Markets have become rather complacent - liquidity conditions have eased dramatically since Central Bankers flooded the system with QE money to prevent further liquidity shock as the pandemic took hold. It seems clear that this has led to a risk rally and it might be argued that many asset classes are somewhat overvalued by this misallocation of surplus money as investors have chased yield. As the COVID pandemic comes under control with the global vaccination program, economic conditions are set to improve by late 2021. The market believes, and has priced in, a strong rebound in growth this year, supporting many assets which have already soared in value since March last year.
As central banks begin to pull back from “emergency measures”, it would be wise to ponder what effect the withdrawal of these policies might have for the second half of this year. Weaning markets off the liquidity surpluses that they have enjoyed for many months will no doubt be handled with extreme care by authorities globally. The benign scenario is, it all goes smoothly, Inflation expectations may rise a little, yield curves and credit spreads begin to normalise gradually and, as money is re-directed away from chasing returns, asset allocations might incrementally change.
However, unconventional policy has some undesired effects, and the debt mountain has continued to grow. Corporate leverage, issuance and debt have increased as low long-term interest rates have proved attractive to corporate treasurers. Access to low-cost credit has allowed many to survive by constantly refinancing their debt. These “Zombie” firms do not earn enough money to cover their debt interest payments, and the number of these are growing. There is an estimated $2 Tn of debt outstanding from so called “zombie” companies in the US alone.
An October 2019 report from the IMF warned;
$19 trillion of corporate debt is considered “at risk”, which the IMF defines as debt from firms whose earnings would not cover the cost of their interest expenses.
The IMF also cautioned the low interest rate environment has driven up demand for debt in emerging and frontier economies, with external debt climbing to 160% of exports, compared with 100% in 2008.....Given this warning was pre-COVID-19, it might be safe to assume that this situation has only been exacerbated by further QE effects.
At what point could this turn into a “risk-off” phase?
The key here might be rising inflation expectations, as evidenced by reaction in US breakevens, should Central Banks be forced to react with liquidity withdrawal and raising of interest rate rates, this could prompt an unwind.
Many investors have been forced to chase yield, with scant regard and little differentiation to credit quality, the assumption that rates remain low forever is high. There is a danger of a re-pricing in global debt markets in lieu of phasing out of cheap and easy money. Should we start seeing increasing credit downgrades, this could cause trouble in the form of widening credit spreads and a potential for a rush for the exit. If economies globally do not pick up as markets expect (and have priced in) there could be some major asset re- allocation and significant disruption, be prepared for volatile, illiquid and unpredictable markets.
What’s left in the central bank arsenal to combat a negative growth shock?
Negative, or even more negative rates? – the jury is out on this one, seems to me that the further forcing of savings into non- performing investments as that’s the only place you can get a positive yield is a dangerous game.
...more QE? – sooner or later this could precipitate a huge backlash, QE was meant as an emergency measure, not a panacea for every economic ill. “I promise to pay the bearer” only holds water when you stop printing more and more promises, and ensure that you can service those promises that you have already made. (part of the surge in bitcoins and other crypto currency value, is growing disquiet from this QE policy).
Economic cycles go hand in hand with capitalism, artificially trying to negate the effects of downturns using policy tools which grow your debt burden and push the problem down the road might be viewed as prolonging the pain and can lead to stagflation. QE is a turbo-charged policy tool, and can mask “the truth”. It should be only used to lessen the effects of a crisis. It should not be used to prop up economies, industries and markets which might be better served by the cutting back of dead wood. It has the potential to suppress innovation and growth in that resources which would be better served investing in new and emerging industry, processes, plant and technology, are allocated to keeping unproductive, inefficient and stagnating ones alive.
Liquidity shock-can markets’ cope with increased demand for margin, cash and collateral if things get choppy?
As mentioned at the start of this thought piece, liquidity abounds right now, but as in the past, much assumed liquidity can prove to be illusory, illiquidity only tends to be revealed “ex-post”. As volatility in assets increase, banks willingness to intermediate decreases, liquidity mis-matching increases, redemptions in money market fund’s increase and margin demanded by CCP’s increase. This “perfect-storm” causes an upsurge in demand for cash and “liquid” assets (HQLA).
Previously assumed liquidity in secured financing markets can rapidly disappear in these scenarios, as seen last march. When volatility increases, the demand for intermediation could easily outstrip the supply of capacity available to market users. These risks, and prudence, dictate that market users are urged to err on the side of caution when evaluating access to liquidity going forward.
Sourcing that additional liquidity should begin in benign conditions, not after the horse has bolted ...
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The views and opinions expressed herein are those of the author and do not necessarily reflect the official position of ConneXXion Markets. They are based upon information the author considers reliable, but should not be taken as investment advice and ConneXXion markets does not warrant the completeness or accuracy of any statements made herein.