“In a time of universal deceit – telling the truth is a revolutionary act”

Trump is not a complete fool. He knows enough to move oil prices up. Threaten to start a war in the Middle East. Works every time! Sure enough, stocks followed higher.

But, even St George would struggle to slay the microscopic dragon at the core of this unfolding crisis. Just a few months ago, none of us foresaw just how deep the downturn the coronavirus triggered could possibly go. In early February, I suggested we faced an economic hit similar to the SARS epidemic – a $40 billion hit to the global economy, and a 16% slide in markets. I massively underestimated.

There are a number of brutal realities:

  1. We still don’t know how much deeper the Virus will dig. The news is very mixed – the first wave is apparently passing in Europe and US, but there are still doubts on subsequent waves, and uncertainty about renewed infections around the globe. Lockdowns are being extended. The social distancing and lockdowns that have trounced the global economy in the short-term aren’t going to end overnight. They are set to continue, with only limited easing, for months, maybe through the year. We just don’t know, which means the real economic damage continues to escalate.
  2. Don’t look to global markets for guidance: they are detached from the economic reality because of renewed financial distortions from QEI (QE Infinity), government support, and bailouts. There is still an element of denial in the markets – but sentiment is beginning to shift as the evidence mounts. A host of indicators such as the rate of downgrades to upgrades being nearly 10/1, central banks buying Fallen Angel junk, and mandatory dividend cuts – all point to rising crisis. (There are still sound investment opportunities out there – but prices are seriously distorted.) The number of recommendations to buy gold is soaring – a sure sign of trouble.

Readers might be wondering why the authorities are apparently conniving at the market’s extraordinary levels? Why do they appear so keen to bail markets and maintain the illusion of normality?

That’s a story of consequences and pensions.

This story began back in 2008 when central banks, bank regulators and frustrated politicians played the blame game on the Global Financial Crisis. It was decided it was the banks who’d been at fault, but since governments now owned the banks and crisis had conclusively demonstrated the importance of banks within the global economy, they embarked on a programme to de-risk banks and their importance in the system. Remember all these promises about separating banks from investment banking, no bank being too big to fail, SIFIs and other such gibberish?

As a result, the most important trend of the last 12 years has been the transfer of risk from the then fragile banking systems to the wider, more diverse and less individually systemically important asset management sector. Converting bank credit risks into corporate bonds was one aspect. That risk is now largely held by asset managers is just one factor. Others included the rise of alternative lenders to SMEs, packaging receivables, debts, loans into formats asset managers could buy. Junk debt packaged as CLOS, anybody?

Guess where all the risk now resides?

There was a time when banks had whole floors, even buildings, full of credit officers busily doing the calculations on lending risks. They were supported by networks of bank managers, sector specialists and analysts who lived, breathed and understood every aspect of bank lending risk within the economy.

Today’s risk management department of a mid-sized asset manager is likely to be a small number of very clever accountants, who are massively underpaid in comparison to the front office portfolio managers.

These guys are managing our future financial security.

Over the last 12 years we’ve seen massive inflation in financial assets – stocks and bonds – as a result of financial repression, QE and ultralow interest rates. The last thing the authorities can contemplate now is a collapse or reset in financial asset prices. While incomes remained flat through the last decade, most Boomers and Gen Xers approaching retirement were placated and encouraged by the growth of their pension pots (missing the fact the asset management business have actually creamed off most of the appreciation of their financial assets as fees).

If markets collapse, and financial asset prices reset, governments are going to face very angry voters who will literally have lost their retirement pots, and a massive ongoing future debt burden.

Here in the UK, we are already moving to a future where £1.10 in every pound of tax collected by government will be going towards paying Civil Service and State pensions. (Yes, it means the government will be borrowing more and more.) You could argue that doesn’t matter under Modern Monetary Theory. But it does. The numbers will become even less sustainable if all the private self-saving pension schemes collapse, leaving a growing population of destitute elderly retirees to care for.

This spawns enormous challenges for governments:

What are the implications and limits of unbounded Modern Monetary Theory on economies, inflation and currencies? Can some nations simply write off the balance of National Debt held by central banks as a result of QE? Do taxes matter? What will monetary creation trigger in terms of inflation? How will FX markets react to burgeoning debt and inflation?

It’s going to be ever tougher for Europe – which has pretty much agreed already that today’s crisis meeting will simply keep kicking the can down the road. (I suspect the acceptance of fallen angels as collateral is anticipating the possibility S&P downgrades Italy to Junk tomorrow.) They are still coping – badly – with implications of the deeply flawed single currency, and the ultimate riddle remains:

How does the consensual committee government of the EU deal with the crisis of avoiding economic shutdown by mutualising debt in a community that won’t accept it?

The situation is likely to get even more difficult.

The planet is now headed into de facto global recession – with a very strong likelihood it turns into a deepest and sustained global depression on record. The degree to which governments around the globe are ditching every vestige of monetary and fiscal orthodoxy to sustain economic activity is astounding. Some will succeed, but many will fail – reordering the global economy for when it eventually recovers. The consequences in terms of social, political and geopolitical outcomes could be enormous.

If it goes wrong we face social unrest, revolutions and, because all the environment, overpopulation, and poverty issues remain, don’t rule out an escalation of resource driven wars.

The confusion and complexity of this crisis is truly extraordinary. But like most things – here in the West – we will probably muddle through.

Bill Blain is a well-known City of London commentator, and has 35 years’ market experience as an investment banker. He currently is Strategist at Shard Capital, a London-based boutique.

Republished from the Morning Porridge by permission.

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