Written by Julius Probst
We are currently witnessing all sorts of macro crises at the same time: a massive unprecedented health pandemic caused by Covid-19. This was initially a supply shock as global production chains and trade linkages started getting disrupted, since China has essentially turned into the world’s manufacturing bench over the last few decades. However, all the macro data has been telling us that the initial supply shock is now being dwarfed by rapidly falling nominal demand. As some European countries are starting to shut down public life, several sectors of the economy will completely tank, especially services: hotels, airlines, restaurants, etc. The shock is also felt in financial markets as equities are plunging, and there is a general flight to safety into US Treasuries and German Bunds.
As a side note, this very moment also turns out to be a breaking point for Shitcoins, uhmm, I mean Bitcoins, and the like, who are currently proving that so-called cryptocurrencies are neither money nor a safe haven asset. Instead they are simply a financial asset that really has no determinate fundamental value and can therefore fluctuate substantially. And by the way, their fundamental value can also be close to zero, which is increasingly likely especially in an unprecedented crisis like the one we are facing.
The destruction of wealth in equity markets in recent weeks will unfortunately also feed back into the real economy, thus essentially creating a reinforcing loop of doom. The financial sector is panicking and a financial crisis à la 2008 is getting more likely by the day. There have only been very few instances when the Dow Jones plunged by more than 8% in a single day, and it did not even happen during 2008/2009!
Financial market volatility is spiking as well, and the VIX has reached levels we have not seen since the Financial Crisis. As volatility tends to cluster, there is reason to believe that a higher VIX might stay with us for a while. There is a huge amount of uncertainty in the global economy right now as the macroeconomic outcomes can range from bad to pretty bad to complete shit. Again, a lot will depend on effective crisis management and the response of fiscal and monetary policy makers to prevent the worst outcomes from being realized.
Finally, there is good reason to believe that emerging market crises are brewing too. These countries have more fragile institutions and feeble governance and generally suffer a lot during a risk off moment. They already experience massive capital outflows as well as currency depreciations. While I initially wanted to focus on EMs, I won’t have time for that in this post. Suffice it to say that we should also brace ourselves for a big wave of currency crises a la Krugman (1999) that might be coming our way.
As for Europe, governments in the Eurozone now need to step up big time and abandon the austerity measures that have harmed Europe over the last decade, especially since interest rates are at all-time lows. However, the brunt of the burden will fall on central banks. Right now, there can only be one mantra: Go big, or go home!
Last Thursday, the ECB basically chose the latter approach, whereas the policy decisions from the Fed were more on point, and hopefully there is more to come. The ECB decided to step up its QE program, another 120 billion over the course of the year, on top of the 20 billion per month that they are already doing. Good, but not enough! Moreover, a more complicated layered program of targeted measures was set up to support the European banking sector – basically subsidies via cheap financing at negative interest rates to avoid a financial meltdown. The big screw-up of the day, though, was when Lagarde blurted out that the ECB is not responsible for sovereign spreads in the Eurozone. Yikes! Doesn’t that remind you of the Eurozone crisis? Spreads do not reflect fundamentals at the moment (De Grauwe, 2013). This is a time of sheer panic, frozen liquidity and credit markets, and the possibility of multiple equilibria with massive downside risk! Do we want to turn this into Eurozone Crisis 2.0?
Her statement had a remarkable adverse effect on Italian spreads, which have soared within just a few days. After the press conference, the ECB did some damage control by clarifying Lagarde’s statement. Furthermore, chief economist Phillip Lane wrote a clarifying statement on the current macro outlook and the ECB’s policy measures.
As for the Fed, they timed this somewhat better. Just a few hours after the partial ECB screw-up, they announced that they would perform 1.5 TRILLION USD in repo agreements, emergency loans to the financial sector in the following days. Moreover, the Fed is also starting a QE program of some 60 billion USD, purchasing Treasuries of all maturities. This is supposed to address liquidity issues in the Treasury market, since yields across the spectrum had been fluctuating quite wildly and leading to weird bounces in the yield curve.
