“He allowed himself to be swayed by his conviction that human beings are not born once and for all on the day their mothers give birth to them, but that life obliges them over and over again to give birth to themselves”
― Gabriel García Márquez, Love in the Time of Cholera
No, I have not read this book.
I did manage to get through Nobel Laureate Garcia Marquez’s other acknowledged master work: “100 Years of Solitude”, and, while I recognized its literary excellence, on balance, it kind of annoyed me. For one thing, GGM wasn’t lying in the title: the story actually goes on for a full ten decades. Four generations in the lives of a single family. And they all have the same names.
It drove me crazy.
More importantly, it left me with no particular urge to read “Love in the Time of Cholera”, which (one has to admit) is a very catchy title. But I was able to get through the Wikipedia plot summary, and I can give that shorter piece, at any rate, a strong review. Both the book and the plot summary tell the tale of two star-crossed lovers, sworn to each other, but kept apart due to circumstance and familial constraints.
I freely admit that this narrative hit close to home for me. It moves me. In this troubled time, it almost makes me want to cry.
And that, for now, is all I have to say about that.
Other than this: I type out this note with the full knowledge that my thematic tactics here are a tad glib. Risk in the Time of Corona? Probably a little too catchy. Even for me.
But I’m going with it and will now move to what I believe are more pertinent observations. This above all: the virus-induced economic downturn we are likely to face is not by a longshot priced into the markets; certainly not after Friday’s monster rally, and even not, I believe, when we put our heads on our pillows Thursday night, with equity indices down >30% down from all-time highs we had enjoyed in those sweet, bygone days, just a month ago.
Because no matter what happens with the virus, even if it fails to wreak death and destruction on the masses, it will, will, in all probability, have taken a huge deflationary toll on the global and domestic capital economy. This, in my judgment, is unavoidable; it is only the magnitude of the hit that remains unknown. And none of us – even geriatrics such as myself – has ever experienced the carnage that is wrought by deflation.
But I did study this stuff in graduate school, and feel duty bound to share some of what I can remember.
Deflation sucks. Really sucks. Above all else, because it renders the cost of repaying debt prohibitive. It reverses the polarities of credit markets, which are founded on the notion that a dollar in one’s pocket is worth more than one promised at fixed points in the future. Upon this premise we have relied, built great societies, rendered, through the miracle of air conditioning, the City of New Orleans inhabitable in the summer, since we were sporting tails. Now, with the specter of deflation, the premise is in doubt.
And this at a time when global indebtedness is surging from one record level to the next.
But before I sink myself and all my readers into the depths of despair, allow me to reveal the solution to the problem, along with the hope and expectation that it comes to pass quickly: Massive Government Intervention: Fiscal Stimulus. Monetary Expansion. Credit Relief.
It’s all coming by the ocean-full, folks, and somebody’s gonna make a lot of money on this; maybe quickly. Maybe it’s us. I also wish to point out that my scenarios reflect, rather than certainties, the risks I see, and am therefore duty-bound, to describe.
So let’s get to the bad news.
Just take a peek at the time path of global financial obligations:
Bear with me as I provide a little context here. First, because it takes a good deal of time to tally these numbers, the chart above only takes us through June of last year. My guess, what with all of the cheap money out there and (at the time) no viruses menacing us, is that the number, at the end of 2019, might look a little more like $300 Tril. Which is a lot of bread to own The Man. More, in fact, and by a wide margin, than the IOUs that had accumulated in 2008. Remember ’08? When a credit collapse came this-close to unleashing a worldwide depression?
And with deflation, the hard road of repayment becomes nigh impassible. By way of example, let’s look at the journey of one company: Occidental Petroleum (Oxy Pete), whose fortunes I’ve been following particularly closely. This has not been a particular inconvenience to me, because Oxy Pete has been all over the news lately — among other reasons, because it lost approximately 2/3rds of its equity market cap over the last couple of weeks.
But I’m much more interested in the debt side of its balance sheet, and specifically its recent quadrupling of borrowings – from the relative pittance of $15B at the end of 2018, to its current level of $60B. Now, for the truly obtuse, let’s bear in mind that Oxy Pete is in the oil business, and, using a trick that us old economists cannot resist, let’s express its obligations in units of Crude Oil rather than dollars. I know some of you may find this wearisome, but please hang with me while I make this point.
Before last year’s borrowing binge, the bubbling crude was holding steady at around $50 per barrel, and here the math is easy: $15B of debt with Crude at $50/barrel implies that Oxy Pete’s obligations could be settled for a mere 300 million barrels – a considerable amount of the greasy stuff (the equivalent of about 10 days’ global production), but perhaps not a fatal one. With 4x the debt and Crude still holding steady at 50 (as it was until recently), the number explodes to 1.2 Billion casks.
