A vector is defined by Merriam Webster as:
: a quantity that has magnitude and direction and that is commonly represented by a directed line segment whose length represents the magnitude and whose orientation in space represents the direction
and;
: an agent (such as a plasmid or virus) that contains or carries modified genetic material (such as recombinant DNA) and can be used to introduce exogenous genes into the genome of an organism
The vector in terms of direction and magnitude of the global economy and financial markets is undoubtedly down significantly. However, the vector of this vector is the COVID-19 virus.
This crisis is different in many ways from past crises. We have been warned in the past that a virus might pose a catastrophic risk.
“If anything kills over 10 million people in the next few decades, it’s most likely a highly infectious virus rather than a war.” (see Bill Gates, TED Talk, 2015)
The risks posed to global health and the global economy are massive. Some estimates of the financial impact have postulated dramatic drops in employment, increased business distress, and financial markets. The human cost of this vector will be incalculable suffering, disease and death.
However, many estimates stop short of the reality of our dire situation in addition to the health costs and suffering. By my calculations, in a worst-case scenario, the global economy could contract by more than 40% this year from the compounding of a global recession that leads to a global depression. This will mean massive market drops (possibly to 2009 levels), unprecedented unemployment, businesses closing, foreclosures, asset bubbles (real estate, oil, gas, high yield bonds, equities, etc.) bursting, interruption of supply chains and real changes to normal life.
The crisis will need, and may yet receive, massive government intervention. But this will not stop a global recession or possibly depression. When consumption, investments, and international trade are all significantly down, it is hard to imagine how global GDP will not follow. Governments will seek to fill the gap, but it will not be enough. Every government has the same problem, and needs money for its own health care, employment benefits and to support “essential” industries.
This crisis may be worse than the Global Financial Crisis (GFC) and nation’s with too much debt themselves may ultimately fail (Italy, Portugal, Ireland, Greece, Spain, Hong Kong or even Japan). Kyle Bass of Hayman Capital has pointed out Japan’s massive debt issues and inexorable population decline leading to a future crisis. This may be the spark that starts the conflagration that burns to the Keynesian endpoint, where interest on government debts can no longer be serviced.
COVID-19 and its effects may lead to a financial crisis indirectly as investment firms, banks, sub-sovereigns and sovereigns are forced increase their debts, write off assets, and then enter distress. Corporate distress, especially with high-yield bonds, may spread risk to the banks and other financial institutions. After all, capital flows between investors, through banks and to capital users. The origin of a crisis is just a spark, where the fire leads is unknown.
To be clear, there is no immediate banking or financial crisis today. The vector in 2008 was the Lehman Brother’s bankruptcy. In 2020, COVID-19 will also metastasize into the financial system. Last time Wall Street impacted Main Street; this time Main Street may well impact Wall Street.
The Post-GFC regulatory overhaul increased legislation but the problem of risk was envisioned as a financial excess, a lack of appropriate incentives and an executive compensation problem. Financial intermediaries and risk-taking would need to be reigned in and regulated. Furthermore, the concept of “no more bailouts” was enshrined into U.S. law and international banking rules. Now we are on the precipice of the greatest U.S. bail-out packages in history reportedly at over $1,000,000,000,000USD.
The risks to the financial system did not go away with the Dodd-Frank Act and Basel III. They were transformed. Today, we do not have crises with mortgage-backed securities or Collateralized Debt Obligations (CDOs) to worry about. However, we should worry about the massive OTC derivatives market which stands at a staggering 640 Trillion (in notional value) and what it might lead to, see Bank of International Settlements. Also, the continuing crisis in the Repo market remains significant. Problems in the repo market suggest a significant dislocation in this important financing arm for banks and other financial institutions which began earlier in 2019 prior to the emergence of COVID-19.
Many banks, at least in North America, appear well-capitalized and relatively stable. But we do have massive financial innovations that have made the markets more concentrated, like Exchange Traded Funds (ETFs). And we have more consolidation in asset managers rather than investment banks. ETFs pose a problem as many investors hold ETF index funds. So, when they sell, they sell the entire index. Rather than selling just some weak equities, this crisis will likely be steeper and faster as mass liquidation of ETFs throws the proverbial “baby out with the bathwater”. And we have more debt, more subprime, and more inflated equity markets, coupled with historically low interest rates. The risks to the global economy have changed. But we were due for a crisis. Below is a chart of what a market crisis might look like.
The above chart was part of a presentation that predicted a drop in equity markets to 2009 levels from an unknown risk or event. This presentation was given to a graduate university program in 2018, 2019 and again earlier in 2020. This kind of event was foreseeable if we are aware of history.
We are now in the unfortunate position of being locked into a near zero per cent interest rate policy, while steaming ahead with the same policies designed to get us out of the GFC into recovery and recapitalize the banks. We have historically low interest rates, energy and asset bubbles bursting, massive bubbles in the equity markets, increasing personal debt levels, increasing risk taking and consolidation of new financial innovations (ETFs) with significant consolidation of capital in gigantic asset managers, and international discord between traditional allies. More disconcerting is the poor leadership and impaired trust for our traditional institutions. We have more risk with fewer options to deal with problems.
And now we are hit with the perfect exogenous risk… a wicked vector. The result will be catastrophic. And I am not alone in these dire predictions:
Ray Dalio
https://finance.yahoo.com/news/ray-dalio-whats-happening-markets-135137108.html
Bill Ackman
https://finance.yahoo.com/news/hedge-fund-titan-bill-ackman-001919501.html
As the prescient Ackman said about the virus, “Hell is coming”. The reason for concern is the exponential growth of the virus and the lack of options and leadership from traditional sources. We have been slow and uncoordinated in our response to this crisis. No matter what your political position, the U.S. Congress is bitterly divided both for and against a recently impeached President.
