Blain’s Morning Porridge Mar 4 2020 – Fed fails to impress. Next?

Blain’s Morning Porridge – March 4th 2020

“The Fed’s Shock and Awe emergency rate cut was awesome for all of 20 minutes..”

Yesterday’s 50 bp “emergency rate cut” capitulation by the Fed and the market’s subsequent down-spike tells us a lot about current sentiment. It’s not good. Following the lacklustre G7 call to discuss the crisis and more dither, the market basically concluded: “We don’t believe you can do “whatever it takes” to avoid recession and market crisis. Prove you can!”

The Feb has opened a whole can of worms, just as we face something unknown, unsettling, and completely outside the scope of markets – The Virus. For the Fed to make such a clear mis-step raises all kinds of concerns. The market is uncertain, swirling in doubt, and pondering the following questions:

· Why has the Fed had caved into Trump’s demands for easing? The Fed’s credibility being questioned at such an early stage of a developing crisis won’t help.

· Didn’t the Fed understand you can’t fight an exogenous supply side crisis with crude monetary easing? The sell-off demonstrated the market understands the limitations of monetary policy – pushing a heavy boulder up a hill with a wet length of wool hasn’t worked these past 12 years, why would It work now? The market will need further convincing the authorities can “do whatever it takes” – which means damaging long-term consequences and distortions to solve for short-term weakness.

· Doesn’t the Fed read the headlines – and grasp the deluge of negative economic reality and remorselessly bad news requires full blooded fiscal and regulatory action? The authorities need to be acting to prevent a cascade of defaults caused by broken supply chains contaminating the whole financial system – potential causing a massive banking crisis. Rate cuts don’t do that. Fiscal measures to stall foreclosures, boost demand, and stimulate activity are required, perhaps with government stimulus through tax measures.

· Why is the Fed using up its scarce policy ammunition at this point in a crisis that is still developing? With the 10 year T-bond at sub 1%, the Fed has limited scope for further cuts – what does it do next to try to placate markets? How dangerous is the policy outlook?

· Does this mean the Fed Put is busted? Are we now likely to see even more manipulative measures – like a full-on QE asset purchase programme. Perhaps Trump will demand the Fed juices the equity markets? This is possible in the wake of a reinvigorated Democrat push.

And.. the killer conspiracy question: 

· What does the Fed know about Coronavirus that we don’t? 

I suppose it didn’t help the WHO announced the mortality rate on the virus is more like 3.4% rather than the 1% typical for most categories of the flu soon after the Fed announcement. While China’s draconian containment policies seem to be working, based on slowing infection rates, most governments are planning for the worst case – Pandemic: transmission, infection and swamped hospitals.

Just read through the negative economic consequences being felt across the board. Smart money has completely written off the global cruise business. Airlines are reeling, laying off staff and cancelling flights. Chinese airlines are asking Airbus to delay deliveries. Weather satellites do suggest Chinese factories are re-opening – they can spot the NoX blooms from space! – but it will take time to ramp up supply chains, and they are vulnerable to a potential second wave of infection.

Where does the market go from here?

Some observers have pointed out the global stock markets are getting smaller as more companies go private and stock buybacks have reduced the number of shares in circulation. As 2/3  of S&P500 companies now pay dividends in excess of Treasury Yields, surely there is still upside for stocks, even if the global economy is headed for recession? The low level of bond yields apparently justifies higher P/E multiples.

Really? Surely lower yields mean a heightened risk environment, which means multiples should fall?

This is what drives yield tourism – artificially low yields forcing investors to take greater and greater risk in the search for returns.  It has massive potential to end badly. Where will the pain strike?

Asset Managers were once 90% Gilt/Treasury holders have become risk takers and yield tourists. Today they are probably 30% junk and near junk bonds, 30% investment grade and 40% equity. The last 12 years has seen a massive and deliberate transfer of risk from systemically important banks, to a more diverse range of asset managers.

Banks understood risk. Their businesses were intelligence led from their on-the-ground bankers and branches, feeding large backroom risk management teams with direct information to monitor every facet of the market. Risk now resides in fund managers, who have small Risk Management departments assessing what they read in the press. MiFid rules ensure they pay for puff put out by the investment bank research departments – many don’t bother. Asset manager risk departments may be good, but they lack the ancestral risk management DNA the banks once had.

The upside is the allocation of risk across the market has become massively more diverse. If one Asset Manager goes down because of risk management failure to exit in time, its far less damaging to the financial system in terms of contagion than a bank going down.

But what happens when the market basis suddenly shifts and the Asset Management universe suddenly tries to exit Corporate debt – doors locked, Junk bonds – doors locked, and equity markets crash. Who loses? Savers? And what happens then….

The next crisis is likely to be on the AM side – and that’s likely to create massive future liabilities for governments as pension saving disappear at a time when debt levels will be under pressure… Another sovereign debt crisis anyone? Just saying….

There is still lots of denial across the City about the Coronavirus panic.

A) If your question is: Why is the market panicking about a virus which seems marginally more dangerous than normal flu? …. you are asking the wrong question.

B) If your question is: Has the market over-estimated the economic consequences of the actions taken by the authorities to contain the virus?… you are on the right lines and looking for a buying opportunity.

C) If your question is: How much more damage can the global economy take before the G7 and central banks can’t help? … you are getting warm, and wondering about the implications if/when this turns into a major crisis…

Meanwhile – Back in the USA

Well done Mike Bloomberg – he’s won his own South Pacific stronghold in Samoa in last night’s SuperTuesday caucus! I wonder if the US dependency has got an extinct volcano he can model into a nice lair for the billionaire supervillain in waiting? 5 delegates cost Mike a lot.

The Democrat Party Core finally got its act together just in time to turn the nomination into a drag race between Joe Biden and Bernie Sanders. Biden won Texas, while Bernie stormed California. The endorsements should flow towards Biden. Will Bernie step aside and give him his support? Over the next few weeks there is a real prospect the Democrats will get their act together and make November 2020 a proper race. I expect the pressure will increasingly be on Trump. It all about the Economy Stupid!

5 things to read in the papers.

FT – Fed rate cut piles pressure on Lagarde to take action

FT – Coronavirus raises the risk of real trouble in corporate bonds

WSJ – Surprise Rate Cuts Are No Miracle Cure

BBerg – Global Fatality Rate 3.4%; Olympics Delay Possible: Virus Update

ZH – Tesla Registrations Plunge in Two Crucial European Countries

I expect its going to be a busy day. Lots going on out there, and some it might be good. But we now know that Coronavirus infected cats bounce higher, which means they have further to fall. Yesterday’s moves might just have been a correction to Monday’s move – but it feels like we’re in a new down phase.

Out of time

Bill Blain

Shard Capital