There are larger problems than Covid-19. It sounds unbelievable, but it’s true. This is a very strange time; not just because many streets are empty, people wear masks almost everywhere and we are being encouraged not to venture out of our homes except for emergencies and groceries.
There has been an extraordinary series of economic events and the financial markets seem to remain oblivious. Equity markets are soaring, bond markets are holding, and some smart people are getting bullish on the “recovery” trade. Some analysts are calling for a large snap-back rebound in the major economies. With respect, there is good reason to suspect that things have, in fact, deteriorated much more than previously recognized. Prior to the Covid-19 Crisis we had a pretty bleak picture for debt for individuals, businesses and nations. In fact, sovereigns have played an increasing role in financial markets, and inadvertently creating monstrous asset bubbles in real estate, equities, bonds and other markets. Things are not normal. Valuations are hot and there are a number of asset “bubbles”.
In a time when corporations are closed or shutdown and people are out of work, government is the only game in town. However, we must look at the global situation as a whole. There are a number of forces coming together to create a perfect storm. Some research from the IMF and World Bank and other think tanks suggests that the confluence of a number of factors will create the next major crisis. The factors contributing to this include rising sovereign debts, GDP shocks, record unemployment, political risks, technological impacts, new financial innovations and investors, normal business cycles, and how they all come together to create a big financial mess.
In 2019, many nations had amassed huge government debts from the fall out of the Global Financial Crisis. Since March 2020, these same governments have been raising lots of debt for “stimulus” programs, which are really not stimulus programs at all but more like “survival” programs. The stimulus has been used to keep people employed and businesses, hospitals and local governments from closing or reducing essential services. National debt levels for many nations had already reached critical levels even before the pandemic.
Worst Economic Recession Ever
Ironically, in the worst economic hit in hundreds of years, and probably in history, some sectors are benefiting, for now. Technology stocks are at historic highs. Real estate asset bubbles are spiking, even though many assets are empty and tenantless junk bonds and real estate products remain largely unchanged. The U.K. announced the deepest drop in economic output in 300 years, and it is not even the worst hit economy.
So, this is a confusing time and the data is confusing as to what in included (or omitted). Why is this so? Here are some factors to consider.
Technology and New Innovations: Exchange Traded Funds (ETFs)
Technology and new financial innovations are playing a role in the market bubbles. People have stopped investing in single stocks and are largely focused on ETFs. ETFs can be a useful diversifier as you can get easy access to an index with a single ETF. This is a good thing. However, it can have a negative effect on capital allocation, which rewards both the good and the bad in an index irrespective of their financial performance. This can create bubbles.
Again, on the downside it makes some investors complacent. Certain specific ETFs have poorly designed, liquidity mismatches. Some bond ETFs have a portfolio of bonds with a duration of several years but offer investors intraday liquidity. If anyone recalls the MBS, CDOs and other financial innovations that had significant liquidity, until they didn’t and then they collapsed in 2008. Also, we have never had a full sell-off or market crisis since 2008, when ETFs really took off as a cheap alternative to stocks. So, we do not know whether they will be resilient in the face of massive redemptions. Although there are arguments that there is secondary liquidity and certain fail-safes in place, we simply do not know the answer to how they will respond. But when an investor gets scared, they sell. If you are holding an ETF of the entire market then the sale creates pressure across the whole market and nor simply on a single, struggling firm. As a consequence, the damages from an ETF sell-off may be deeper and broader than we have previously experienced.
New Investors and Historic Bubbles
There is a lot of risk taking and extreme speculation in the equity markets by unusual participants, like retail day traders. The markets are at all time highs. Many sage value investors, like Jeremy Grantham, believe the crash will be epic, rivalling 1929 or worse (see for more details his talk with Bloomberg https://youtu.be/RYfmRTyl56w). Consider the Nasdaq and its meteoric rise in the past 12 years, since February 2009.
While new investors are excited and there is a lot of FOMO (or fear of missing out), we are likely at a new peak of the tech mania.
Robin Hood and expansion of investments to retail investors is both good and bad. At its best it is a new form of economic egalitarianism for retail investors. At worst, they are unscrupulous bloggers using en masse market manipulation strategies (like pump-and-dump, remember the GameStop fiasco) and ill-advised speculative bets using extreme leverage or risky derivatives. The number of options in the retail market in the U.S. has spiked since Covid-19 started, and this is normally a very strong sign of a market bubble. Also, market observers and fundamental investors will note that Price/Earnings ratios (a key indicator of frothy markets) are more than double historical averages for the S&P500. The average P/E ratio was approximately 8 in the Global Financial Crisis, with a historical average of approximately 14 and it currently stands well over 30. For example, Tesla has a P/E ratio above 1200. We have massive bubbles in the tech and larger equity markets.
