Given the unprecedented times we’re living in, we thought that it might be helpful to send, once a week, a summary of 3-4 articles which reflect the new realities and their potential impact on our lives and assets. Our assessment is that it may take at least 3-4 years until we return to the pre-Covid 19 normalcy. Below are summaries of four intriguing articles with some unique insights. 

Our plan is to publish our commentaries on Tuesdays, the summary of the articles on Thursdays, and the weekly summary of market developments on Saturdays. Our clients will continue receiving private emails regarding market developments from our Managing Director.

Financial Times – The Fed’s Vietnam moment
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“Why not load the bazooka with the kitchen sink and go nuclear?” – This assessment of the Fed’s unparalleled response to the pandemic by Alan Ruskin of Deutsche Bank reflects the central bank’s commitment to secure prices, buoy employment, and stabilize the financial system in crises such as this. Robin Wigglesworth writes that while the Fed’s drastic response is certainly necessary to prevent a deep recession from becoming a depression, the financial leaders of tomorrow may come to rue today’s decisions, much as the decision to escalate the Vietnam conflict in 1961 “led to a series of seemingly rational but ultimately ruinous decisions.”

Chief among these risky maneuvers is the federal purchase of corporate “junk bonds.” While its primary actor will only purchase bonds below “investment grade” if those bonds were downgraded from that status after March 22 and were only downgraded as a result of the pandemic. However, a secondary body (the Secondary Market Corporate Credit Facility) will purchase junk bond funds, and a third program will “support top-rated slices of bundles of ‘leveraged loans’ and commercial mortgages.” These three initiatives come to a $850 billion bottom line, already half the size of the entire first wave of quantitative easing in 2008-10.

These moves are seen by some as a “de facto bailout” of risky companies (e.g. private equity companies who use risky leverage to juice returns). Not only does this raise the distasteful notion of “socialized losses and privatized gains,” but the question must be asked – if this is the response to the first market dive, what will happen if there is another? Will the Fed continue to take on riskier and riskier debt? And will it be able to cease doing so once the crisis passes? These and more questions will determine whether the Fed is able to emerge from the coronavirus quagmire victorious or will sink into the swamp.

Project Syndicate – Germany’s Judges Declare War on the ECB
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Germany’s Federal Constitutional Court has ruled that Bundesbank, the central bank of Germany, has no obligation to continue participation in the eurozone’s Public Sector Purchase Program (PSPP). Germany’s highest court believes the objectives of the program, which aims to extend liquidity and other forms of assistance to struggling eurozone countries, are disproportionate with the policy effects resulting from it and therefore violates the “principle of proportionality” as explained in the Treaty on the European Union. 

 The European Central Bank has recently expanded the PSPP to include a €750 billion Pandemic Emergency Purchase Program in order to address the Covid-19 pandemic. The German court’s decision requiring further reviews and justification of the program puts other eurozone countries at risk of falling out of the monetary union as they face a period of deep economic crisis. The issue has, once again, escalated the deep-seated political tensions within the European Union. 

Foreign Affairs – Chinese Debt Could Cause Emerging Markets to Implode
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Multilateral financial institutions such as the World Bank and International Monetary Fund (IMF) have stepped in to aid the world’s low-income countries as they face Covid-19 induced financial ruin. The World Bank and IMF have released billions of dollars worth in emergency funds to these nations while the Group of 20 (G-20) creditor nations have announced the suspension of debt repayment obligations through the end of the year. Though a member of the G-20, China is not extending as much goodwill as it seems. 

China signed on to the G-20’s pledge, but excluded hundreds of large loans the country has extended through its Belt and Road Initiative (BRI). China continues to demand debt interest payments on high-interest loans, forcing low-income nations to choose between servicing debts and buying essential goods to fight Covid-19 and bringing them to the brink of default. To make matters worse, foreign investors have withdrawn millions upon millions across emerging markets since the start of the Covid-19 crisis which has sent the currencies of emerging and developing countries into a tailspin. As a result, the costs of essential imports, such as food and medical supplies, have spiked. If China does not extend a hand to the nations it is smothering with debt, the global health and economic crisis will become unmanageable for many countries. 

Financial Times – A return to 1970s stagflation is only a broken supply chain away
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The circumstances of the impending economic recession bear little resistance to the suffocating stagflation of the early 1970’s – oil prices have collapsed, record unemployment has all but eliminated wage inflation, and demand is stifled under the weight of social distancing measures. Yet, says Stephen Roach of Yale University, the repression of consumer spending due to the pandemic could lead to a release of pent-up demand on the arrival of a vaccine, especially if that vaccine is delayed by a year or more. This may “spark an inflationary spiral that markets are not expecting.” Furthermore, the disruption of efficient global supply chains, a bastion against inflation since the 1980’s, could compound the problem by pushing producers to look to more expensive domestic suppliers, driving up costs as markets begin to recover. Not only this, but increasing debt and deficits could also contribute to post-coronavirus stagflation, as inflation would pull interest rates out of the zero range, slowing economic growth.

Despite these dangers, inflation may be the only way forward for beleaguered western economies. U.S. public debt is on track to reach about 120% of GDP, well beyond the prior post-WWII record of 106%. Yet near-zero interest rates, open-ended quantitative easing, and a massive debt overhang cast a deep shadow on the future of bond and equity markets.