Via the excellent Viktor Schvets at Macquarie:
Another question that preoccupies investors is whether we are facing a V or W or U-shaped recovery, and the possibility that what has started as an attack on the P&L might morph into a far more deadly and prolonged balance sheet recession.
1. First, regarding the shape of recovery, it is quite possible that it could be fast. As we have discussed in our notes, the pace will depend on lowering COVID-related panic and pacifying the petrodollar complex.
While we believe that recovery does not require presence of the vaccine, it would be difficult to achieve a meaningful opening of the economies, without ubiquitous testing and treatment options. We maintain that over the next several months, both of these conditions will be satisfied. At the same time, investors need to see that the supply of USD is sufficiently strong to overcome regular panics, and that spreads do not start boosting USD. In turn, this requires, a massive and ongoing expansion of the US monetary base as well as ability of the Fed to place USD into foreign hands via much more extensive and cheaper central bank swap lines. In that respect, the Fed is progressing rapidly on both fronts, with supply of USD now growing at close to a double-digit clip while swap lines are already capping pressures in the USD market. At the same time, having crushed USD yields, the Fed has massively narrowed real and nominal spreads. Also, speculative positions are currently not excessive. The combination of higher supply, narrower spreads and decreasing panic is already starting to weaken the USD. This is the key to any global reflation. At the same time, there are tentative signs of a breakthrough in the relationship between Saudi Arabia and Russia, and although recently agreed cuts (less than 10m b/day) are not yet sufficient, it is a distinct change of attitude. Thus, it is quite possible that the two key growth constraints could become more positive in the months ahead.
Currently, Macquarie’s desk strategy economics team expect a relatively shallow and protracted recovery, rather than a strong and quick V-shaped rebound, with both the global and the US economies contracting YoY through 2Q-3Q’20 and getting back to fairly indifferent but steady growth into 2021. As far as inflation is concerned, our team does not anticipate any significant inflationary spikes, which intuitively is in line with the gradual nature of recovery. Importantly, neither do they anticipate a strong disinflationary climate beyond 2Q-3Q 2020. We suspect that there is further economic downside in 2Q3Q 2020 numbers than what is currently baked-into the forecasts. However, the key unresolved issue is the possibility of a second wave into late 2020 and early 2021.
2. In terms of extending this P&L recession into Richard Koo’s balance sheet recession, we believe that over the last two decades, the dividing line between the two has become increasingly unclear (here). Given the importance of financial assets in driving almost al economic outcomes, any setback is now effectively a balance sheet recession. This makes investors nervous, as balance sheet recessions are associated with prolonged recoveries lasting years or even decades, with a permanent loss of potential output.
However, as we keep highlighting in our notes, unlike 1991 Japan or even the GFC in 2008, we now have far more aggressive public sectors (monetary and fiscal) and both the public and politicians are today far more attuned to relying on governments for support. It explains how quickly global policy makers coalesced around an extremely ambitious agenda when compared to debates and lingering uncertainty during prior discontinuities.
If we examine G5 (i.e. US, UK, Eurozone, Japan and Switzerland) Central Bank balance sheets, these have already expanded from the low of US$15.8 trillion in September 2019 to US$19.2 trillion by the middle of April. In other words, in just over six months, CBs have pumped over US$3.5 trillion of extra liquidity, or equivalent to the incremental liquidity supplied over an almost two-year period after the new Plaza Accord in February 2016.
At the current pace, public sector liquidity is already galloping at ~15% clip when compared to declines experienced for almost 18 months until September 2019. Although there are a lot of ‘smoke and mirrors’, and the pace remains discretionary, it seems highly likely that between backstopping almost every asset class as well as ensuring an orderly functioning of the Repo market, G5 central banks will extend their balance sheets by at least US$9-10 trillion through 2020 (CB assets rising from 36% to ~60% of GDP), keeping public sector liquidity growing at a 15%-20% clip, which is far more than pre-COVID nominal GDP growth rates for advanced economies of ~4%. All of this extra liquidity will need to find a home, and while some of it will be financing direct government spending, at least half will probably end-up in various asset classes. Also, unlike 2016-18, this time around, most of the liquidity is provided by the Federal Reserve rather than ECB or BoJ, which is far more important from a global reflationary perspective.
Thus, we maintain that the key risks facing the global economy is not the traditional balance sheet bugbears, such as overleveraged consumers or corporates, excessive real estate bubbles or undercapitalized banks, but rather ability and willingness of Central Banks and fiscal authorities to identify and corral excessive volatilities within the ‘cloud of finance’, and ensure that financial volatility does not spill over into real economies. CBs are not aiming for higher asset prices, other than to ensure that holistically defined assets do not suffer from uncontrollable value erosion, and the best way to do this is to control volatilities. Thus far, CBs have been relatively successful in that task, and even though most risk factors remain quite extended, at the very least, a significant rise in volatilities through February and March have been contained.
For example, banking and commercial risks (as measured by OIS and TED spreads) while remaining exceptionally high, have somewhat de-risked in the first half of April. The same occurred in most segments of the high yield market, whether we look at CCC or below, average or EM HY spreads. Also, basis points (or price of swapping currencies) returned to relatively benign levels. The same occurred with a number of key volatility indicators (such as VIX or MOVE).
In summary, while uncertainties are high and most risk indicators remain highly elevated, at this stage some easing of COVID-19 pressures and a great deal of monetary support as well as indications that petrodollar pressures might ease, has led to a moderation of credit and balance sheet risks. While there is no doubt that the latest IMF estimates2 are correct (i.e. it will take until 2022 for global economies to return back to pre-COVID levels, and if there is a strong second wave, it might take even longer), the key to the investment strategies is not so much the strength of recovery but rather the urgent need to stop looking into the abyss.
Our base case remains one of a protracted recovery, but we do not believe that inflationary pressures will cause any significant grief for investors. The key remains the ability of central banks to contain volatilities and avoid an uncontrolled cross-asset liquidation, prompted by a highly de-stabilizing mix of ETF, parity and volatility indices as well as computerized and algo trading.
In short, communism is here. Buy it if you dare!