Central Banks
Central banks may be creating inflation by increasing the money supply (M2 has jumped globally in 2020). And central banks have flooded the markets with cheap sovereign debt and used it to finance stimulus and make investments in the financial markets. Stimulus spending has become significant amounts of GDP, both Japan and Canada have stimulus over 20% of their GDP. In fact, the U.S. has spent over 13% of GDP.
In addition to fiscal stimulus from Congress, the Federal Reserve (Fed) has also increased its balance sheet massively (by over $3.5 trillion dollars) since March 2020 (shown highlighted above).
Given that that the Federal Reserve has dumped 3.5T into the markets we have not seem a recovery as much as an overpayment for assets and a consequent consolidation of risk in the U.S. Central Banking system. So the real U.S. government intervention is closer to 30% of GDP. Moreover, the Fed is buying lots of unusual investments, everything from junk bonds, ETFs to individual securities and other debt. The Central Bank’s buying spree has been massive and promises to continue under the Biden administration.
Historically Low (Negative) Interest Rates
While investing in lot of stuff to prop up markets, Central Banks (with government support) have dropped both short-term (T-bills) and long-term (10 year government bonds) interest rates to historically low levels. Interest rates are at near zero or even negative in many developed (G20) countries, like Japan, U.S., Canada, U.K.. Germany, France, Spain, Italy and Switzerland.
As a result, all of the financial models would now suggest that long term risk for investments is low. This is wrong. Artificially dropping interest rates may create cheap borrowing, but it does not reflect rates in the real economy which are often much higher. Because sovereign debt is unsecured debt but regarded as the riskless (for “AAA”) nations, and this crisis has impacted everything from “AAA” and “C” (the weakest bond rating) nations severely. Thus, low interest rates may not be sustainable as international investors turn away from old standards, when there are better risk-adjusted offerings available.
And let’s remember the capital structure for a moment. If government bonds spike then corporate bonds and other fixed income products will be crushed, and equities will hurt most of all. But many are pinning their hopes on new technology.
Digital is Now Mainstream: But So What?
It is true thatCovid-19 has increased online platforms, communications and virtual meetings, but let’s remember technology is largely deflationary, and many of those companies do not make money from those services. Think about your free email account, reading this article or your free virtual meeting or Wi-Fi phone call. In the past, you would have had to pay for all these products and services. Similarly, compare the salary of a receptionist or executive assistant (maybe $50,000 per year) to the cost of an iPad used at the front desk of an office ($200 per year). It isn’t even close. It is natural that technological advances can lead to price drops, but if you think that you can charge money for these services in the future, that’s only likely to be true if you put all the other options out of business or into bankruptcy.
So Covid-19 has increased digitization, but it is not clear that this will be profitable or good for the larger economy, traditional businesses and jobs. It is also not clear at all that sky-high valuations of tech superstars like Tesla, Zoom or others is justified. This tech bubble may only be good for an oligopoly of tech conglomerates. And these tech companies may face backlashes and new regulations to combat these larger negative effects on the economy.
Unemployment remains at Historically High Levels
Unemployment and related employment benefits are at historic highs. The global picture is bleak for 2020. 2021 will likely continue this trend given the distress and probability of bankruptcies is increasing.
The increases in unemployment have been felt most as a percentage in the U.S. and Canada.
But bankruptcies and restructurings have yet to spike. In fact, they have plummeted. So where are the bankruptcies and permanent job losses? Although some traditional brick-and-mortar retailers have filed for bankruptcy, such as struggling big box retailers, there should be a historic number of defaults and bankruptcies, the majority of bankruptcies have been delayed by government spending and free money propping up failing firms. Bankruptcies are at historic lows in many countries due to massive government programs (see the blue line in the chart and compare that to the Global Financial Crisis in red). Given all economic indicators we should expect that bankruptcies will be worse than 2009, and will soar in 2021 and 2022. Some nations have overpaid people and businesses significantly to prop them up during the Great Lockdown. This has delayed the crisis, but the underlying problem remains.
For example, Canada has increased many employees’ salaries that have created an incentive for them to sit out the pandemic and earn more at home than they would have working. Nonetheless, the defaults and bankruptcies will come, and probably broader and more significant than ever before.
While the general idea of governments is that a “rising tide lifts all boats”. However, as Warren Buffett sagely noted “only when the tide goes out do you see who is wearing a swimsuit.” This is an uncertain impact, but the tide is going out and we are yet to see any sign of speedos.
The Stimulus Effect is Temporary
When the stimulus programs are gone, only the debt will remain. Debts have increased significantly in many small and large businesses (with cheap credit available) while revenues and profitability of businesses have dropped precipitously. It is only a matter of time before debt works its way through the system, and creditors realize asset values and businesses are no longer viable and restructuring or liquidation occurs. Also, this will be revealed at tax time when tax revenues will drop massively. Credit has expanded dramatically since 2008, but it has been driven by new players, fintechs, online platforms and private credit investors, and investment managers.
