A world out of balance, tilting from one extreme to the other

The pandemic has triggered three key macroeconomic impulses: global demand shock, global supply shock and the oil war, which has pushed prices to long-term lows. This last event will lead to significant destruction of capital, and soon to structural unemployment.

In 30 years of working in this profession, I have not yet seen the economy hit three blows at once. I am reminded once again of 2008, when small events such as the closure of a high-yield fund by BNP Paribas, the closing of hedge fund units by Bear Stearns in 2007, and finally - the bankruptcy of Lehman Brothers, resulting in a nervous, systemic crash in the markets, just as quickly damaged the foundations of the economy.

Investments were extremely difficult at the time, and it was difficult to grasp the full picture of the economic consequences. Current events have already overshadowed the chaos of 2008 on some markets and we have unexpectedly found ourselves in a world where certain markets can gain and lose more in a day than it was in an entire year. There may be a bull market and bear market in the same week. The behavior of the markets this year is completely unprecedented and shows a lack of liquidity in the markets after this triple shock.

Volatility is the worst nightmare of traders and market makers: it is a situation in which prices become "discontinuous" or they jump like a plane in a turbulence. Buy and sell price spread (the bid / ask) from the ordered track 5-10, 6-11, 4-9 jumps suddenly from 5-10 to 25-35, and then to the sale price of 45 - but where is the buy price? 70? 90? This is a test for trading systems, how they deal with chaotic input. More importantly, however, this forces many financial investors to deleverage, as fluctuations in profits and losses are becoming too rapid, and counterparties are already initiating an avalanche of calls to replenish the deposit.

In the environment of panic deleveraging, the mantra "cash rules" begins to sound. Funds, banks, investors and even companies suddenly notice not only a dramatic depreciation of assets, but also crazy fluctuations in portfolio correlations and profits and losses.

Meanwhile, central banks are trying to respond quickly by offering "support" in the form of interest rate cuts and liquidity injections. This is some help for a company or fund basing part of its activity on loans, because it reduces the future cost of financing liabilities. This does not help, however, share prices or credit on the asset side. Here, the metaphor of "crowded theater with a narrow exit" applies, when everyone sells all kinds of assets for deleveraging. This sale often concerns assets with low liquidity even during the period prosperity.

This cycle is even worse than the previous ones because the current era of low and negative yields has led to a "pursuit of profitability", forcing players to take more and more risk and invest in extremely illiquid financial assets such as private equity or high risk corporate bonds.

Markets become most fragile when dealing with discontinuous price structures. The shock we see in Q2021 will affect the investment environment and risk tolerance in 60. However, it will also change the long-term investment model from a 40/XNUMX bond / equity investment - or on a similar basis of fixed income-weighted risk parity - to for adequate hedging through raw materials (protection against inflation) and long-term volatility (protection against fat-tailed price action).

In this situation, investors will be in a more favorable position. The common opinion that the scope of investment in assets covers only combinations of bonds / shares up to the most risky XNUMX% share positions, has always had its drawbacks, however, the illusion of security was measured by profits, not risk. At present, the risk can turn against us.

Economic Forecast

The triple blow to the world economy is almost guaranteeing that the 2020 economic year is already lost and policymakers should take all necessary measures to fight a real global recession.

The political response has traditionally been associated with lowering the price of money. However, because the feet FED they reached zero even before the start of QXNUMX, all the world's largest central banks were at the same level (and some even lower, taking into account the policy of negative interest rates). The potential of monetary policy is limited at best, and at worst - directly detrimental to the ability of economies to respond - as low money circulation means lower inflation and therefore less net credit demand.

We now have an output gap, a supply gap, and an energy sector struggling to survive as cash flow in 2020 shows significant losses for strong players and bankruptcy for the weakest producers.

The market is on the brink and may get out of control as the loans dry up, which are key to today's market - to the extent that US mortgage rates are rising despite the sharp decline in US thirty-year government bond yields. In other words, the market is tightening credit terms, even though the Fed is trying to loosen policy by cutting rates.

Since the central banks have run out of tools, we believe we are approaching the full implementation of Modern Monetary Theory (MMT), when politicians will take over from the losing central banks and increase spending without restrictions on issuing debt (real money printing!).

The first sign of this change was the UK budget, developed before the effects of the coronavirus materialized. It seems that the concept of filling the demand gap by the government was even accepted by Germany, following Draghi's declaration of 2012 ("making all necessary efforts"), announcing unlimited support for German enterprises, both large and small, through KfW, that is, the federal development bank.

The parallels with the Marshall Plan after World War II, when the United States granted unlimited credit to post-war Europe, to generate demand and help rebuild the continent's devastation. In economics, we have Say's law: the assumption that supply creates its own demand. And that's exactly what will be a good solution, because bankruptcy through debt deflation and credit implosion is not an option. Governments will create money beyond any balance sheet or off-balance sheet constraints. It is worth noting that Germany used a government agency for this purpose, not its budget.

Is the system so damaged or upset that things have to worsen before it can improve? Let others look for answers to this question. However, we are convinced that after the end of 2020, the political measures taken will trigger strong inflationary forces, which may even indicate a risk of stagflation.

Our investments will focus on expanding our portfolios with long inflation and long volatility. The era of low volatility since the global financial crisis has been the result of financial repression and lowering interest rates by central banks. Now this era is over. We found ourselves surrounded by further price discovery, which means significantly higher volatility, and thus cleaning valuation models private equity and other high-risk assets based on low interest rates, central bank interventions and the somewhat naive assumption that multipliers can rise indefinitely.

The global economy has become a financialized supertanker powered by credit and low interest rates. He was heading to Deflation Port, however, as a result of the current crisis, he had to change course as soon as possible - i.e. not very fast, and the sea is rough - towards High Inflation Port. The 2009-2020 bull market, the longest in history, has just died of a coronavirus. Meanwhile, our economic and political structures are the weakest since the 30s.

Fasten your seat belts - it will be a real adventure that no one else (except maybe the oldest of us) has ever experienced in your entire life.

The full version of Saxo Bank's forecasts can be downloaded here

source: Steen Jakobsen, Chief Economist and CIO Saxo Bank