But in case you missed it, Crude collapsed about a week ago. And now, if I slap a $30 price on the commodity, the liability expands to a rather alarming 1,680,000,000 barrels, or about 55 days of the world’s output. Which Oxy Pete may not have lying around. More importantly, in five quarters, the combination of excessive borrowing and the commodity price implosion has rendered its repayment burden 6x the levels it faced just 15 months ago.
So when its stock collapsed, it wasn’t just because the prospects of core operations took a turn for the worse. They borrowed $10B from Buffet alone last year – and he’s not a guy much accustomed to rolling over and getting stiffed. Thus, the sound you heard when Oxy Pete’s stock was crashing was its capital structure collapsing on top of itself; the handing of the keys over to the guy in Omaha and his pals. Poor Oxy. Poor Pete. Heck, the way things are going, maybe even poor Warren.
But enough about Oxy Pete, right? Let’s look at the whole Energy Sector, which accounts for approximately 10% of United States GDP. While this math won’t fly in an economics classroom, I think it would be fair to state that the ~40% decline in petroleum pricing power equates to approximately 4% in deflation terms.
And that’s just Energy. Virtually every sector of the economy will need to contract for us to tame this here Corona Tiger. Industrials, TMT, Housing, Transportation – you name it (maybe not Health Care) — all just went on fire sale. I beat it out of NYC on Thursday and do not plan to return until the coast is clear. Which could be weeks. Or months. I’m pretty sure that my spending during this time period is going to drop dramatically.
As is everyone else’s. And just until recently, we were basking in never-ending praise as to the resiliency of the U.S. Consumer, who accounts for approximately 70% of our GDP. How’s that looking now? Maybe ask a random sample of New York restaurateurs. Or any vendor in suburban New Rochelle.
Or consider the cancellation of March Madness: the two-week/15 city money spending binge which, since time immemorial has offered, for so many of us, an emotional bridge from Winter to Spring. The NCAA alone was fixing to bring in nearly $1B on the saga. Advertisers had allocated even a greater amount. Betting was projected at approximately $10B, but we’ll lay that aside because that money is mostly just a transfer of wealth from suckers to their enablers. But how about the hotels, restaurants, parking facilities, merch guys, etc.? My guess is that we’re looking at a loss of at least $5B to the overall economy.
They also – and unthinkably – just deep sixed the Houston Rodeo, and the $400M in revenues the rip snorting spectacle generates. And Houston is the Energy Capital of America. Home, incidentally, to Occidental Petroleum. Poor Houston. Poor us.
And that’s just two cancelled events. If you extrapolate the math… …Well. I. Just. Can’t.
Maybe things will look up by Cinco de Mayo; we can only hope. But fair warning: if this here menace extends to the start of NFL training camps, I won’t be responsible for my own actions.
More to the point, we’re looking at an economic contraction of epic proportions, and, unfortunately, this kind of thing feeds on itself. Prices of everything (other than maybe, and irrationally, toilet paper) will be on the down, and consumers will expect this to continue. So they will tuck their spending in even further, in anticipation of even greater bargains down the road. Money won’t sufficiently circulate. And banks won’t lend. Why would they? The amount they can expect to receive – if they get paid back at all – won’t be worth the risk of the service they provide. And while this is a well-kept secret among us econ types, it is bank lending that creates new money. I won’t go into the gory details here; suffice to say that most new currency does not come off of printing presses at registered mints. Instead, it appears, as if by magic, by the creation of new loans.
Thus, with the above-presented primer on deflation behind us, we can safely conclude that the government’s financial response to the crisis has thus far been woefully inadequate and will need to grow by many orders of magnitude to attack the financial issues that may await us.
That $50B Congress approved on Friday, which produced such a joyfully nostalgic rally at the close? It is little more than the equivalent of what it would take to return Oxy Pete’s debt down to levels where they resided a little over a year ago.
The $1.5B liquidity injection by the Fed? It equates to 0.0005% (0.05 basis points) of my above-mentioned estimate of global indebtedness.
So the government is going to have to do a sh!t ton more to even to begin to attack this problem.
And it will. In a world where uncertainty just took a quantum leap, you can count on this.
Let’s start with interest rates, which need to come dramatically down. Here, alas, I am compelled to revert to another faultily remembered grad school lesson – one involving the true economic costs of money. In the Dismal Science, there is a shady but important concept called the real interest rate, which is defined as the rate you see quoted on your screen, less an even shadier factor called inflationary expectations. The latter, of course, is unobservable, but one can, and arguably must, estimate it.
I’m going to be gentle here and set my inflationary expectations at negative 3% (i.e. my deflationary expectation is +3%). Now, let’s look at the forlorn path of equity valuations and yields on the 10-Year Note (Madame X) over the course of the troubled year of 2020:
Madame X Yields Drop as the Gallant 500 Retreats:
A close review of these misanthropic timelines reveals that just a month ago, when our equity indices were frolicking around all-time highs, the 10-year was throwing off about 1.6%. I’m gonna play with some math here, under the guise of poetic license, and set the rate of inflationary expectations at the time at about 1.5%. And, applying the formula presented above, we can fix the real interest rate, right around Valentines’ Day, at a meager 0.1% (1.6% – 1.5%). And this, again, with markets at all-time highs.