The Shadow Banks
Ironically, it was the efforts of G20 governments to de-risk the financial system, with the Dodd-Frank Act, the Basel Accord, CCAR, and other prudential oversight regulations, that have pushed risk from the banks and into the shadow banking system. The shadow banking system includes fintechs, peer-to-peer lending, and new investment management vehicles. Unfortunately, the shadow banking system may not be as understanding towards defaulting loans and investments in their portfolios as banks were post-2009.
And, if investment managers are unable to recover from defaulting loans and investments in their portfolios there will be consequences to liquidating portfolios of illiquid mortgage and debt investments. Governments may not even see the problem like the failure of a Lehman Brothers or Long-Term Capital Management until it is too late. Also, with the advent of increasing technology fast trading, things could deteriorate very quickly. Further, governments will have difficulty with the public support to bail out an investment manager or opaque funds and fintechs, even where failure to do so could cause a dangerous domino effect in traditional and the shadow debt markets. To be clear, some fintechs and shadow banks perform much needed services and are valuable participants in the finance industry, but there are some that are poorly run, lightly regulated, and highly levered that pose significant risks.
But even more important than the fact that many governments do not regulate or directly control the shadow banking system, one of the key factors is governments complete disregard for normal business cycles. It’s as though monetary policy and rushed fiscal stimulus plans can fix all economic problems.
Business Cycles are Real, But Ignored
Business cycles do exist and are a natural part of the economy. We have been on a historic ride since March 2009, which was fueled by massive government policies and spending. However, there is a normal undulating process of growth in four distinct phases: expansion, peak, contraction and trough. Many countries were already in contraction when Covid-19 hit. But short-term thinking and (short-term democracies) leads many policymakers and governments avoid a contraction on their watch. They would rather inject stimulus into the economy and lower interest rates even in the good times, in the vain attempt to create a monetary elixir for perpetual economic expansion, without peak or contraction. Or at least they want to kick the problem down the road to the next government administration.
Nevertheless, there is no magic economic bullet, and the recession (which is a technical depression) is here and is deeper than ever in many nations. Despite what the sell-side equity analysts would have you believe when they advise you to buy into the recovery trade. Remember, never ask a barber if you need a haircut. They always say yes.
Debt for Consumption Always Ends Badly
In the end, debts for business or building on positive net present value (NPV) projects that will be productive in the future is a good thing.[i] However, debt for consumption or wasteful projects are very destructive for an economy, and lead to suffering for citizens. Propping up zombie businesses that will just wait to fail is pointless and costly. Consumption debts remain but the positive impact will disappear like yesterday’s free lunch. And the government programs have largely been debt for consumption, or creating arbitrage opportunities for businesses to cheap government support to refinance at lower rates. There are few long-term viable economic or infrastructure projects that have been proposed or developed. $1400 Stimulus checks may spur some minor consumption, but it is likely to dissipate without lasting impact and definitely is not enough to start new businesses or even pay rent.
GDP has Dropped Globally.
The GDPs[ii] of all major economies have all taken a hit from 2019 to 2020. On the extreme end, Brazil, Mexico and India and other emerging markets have been severely impacted.
But the GDP of numerous developed nations has also dropped, including the U.K., Canada, Japan, France and even the U.S. Shockingly, China’s GDP growth dropped by over half based on their own data.
Governments have spent record amounts on Stimulus.
The governments have spent significantly on stimulus, fueled by debt. The old government debts were already significant from the recovery plan from the Global Financial Crisis (2007–2009) and the European Sovereign Debt Crisis (2010–2012).
So, what is to come now? These are just the national public debts. They are not reflective of the entire debt picture, which includes external debt. External debt makes the U.K. look similar to Japan’s debt predicament. Looking at the full debt picture is beyond the scope of this article and will rely on a further analysis of external debts from international investors. But we do know that GDP has dropped and stimulus debts are much higher than expected.
GDP has Dropped and Debt has Increased.
The New Debt to GDP show the increase in debt relative to smaller economies, and larger debts added for stimulus. Debt to GDP is a critical consideration and if you include non-financial and financial, domestic and international debts the size changes dramatically.
For simplicity we will just look at national debts for comparison purposes.
Japan now stands at the highest (319%), while Italy (178%) is over its European Sovereign Crisis levels, and Brazil (158%) has ballooned its debt and been the most hard hit from Covid-19. However, other G7 nations are not far behind. Canada stood as a leading and safe-haven currency in 2008 with national debts (around 80%) but now stands at (139%), which is similar to Italy which went into crisis in the 2010–2012 European Sovereign Crisis. Finally, Canada does not have a Mario Draghi or the “bazooka” of the ECB behind it to water down any problems. Remember Italy.
