values not expected to go up anytime soon to break-even levels, civil unrest will be highly probable, even with OPEC cuts.

It would not be a far stretch to think additionally the oil crash was not intentional. It is well versed the Russian-Saudi annoyance towards the young shale and fracking industry in the US, which commands a higher break-even price and is not state supported, thus leaving room to quickly shock the unprotected industry, before slowing the pumps.

Closing remarks with a Gothic upswing

There will be a lot more debt in society, and a stronger desire of companies to look at resilience before efficiency, as a global supply chain can only be efficient if effective.

The rewiring of supply chains away from the inter-dependence of global health will be a major step, already in process. The epidemic in some ways may have triggered an inevitability, as US-China trade tensions from 2019 linger on and the crumbling of the EU collective continues its course.

It would not be a far reaching thought to see a pre Great Depression scenario, whereby the cost of goods and services increases, as well as barriers to entry for international trade, through taxes and tariffs for the protection of home industry. This will deeply stimulate cost push and demand pull inflation. Though, with the technological overview to monitor the economy and global cooperative approaches in the 21st century, it could create a balancing in the distribution of wealth to domestic economies, to the lower income earners. This would occur, as new employment is created locally and low skilled labour is required, leading to social policies winning greater favour in local government institutions, perhaps in the mid-term to incentivise the demand for labour.

Macroeconomic Pathogens

As Andrew Bailey warms up to his new office as governor of the Bank of England, he has a weather pattern that doesn’t sit well. He must wield the hand of a strained monetary policy in an upcoming Brexit world, and look to his fellow BoE economists in the impact modelling of Covid-19 on the UK. He knows the effectiveness of his institution is being tested, and as the rain pours down on thread needle street, the Dow Jones Level - 1 circuit breaker is hit.

Level 1: A drop of 7% from the prior day's closing price of the S&P 500 triggers a 15-minute trading halt. Trading is not halted if the drop occurs at or after 3:25 p.m. ET.

Level 2: A drop of 13% triggers a 15-minute halt. Trading is not halted if the drop occurs at or after 3:25 p.m. ET.

Level 3: A drop of 20% triggers a halt for the rest of the trading day, and trading resumes the following day.

Viruses and the economy

A pandemic is an interesting economic scenario, because it really has an open rule book to how it behaves, depending on the origin. It typically hits supply first, instead of demand. No matter how high the want for Parmesan cheese may be. A closed factory with a quarantined workforce in Italy will not meet the consumer demand. Take this with the additional pressure from panic buying, and we have an inverse relationship occurring.

In December, in a small district in the city of Wuhan, China. A local food market formulated, under the correct conditions Covid-19 that became the kick-starter to the correction of the world economy and largest global pathogenic outbreak in the industrialised world. Covid-19 has taken advantage of our interdependent infrastructure and supply chain. Bringing the economic might of China to a halt, and has now spread beyond borders and across the globe. Now with halted production, the dynamic borrowing small & medium enterprises in China depend on are becoming the first economic casualties.

Troubled water for the fishes

March was always going to be a difficult month. Fragile OPEC talks took place whereby leading oil producing states turned hostile in talks. Already having to deal with an economic slowdown from the virus, led to a terrible disagreement on supply cuts in order to combat the decline in oil receipts. This combined with negative data ensuing from the previous week, made markets on the 9^th of March hit the circuit breakers on US indices.

What further impact will be felt, is still early days, however these corrections will turn the portfolio manager to dive deeper into their folder and see which institutions and corporations are weak on the cash side and are “zombies” to this economic stagnation.

Airlines usually are the first ones with blood in the water and will be an interesting case with the crippled airline manufacturing issues from Boeing. However, they are hit in two ways. A reduction in sales, though also a reduction in fuel costs as now Jet fuel futures turn cheap. Yet, sales will take precedent, in combination to employee costs from the Covid-19 impact. March is the main month that fills the balance sheet and with the high ratios of the industry of net debt to Ebitda, the sharks will be circling for the bite.

Passing of the Baton to Fiscal

The last ten years has seen the largest global injection of cash into financial markets, with central banks fighting the faults of a stalling global economy. Yet, there are some human elements central bankers cannot solve, and where politicians will have no choice but to step up, as monetary policy shows its limit.

Government bonds took up the majority of the capital flight as US and European notes hit historic highs and as the fed made an emergency cut of 50 basis points, the central bankers of the world reaffirmed their position. Fiscal policy needs to step to the plate. 

Despite these warnings for many years, few economies are willing or able to act. The US congress passed a $8bn emergency corona virus response bill, to help struggling industries, though the euro-zone's export animal Germany needs to act fast, and reduce it's bickering on the purse string to the €1tn budget for the euro-zone. Despite having year-on-year fiscal surpluses Berlin has yet to relieve the several quarters of weak growth to fiscal policy. 

Closing remarks

After some further debating, OPEC will reach an agreement after their economies woo on sentiment. Yet, depending on the global fiscal response to small and medium sized industries, the a short lived bear could be an underestimation.

This brings me to my most beloved index. The VIX made it's comeback from the volatility and mania of 2008 on Monday, and acts as a careful reminder to governments and institutions, of the many weak spots the economy still has, if left unbalanced.