Fast forward to the present. Yes, as anticipated, 10-year yields have come down, but by an astonishingly tepid amount. In what I believe to be a moment of Fellini madness, Madame X sold off to a rising yield of nearly 1.0% this past week. Applying our time-tested formula, real interest rates, as measured in Madame X equivalents are now approximately 4.0% (Nominal Rate of 1.0% plus a deflation expectation of 3%) – forty times higher than where they were just a month ago. When the market was soaring. Before the global economy faced frightening contraction.
I was puzzled as to what fresh circle of financial hell had caused yields to actually rise this week, and I didn’t like the answer that came most prominently to mind. Our notes were selling off at least in part because investors needed liquidity. Now, if you follow the markets with any rigor, you should be aware that Madame X, in addition to her myriad other charms, is universally considered the most liquid financial instrument on the planet.
So, when her financial realms begin to dry up (as did those of her fetching sisters such as the Bund and the JGB), and are used as an ATM by investors, one can safely assume that our liquidity rivers, normally so deep and wide, are becoming narrower and shallower.
And rates must plunge here. Because no one, not even the U.S. Treasury, is gonna borrow right now at a real rate that high.
This means you can help yourself to as much of Madame X’s wares as you can afford, at what I believe to be bargain basement prices. If nothing else, it will help hedge your impaired equity exposure.
And whether or not you take this action, rest assured that the Fed will. The smart guys and gals with whom I reason believe that even last week’s massive monetary move just bridges the Central Bank to the next FOMC meeting – scheduled for St. Paddy’s Day (Did I mention the cancelling of the parades across the world? Even in Ireland? Apparently old Saint Pat can drive the snakes out of the Emerald Isle but is powerless against a mutating flu-like bug). The Fed is likely to go big on Wednesday. If, that, is, it can wait that long.
Beyond this, you can expect a much bigger fiscal package out of Washington. And soon. Everyone is staying home for the foreseeable future. No one is spending. In the commercial economy, orders are being cancelled, deals delayed, payables deferred/defaulted, etc.
And businesses will face a revenue and cash crunch. And, unless we are proactive with relief, massive layoffs could begin before you know it.
My guess is that the offices of all 435 members of the House of Representatives are being flooded with demands for said relief, and that this will continue and expand. It’s an election year. And it’s not about Trump vs. Biden (a Hobson’s Choice if ever there was one). When the layoffs start, everyone in Congress (even AOC) will be forced kick into action.
In light of all of the above, I don’t expect Friday’s rally to hold, and don’t believe we’ve seen a bottoming of equity valuations yet. I could be wrong, and I hope I am. But the math, right now, just doesn’t add up.
For all of this, and from certain perspectives, equity markets are likely oversold. The only answer to what plagues us, from a market perspective, is a massive fiscal/monetary/credit injection. We’ve got to reflate this economic balloon, losing air with each passing breath. And we have the tools to do it. It won’t be costless to deploy them, but the price of not doing so will be prohibitive. The deep pockets are aware of this and are biding their time/looking for spots to hoover everything up that they don’t already own. Our goal should be to place ourselves in a position to get in on the action.
So, what, in the meanwhile, should you do to relieve the suffering of your ailing portfolios? Well, first of all, unless you b!thched it up completely, do not blame yourselves for your losses. What has happened is an Act of God, and precisely the sort of risk we are all paid to take. All asset holders faced a downward value reset of their inventories, and it is likely to increase in magnitude. In all probability, it will pass. And those who have played it with calm, sobriety and sound judgment stand to make a fortune. Here’s hoping you are one of them.
Also, did I mention that you should buy the 10-year note? If not, forgive me. And if I did, let me repeat it: you should buy the 10-year note. Because it’s going to go up in price when everything else is plummeting.
And yes, I believe Garcia Marquez is on to something: periodic rebirth is part of the human condition. Now, arguably, is one of those periods. The lovers in “Cholera” had to endure a prolonged, painful wait before they could be joined as one, but (spoiler alert), through the power of persistence and love, they came together. Like a dream.
It’s a dream I dream. And I know you do to. If we rely on our considerable inner resources, we’ll get there.
Cholera last posed a major problem around 1920. It still exists but has spent the last hundred years in relative solitude. Love has abided. We now have Corona, and, with it, a passel of risk. There’s a way forward here, my darlings, but the path will be neither easy nor linear.
We can do nothing but call upon our efforts and judgments and apply them to the best of our abilities.
The rest we must commit to the hand of God.
Stay clean and safe out there, and, as always…
TIMSHEL