Recalling Italy after the Global Financial Crisis should give us reason to pause. Italy went from a stable and important member of the E.U. financial community to full distress in a matter of days due to a minor change to the rates that international investors demanded for Italian sovereign bonds. They raised rates by little more than 1% and the Italian economy went into full crisis.
It is likely that unsecured creditors will demand more from international sovereign bonds in an environment with both failing economies and rising national and foreign debts, and reduced domestic tax revenues. After all, sovereign debts are unsecured and the risk of default has increased on most sovereigns significantly. Therefore, a rise in the risk premium would be a normal response to an increased probability of default for any debt. Wouldn’t it?
Sovereign Crisis Looming
There is another sovereign (or sub-sovereign) debt crisis looming as the waves of debt arrive. It may start in any of Japan, Italy, Brazil, Spain, Canada, Greece, Ireland, Portugal, or another nation. It may be set off by a large bankruptcy, or international financial institution, or simply international or domestic investors moving away from old government investments but make no mistake a new sovereign crisis is coming. What event or entity or nation will spark it is the only real question?
It is too early to tell at this point. But it is unlikely to be a nation that is in the basket of global reserve currencies. Japan, the U.S., and U.K. will likely be involved but not the epicenter. So that leaves Italy, Spain, Canada and Brazil as the highest probability nations as they have been impacted severely, already spent significant amounts of their GDP on consumption stimulus, and do not have a direct ability to delay the impact from monetary tools. However, Italy and Spain and their banks have been bailed out before. The European Troika (which is the International Monetary Fund (IMF), European Central Bank (ECB) and European Commission (EC)) would be reticent to let them fail on a grander scale in a pandemic. This would involve some dangerous political calculus on the future of the whole European Union. This is especially so with the bitter memory of Brexit in the recent past.
Brazil and Canada
So then some of the hardest hit, non-reserve nations, with high debt levels should be considered. And so, Brazil and Canada or another emerging market look like prime candidates. The IMF has warned Canada that its extreme debt plan requires “justification”. In economics, this message translates to “your debt binge for consumption does not look smart for the future.” And the new Debt to GDP ratio looks very bad, indeed.
Depending upon the statistics we choose the picture looks much worse. But the trajectory is very clear. For example, in Canada debt to disposable income has been growing for decades, see chart below.
by René Morissette, Social Analysis and Modelling Division, Statistics Canada, 2019
Canada’s debt problem has grown since the Global Financial Crisis in 2008. Where the U.S. and Canadian debt were similar in 2008 at the height of the subprime crisis, the U.S. (in blue below) reduced leverage but Canada (in red below) continued to expand household debt to historically high levels.
Government, personal and household leverage in Canada was much lower in 2008. But it has steadily grown, but absolute debt to assets has dropped thanks to the Canadian real estate asset bubble.
And the larger debt picture for Canada for the government, businesses and non-financial debt is massive. Canada reportedly has “a total non-financial debt-to-GDP is considerably worse than the global average; at a massive 343 per cent it is one of the highest in the world.”
Whether this unfolds as a full sovereign crisis or just national or regional debt crises is uncertain, but Canada is now in the crosshairs.
There are plenty of economic storm clouds on the horizon for Canada, Brazil and almost all other G7 nations. When sovereign debt issues appear it can take an uncertain path and ensnare previously sacrosanct financial institutions, businesses and even nations. We can expect that it will bring the equity, debt, and real estate bubbles down to earth. When the stimulus ends and legacy bills come due we will see the real economic damage done by Covid-19 and sovereign debts for consumption stimulus.
Vaccines give hope, But the Economic Damage is done.
If we think the crisis is over once mass vaccination is achieved, we are wrong. Let’s hope the vaccines work on all virus variants and Covid-19 is defeated as a medical crisis in 2021. We will still be left with the economic damage. It is hopeful but unrealistic to think otherwise. While life may return to more of a normal state, in that people will begin to congregate again, children will attend school in person, and the daily news of horrible infections and death tolls may be reduced or end. But the debts incurred will remain. Unemployment will increase. Businesses will fail and go bankrupt. The impact of massive government stimulus debts is likely just starting to be felt.
Endnotes
[i] Positive NPV projects create value for investors, whether nations or private individuals.
[ii] A nation’s economy is represented by Gross Domestic Product (GDP). GDP is composed of Consumption, Investments, Government Expenditures, and the Trade Balance. Nominal GDP includes both real growth and inflation, whereas Real GDP tries to discount out inflation to get an understanding of true growth rather than inflation. Countries with extreme inflation are not healthy, although their economic metrics seem to be increasing.