While financial markets were not impressed at first, and US equities continued to fall last Thursday when the statement was released, the recovery on the next day was quite impressive.
Then, this Sunday, the real Bazooka came. In a surprise move before Asian markets opened, the Fed slashed its interest rate all the way to zero and also announced a new QE program in the amount of 700 billion USD. Furthermore, USD swap lines with all major central banks, ECB, BOE, BOJ, etc. were introduced to enhance global dollar liquidity. Kudos to the Fed and Jay Powell, who are truly showing that they are not messing around this time! Expect the Fed’s balance sheet to massively swell in size again.
As of right now, it’s still hard to say to what extent all the macroeconomic interventions will be able to support financial markets and prevent a macroeconomic disaster. After years of being a passive bystander, the German Ministry of Finance and Economics released a strong statement that it would support German companies with dozens of billions of Euros in emergency loans during this time of crisis.
Moreover, the EU pledged to abandon its very tight fiscal rules, something that should have been done a long time ago during the Eurozone Crisis, and will also support Euro Area economies with some 30 billion Euros plus, and hopefully more to come.
The financial market rollercoaster we have observed in recent weeks mainly stems from two facts. First, it is still extremely difficult to judge how bad the health epidemic will be in terms of people infected and total mortality. Second, it is also hard to judge how long the shutdown of public life will last and how big the negative macroeconomic impact will be. As an example, naively assuming that about 50% of the economy is closed down would imply an output loss of 1 percentage point per week, so already 4% after one 1 month and 8% after two months!
These are negative impacts similar to and even exceeding those of 2008/2009 and it should therefore come as no surprise that equities have already lost a third of their valuations, with probably more to come.
Finally, there is the uncertainty about fiscal and monetary stimulus to offset some of the negative effect. As of now, it really seems that at least some policy makers are trying to adopt a “Whatever it Takes”- à la Draghi – approach, and rightly so, since macroeconomic fundamentals are deteriorating by the day.
However, this creates additional policy uncertainty and therefore also affects the true fundamental value of equities. For the time being, we should expect heightened global uncertainty and increased volatility for the times to come. And look out for those emerging markets! Their fragility will soon become apparent, and currency crises are to be expected.
Looking at GDP Nowcast models for the US, two things stand out. First, the forecast value for Q1 did not decline significantly yet, only from about 2% to roughly 1.6% in recent weeks. This forecast strikes me as overly optimistic.
There are probably two reasons for that. First, the model might not be able to catch inflection points that quickly, since the macroeconomic data it relies on only catches these turning points with a lag themselves.
Second, the US is as of right now not in complete shutdown mode yet, contrary to some European countries (Italy, France, Denmark, etc.) where public life has come to a complete halt. As a significant part of the entire service industry is now closed down (restaurants, pubs, cafes, public entertainment, etc.), these countries will effectively already experience a recession in Q1, while the US is currently still lagging behind.
Finally, hamster purchases are offsetting to some extent the negative demand shock. However, these actions are simply pulling demand forward in time, meaning that there will be less demand in the future, which is why one can expect a bigger drag in Q2. This is reflected by the pretty harsh downward revision for Q2 growth from the NY Nowcast, down from more than 2% in the end of April to just a little over 1% today, still a rather optimistic forecast. Currently, markets are pricing in a recession for the Eurozone and the US economy is also more likely than not to have an upcoming recession. Therefore, expect more significant downward revisions in the Nowcast model in the weeks to come.
While as of now the negative shock is not yet approaching 2008/2009 levels, we are inching closer every day. Besides trying to save as many people as possible with social distancing, we must also count on fiscal policy makers and Central Banks to do the right thing and bail us out. Go big or go home, there is no middle way right now. There is plenty of fiscal and monetary firepower left. Follow the Fed and have the courage to act!
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