[UltraVid id=22 ]the question on everyone’s minds at the moment is whether this sell-off in equity is going to evolve into a much larger crisis now there’s a beautiful framework that’s been created by the economists hyman minsky and what he says is that when we have a very long period of economic expansion as we’ve just seen then it can inflate credit bubbles so we’ll look at an example of a potential credit bubble in developed markets but also one in emerging markets and if you do want to keep abreast of whether this is evolving into a crisis what better way could there be than our free weekly market round up there’ll be a link to that at the top of this page so now let’s look at that in a bit more detail this is not a recommendation if you want advice tailored to your specific circumstances seek independent financial advice the initial short-term reaction to the coronavirus has been a sell-off in risky assets and by risky I’m referring to equity funds but also real estate investment trusts and other risky assets such as Bitcoin where our safe haven assets such as gold and here I’ve got the iShares gold tracker in the US have actually risen and the longer duration government bonds such as those in the US long duration Treasury ETF TLT have risen considerably as yields of fallen you can see that split between safe havens and risky assets more clearly if we look at a selection of Vanguard funds in this case denominated in Sterling the funds which have performed best are those which have government bonds inside them in the euro zone in the US but also in the UK and as the equity assets which had performed worst so if we look at the live strategy funds life strategy 20 which only contains 20% equity has only lost 0.6 percent since markets were at their peak on February the 19th and as we dial up the amount of equities have 40% 60% 80% and a hundred percent you can see that the losses mount up to over 9% for life strategy 100 which is just a globally diversified equity fund if we look at indices rather than funds you can see that gold has rallied by 1.6 percent say that peak for equity markets in mid-february and the epicenter of the outbreak in China has actually started to rally because it does look like the virus has been contained in China as it spreads through the rest of the world whereas commodities like oil which are very sensitive to global growth have lost a lot of their value as have countries which depend largely on oil exports such as Russia now the Falls we’ve seen so far are far from making equity cheap if we look at the forward price to earnings ratio for the S&P 500 that certainly fallen a lot but currently that just brought it into fair value compared to the last five years and if we look at a more representative ten-year period we’re still considerably overvalued compared to forecast earnings for 2020 now those earnings forecasts have not factored in the effect of coronavirus if those do get revised downwards then effectively that would lower the safety net for valuation of the S&P 500 and that would fundamentally justify a larger fall in prices but we’re not going to find out about that until we wait for the next earnings season and they only happen quarterly so to get real clarification on earnings growth in the US we’re going to have to wait three to six months and that six-month period is going to be critical for determining what happens to prices over the medium term hyman minsky came up with this framework to think about cycles in the credit market but we can apply it more generally to other markets such as the equity market he said that these cycles happen in five stages he called the first stage displacement there are many forms of displacement which he considered it could be the development of a new technology such as the railways or it could be the outbreak of war the transition from fossil fuels to electric vehicles or the development of the internet following one of these displacements what you typically see as a boom the mosaic browser was introduced in 1993 and that gradually developed a whole new infrastructure and although wasn’t wholly responsible for the rally that followed it certainly became more important for equity growth as the decade of the 90s wore on the next stage is called euphoria during this period we saw many Oh’s or initial public offerings for companies that were simply burning cash but which still managed to come up with huge valuations so for example the company Priceline floated in 1999 and practically overnight it got a valuation of almost 10 billion dollars and people were saying crazy things like valuations don’t matter at a certain point people start taking profits in other words selling at these very inflated prices in 2000 Barron’s published an article called burning up which warned that Internet companies were running out of cash fast following the profit-taking stage we get a stage of panic and in the u.s. this might have been triggered in 2001 when there was a recession from March to November and then the next cycle started another useful framework which Minsky came up with is called the financial instability hypothesis Minsky says that capital can be raised using three different types of unit the safest is called a hedge financing unit these structures are mostly funded by equity in other words they depend very little on borrowed cash and they can satisfy all of their payment obligations in terms of interest and principal repayments with the cash flows generated by the business a slightly riskier form of financing unit is called speculative finance the cash flows of the business can fulfill all the income obligations but they can’t repay the principal this means that an entity has to continually roll over their existing debt to repay their maturing debt which means they have a permanent state of indebtedness so for example the US government always has outstanding debt and is continually having to roll over that debt by issuing new Treasuries and many companies are in the same situation the most risky form of financing is a Ponzi unit and in this case the income cash flows can’t fulfill the income payments or the principal repayments and this is a reference to a Ponzi scheme where new investors to a business are the source of capital to pay obligations