Unquestionably, the White House failed to show leadership or coordination on this health issue with its traditional partners. Unfortunately, the President and White House did not take the vector seriously and staff reportedly called it the “Kung Flu”. The Federal Reserve’s ill-advised massive drop in interest rates did nothing to stop a market rout last week and shows no lasting impact. And interest rates at near zero levels leave little room for monetary policy to ameliorate extreme economic conditions or unfolding events.
The U.S. will be the hardest hit in terms of the virus with what may be the steepest trajectory for the virus, and its impact on people and businesses. The U.S. will not be able to lock down the entire country as it is inconsistent with American rights and freedoms and would likely be considered politically unacceptable.
The U.S. is the most international economy in the world and is open to the international risks. Each state or territory will decide its own haphazard path. Also, the U.S. and Europe will be more impacted as consumption is a larger proportion of GDP and will be impacted as consumer confidence drops precipitously. The economic impact, according to Dalio, will be over 4 Trillion USD to the U.S., and may be 12 Trillion USD for other nations. With great respect to Dalio, who is a brilliant thinker, I suspect that this number is low.
China recently showed numbers that suggest a drop of over 20.5% in retail consumption, and over 13.5% in industrial output, and fixed-asset investment down 24.5%. These numbers are likely low and will increase, and this was when it was alone in this virus disaster. International demand was steady. The virus impaired the Chinese economy internally. Now there will be a domino effect or contagion, as more nations head into recession, each nation compounds the economic impact. This will create a vortex of economic destruction as both supply and demand falter internationally. China’s experience may ultimately be the mildest, as it was the first and only at the time to suffer. Now we have many, many nations, at different stages, going through the same health disaster and economic downturn. Each will drag the others down with it. Each will be looking for its own government bail out or stimulus. Furthermore, how and when to restart the international supply chains will become a huge economic and logistical problem, as they have never ground to a halt before. How do you restart the economic heart of globalization? Will it return or do we need another economic and trade model?
The virus is more deadly and more prevalent than is being currently reported. The bottom line is that this is a deadly vector (like the Spanish Flu of 1918) with exponential growth trajectory. On March 22nd, 2020 we have over 267,000 confirmed cases in 184 countries, areas or territories.
This means if the current trajectory continues in 10 weeks then over 5 billion people may become infected. That is over half of Earth’s population. This worst-case scenario may be averted with some extreme public health actions, but the predictions of many experts is that millions, if not billions, of people will be infected in the next few months.
Accordingly, hospitals will be swamped, and access to drugs and medicine may be impaired as transportation and supply chains are dislocated. Also, recent studies suggest that fewer than 5% (1 in 20) of COVID-19 cases are being reported as testing is not available or not trusted. Many people hesitate to go to the doctor or hospital. If they have it then what is the point (most of the time it is a mild condition) and if you do not have COVID-19, then you may get it while you are there in a waiting room. It is an impossible situation for both health care providers (who have no treatments) and patients (who often must pay for an expensive test if it is available).
Unfortunately, the problem is bigger than we know right now. COVID-19 is likely impossible to contain and is more contagious than the flu. It is now airborne and can survive on surfaces for more than nine days according to some medical studies. It may turn into a vector like the Spanish flu (where between 20 million and 90 million people died and over 500 million people were infected). Currently, the numbers of people inflected with Covid-19 will reach into the millions by the end of April and thousands more will have died. This virus is growing at an exponential rate. Canada and the U.S. are reportedly doubling every 2–3 days. Other areas are doubling approximately every 3–10 days, including Brazil, Russia, India, Europe, and emerging markets. All nations are all on a steep trajectory.
This is a global pandemic and it will have unprecedented and unforeseeable impacts to our lives, jobs and finances as it develops in the next year. It will not be over by summer of 2020. Intermittent and inconsistent policies and quarantines will mean rolling pockets of sporadic disease outbreaks. Unfortunately, it appears each nation will set its own course and battle this virus alone, albeit at the same time. We should expect severe economic and health disruptions and many casualties to continue into the Fall of 2020 and beyond, with associated problems from corporate defaults, market crashes, and sovereign crises continuing thereafter.
In my book, When Prime Brokers Fail, I wrote the final passage:
The financial crisis has led to the development of new knowledge only by destroying the old. The paradox of knowledge is that only when old assumptions are proven wrong is knowledge advanced. With the rediscovery and recognition of the unheeded risks of the past, we have another opportunity to address the challenges of tomorrow. One can rest assured that the problems of tomorrow will be born from the solutions of today. (When Prime Brokers Fail, p.253)
As a child, Bill Gates thought the greatest risk was nuclear war. Lehman Brothers bankruptcy made us think the greatest risk to the global economy was the bankruptcy of an important financial intermediary. But COVID-19 is a vector that will impact the global economy in a massive and unexpected way. The legislation and regulations imposed to curb risk did not conceive of risk in this way and will not protect us today. Instead, they may hamper efforts of a bail out or other economic support. We now know that regulating financial firms to avoid bankruptcy is insufficient to protect an interconnected global economy. It seems trite to even say it.
Be prepared for the worst with the COVID-19 crisis. We may be headed for a global depression born of a vector and the economic policies of the past.