to existing investors now a world in which we just have the safest form of financing which is hedge financing leads to a stable State in other words an economy which seeks and contains an equilibrium state which is stable but if the economy is dominated by speculative and Ponzi finance then it becomes a deviation amplifying system in other words an unstable system that leads to bubbles and crashes and what’s relevant to the current situation is when Minsky says that if we have a protracted period of good times and of course we’ve just had over a decade of US economic expansion capitalist economies move from hedge finance which is the safe form to a structure in which you get lots of speculative and Ponzi financed amounts because people are trying to get higher capital returns by buying riskier assets one example of this is the leveraged loan market in the US but also in Europe a leveraged loan is when you take a syndicate of banks which is just a group of banks that issue alone to companies which are heavily indebted and that means that they tend to pay a higher rate of interest for which there’s a great demand in a yield starved economy as we’ve had recently and leverage means that there’s lots of debt compared to a company’s assets the size of the leveraged loan market isn’t much less than a trillion US dollars and it’s been growing very rapidly furthermore the credit quality has deteriorated as time goes on the greater accompanies leveraged the greater the risk of default when interest rates start to rise or if there’s a macroeconomic shock and investor protection which is written into the documentation of these loans has deteriorated over time these protections which are called covenants show that the quality of the debt which has been issued has weakened I think leverage loans form a perfect example of what Minsky would have called a Ponzi unit one way to think about the spread of fear in one of these markets sell-offs is like the spread of disease the science of the spread of disease is called epidemiology but really what it comes down to is people talking to each other it’s illustrated in this wonderful cartoon by cow which shows how one misheard comment which contains the word Excel gradually transforms into a selling frenzy and when someone’s overheard saying goodbye it turns into a buying frenzy in his book exuberance The Economist Robert Shiller gives an example of how the SEC who is part of its market surveillance has to track communications to detect insider trading he cite an example in May 1995 when a secretary at IBM was asked to photocopy documents which referenced IBM’s takeover of Lotus Development Corporation now this was supposed to be a top secret the only person she told about this was her husband who was a paging system salesman On June the second her husband told one of his colleagues at work who 18 minutes later bought some shares based on this insider information and of course that’s illegal he also told a computer technician about this who called a whole bunch of his friends by June the fifth when the takeover was announced 25 people connected to this core group had spent half a million dollars based on this tip that included a pizza chef an electrical engineer a bank executive a dairy wholesaler a former school teacher the gynecologist an attorney and four stockbrokers and what this shows is both the power of verbal communication from our friends and colleagues but also the speed at which this information can now spread and this is the primary conduit by which fear probably spreads through markets and this is what really sets apart this epidemic from previous ones which is the prevalence of social media which can spread fear amongst investors now let’s consider what might be the longer-term impacts of markets once we’ve got over this initial fear response a book that’s always worth referring to is called this time is different which makes a science of looking at previous crises here they’ve got a whole bunch of banking crises since 1890 the common cause of these crises was things like commodity prices falling such as a drop in copper prices which caused banks to become insolvent world war 1 was also a common cause of banking crises then in 1991 and 1992 it was a real estate crash in Nordic countries but also in Japan which triggered a banking crisis in several countries due to the development of global capital markets it’s now much easier to invest international which means capital can flow very rapidly to emerging market countries but unfortunately it can also flow outwards very quickly too and this triggered the Mexican tequila crisis in the early 1990s as these capital inflows reversed and we also saw that in the Asian currency crisis and of course in 2007 and 2008 the trigger was the subprime real estate market on the basis of all those examples a variety of authors have come up with a rough model of how a banking crisis happens following a stock and real estate market crash we often see an economic slowdown which can lead to some or all of these events taking place a currency crash and emerging markets have been particularly prone to these although what characterize markets at the moment is a lack of inflation and that can lead to default on sovereign debt that’s much more likely in emerging markets than in developed markets this time around certainly for developed markets a banking crisis is much less likely because regulators have been very careful to make sure that banks are well capitalized but you never really know what’s on the balance sheets until a crisis hits there’s a great publication by COEs Nagel owned saw gay and sugawara called global waves of debt causes and consequences they point out that low interest rates which of course we’ve seen for over a decade now combined with innovations or financial market changes which promote borrowing have consistently led to waves of debt in the past now what’s unfortunate is that these waves of debt always ended with financial crises and usually with a global recession or at least a slowdown the amount would include the recessions of 1980 to 1991 and 2009 but also just downturns like in 1998 in 2001 the usual trigger for these crises was a shock and here’s a shock looking person to illustrate that and the effect of the shock is to increase investor risk aversion as people pull back from risky assets such as equity and high-yield credit and leveraged loans the cost of funding increases for those instruments you also get a sudden stop of capital inflows to emerging markets and the consequence can be a deep recession currently were in the fourth wave according to the authors which is quite similar to the previous three in some ways the first and obvious one is that we’ve had low interest rates which means that people have been searching for yield which has created that demand for Ponzi units and a narrowing of spreads in other words reducing the borrowing costs of emerging markets and this demand for local currency bonds has certainly increased borrowing by emerging market countries but it’s not just sovereign debt which is increased it’s also corporate bonds that’s companies in emerging markets borrowing in international bond markets and recently this story has been one of slowing global economic growth which increases vulnerabilities to shocks such as the corona virus the market which really stands out is China since 2010 there’s been a significant increase in bond issuance both in the domestic Chinese market and to a lesser extent in international markets but that’s also true of Brazil South Africa Russia and other emerging markets in developing economies and the amount of debt outstanding as a proportion of the economy has increased from less than 40 percent in 2007 to more than 50 percent in 2018 and the increase has been broad-based it isn’t focused in just one country and corporate debt which is when companies borrow has risen even more rapidly than sovereign debts when governments borrow the fourth wave is characterized by three differences to the previous waves the wave is larger with a twenty percentage point growth relative to GDP in a third of emerging market countries the growth has been faster as an average of 7% growth in debt to GDP per year since 2010 and it’s been broader because it affects more than 80 percent of emerging market countries so if you do hold a merging market debt as I do you’re probably growing more nervous about what the effect will be of the sudden decrease in risk appetite now governments and central banks are trying to fight back so for example the Chinese government has encouraged companies in China to issue coronavirus bonds the deal is that if you spend a proportion of the capital you raise to help try and control the virus then you can get very cheap capital the US central bank the Federal Reserve also called an emergency Fed meeting which it hasn’t done since 2008 in which it cut its interest rate by 50 basis points now normally it only cuts in point two five percent notches so this was a two notch cut in the interest rate but the effect on markets was negligible and the Fed has a lot more leeway because it had already started raising rates until the end of 2018 the Bank of England hasn’t even started to cut rates but it’s certainly thinking about it but the Bank of Japan and the European Central Bank have a lot less leeway because rates there are already negative and the Bank of Japan’s balance sheet is already bigger than Japan’s GDP so starting a new program of asset purchases or quantitative easing it’s going to be much more difficult in Japan than elsewhere fortunately the US had already started to run down the size of its balance sheet and the Bank of England never really ran it up in the first place so this response is called monetary policy and it usually takes the form of setting interest rates or alternatively asset purchases in which they buy government bonds or in the case of the Bank of Japan they also buy Japanese equity exchange-traded funds President Trump has suggested that they have a payroll tax cut and what would be good about that would be that it would create a very rapid stimulus by putting money straight into people’s pockets and hopefully that would make them spend money to counteract the negative economic effects of the outbreak but there’s been some political wrangling to determine what the form of that stimulus should be the chair of the US Ways and Means Committee Richard Neal wanted more targeted funding which would accelerate vaccine development and provide health workers with the medical supplies that they need but one of the benefits of low interest rates is that governments can borrow at almost zero cost in order to fund this fiscal stimulus because when the government spends lots of money that money flows through the economy and stimulates growth but again Japan is fairly limited in terms of how much it can spend because it’s already heavily indebted as is Italy which is also heavily hit by the corona virus but in the US the UK and certainly in Germany there’s a lot more leeway for fiscal stimulus because debt to GDP ratios are much more manageable although we haven’t seen any hard data so far organizations such as the OECD have downgraded their growth forecasts for 2020 and beyond and the biggest downgrade of course has come for China the forecast for 2020 has fallen from above six percent to under five percent a mantas human that the virus is contained global growth which was already weak has also been downgraded that was assuming their base case scenario which was containment of the virus if there’s a broader contagion scenario the impacts will be much larger with almost a two percent drop in Chinese GDP with global growth 1.5 percent smaller but it was only 3% in the first place so that’s a halving of global growth so the key things to watch in the months ahead is what happens to corporate earnings because that will determine whether the impact of coronavirus is going to be large and longer-term or more of a short sharp shock to the global economy and to asset prices so that forecasts from the OECD does look quite alarming a Harvey of global growth would certainly impact equities further but the thing to remember is not to panic for most people it’s best to find an equity bond split you’re happy with and to stick with it now that’s the kind of question we often get on our Sunday evening call you can join that for just $5 a month you also get access to slack and all of our previous calls which is growing longer all the time and as always thank you for listening