A little learning is a dang’rous thing



A little learning is a dang’rous thing’

So wrote the great English poet Alexander Pope, in 1711.  And more than 400 years later I shall prove him still to be correct – as I address a topic of which I have only a passing knowledge!

Credit markets

In this series, we have looked at the health, social and economic impacts of COVID.  Today we turn our attention to its impact on financial markets and in particular credit markets.

Every night our evening news gives a ‘market update’ on the daily gyrations of the ASX.   But what about the forgotten bigger brother of the equity markets – the credit markets?

In 2018 global equity markets (ie. stock exchanges) were capitalised at ~USD75 trillion, compared to ~US100 trillion for global credit markets, making credit markets one third bigger than equity markets.  Equity markets get more press because they are open to retail investors, unlike credit markets which are typically open only to large professional investors.  But that does not make them less important – quite the contrary.

Credit spreads

Other than being a critical source of debt capital for our economies, credit markets also provide a great insight into the prospects of our economy and businesses.  The risk which lenders (bondholders) attach to corporate borrowers, is measured by the ‘risk spread’.  That is the difference or ‘spread’ between the interest rate earned on ‘risk-free’ credit returns (typically something like a US Treasury bond) and the interest rate earned on corporate bonds.   This graph shows that in times of high economic stress (such as GFC and COVID) that spread increases.

Jonty Financial Graph

What happened to credit spreads this year?

The credit spread in investment-grade bonds increased from ~100 bps to ~400 bps between 19 February and 23 March.

That is, in the month to 23 March, the credit markets (ie. lenders) decided that the impacts of COVID made it 4x more likely that corporates would default on their loans – and the markets saw that risk increasing exponentially.

But suddenly the credit risk expectations not only stopped increasing, they reversed rapidly – so that by 1 June, the ‘spread’ has dropped from 400bps to 181 bps.

And why?  Because on 23 March, the US Federal Reserve said it would do whatever was required to solve the looming credit crisis.  And this was shortly followed by a coordinated intervention by the G20 Governments and Central Banks.   By the end of May, more than USD 15 trillion has been unleashed through a combination of quantitative easing (~USD7 trillion), fiscal policy (~USD6 trillion) and loan guarantees (~USD4 trillion).

This intervention is extraordinary in scale (representing more than 10% of global GDP) and scope, with quantitative easing taking Central Banks into unchartered territory.  The US Federal Reserve led the charge through buying corporate investment-grade debt and high yield debt.  The Australian RBA has also intervened, lending against investment-grade corporate bonds, rather than the traditional security of bonds issued by sovereign Governments, banks or high-quality financial securitisations.  In a world where so much is mischaracterised as ‘unprecedented’, these moves were truly unprecedented.

So, the confidence of credit markets has been restored, but only because Governments and Central Banks have taken on significantly more debt, with public debt now forecast to account for more than 200% of GDP for several G20 nations.

What does this mean?

I don’t pretend to have any vaguely informed view of where this explosion in public debt will lead us.  However, two things are clear.  First, at some point, we will face another crisis.  And secondly, we will have much less firepower to deal with the crises when it comes.

I don’t know what the next financial crises will be, when it will occur or what will cause it.  But we only need to look at our recent history to know that it will occur.  Just in the last 25 years, we have had the Asian financial crisis (1997), Russian default and LTCM (1998), Dot.Com crash and Argentine debt default (2001/2), Sept 11 (2001), SARS (2003), GFC (2009) and the European debt crises and Japanese earthquake and tsunami (2011).   It is inconceivable that we will not confront another financial crisis in the next 20 years.   We should assume there will be one and that we will seek to mitigate its impact on our economy and our societies.

Our capacity to mitigate the impact of any future crisis is far more limited than it was a year ago, let alone 15 years ago.  The three obvious levers to mitigate the impact of financial crises are monetary policy (Central Banks reducing interest rates), fiscal policy (Governments increasing expenditure) and monetary supply (Central Banks creating more money).

  • With close to zero interest rates, monetary policy is now ineffectual.
  • With significant increases in public debt, fiscal policy is constrained. In last week’s interview Chris Hall, CIO of Ellerston, explained why we can’t just ‘grow’ our way out of this public debt, as occurred after WWII. The Global demographic trends will prevent this occurring, meaning that the debt will need to be repaid, thus limiting Governments’ ability to incur further debt to fund fiscal policy.  And if the ability to borrow is constrained, fiscal policy can only be funded by higher taxes, which reduces economic growth and further inhibit the ability to repay existing and future public debt.
  • Some theorists promote the concept of Modern Monetary Theory or MMT. MMT suggests that Central Banks can issue unlimited currency to grow the economy.  I struggle with MMT – the concept of infinity is always a tough one!  My schoolboy economics tells me that currencies serve two fundamental purposes: a means of exchange and a store of value.  With currencies no longer asset-backed, that store of value relies entirely upon public confidence.  Should that confidence dissipate, then the value of the currency falls.  And if that confidence falls sufficiently, the loss of confidence becomes self-fulfilling – I imagine to the point that MMT can no longer work.

In any event, of the levers we have to pull: the monetary policy lever has been pulled off the wall; the fiscal policy lever has been already been pulled with limited scope to pull it further; and the monetary supply lever (of the likely scale required) is based on an untried, untested and (to my mind) unconvincing academic theory.

So the upshot is that we will mitigate the impact of COVID, but in doing so compromise our ability to deal with the inevitable future crises – unless we take the time (and suffer the pain) to reset those levers.  If we don’t reset those levers (and we certainly did not post GFC) one day we will face a crisis which we cannot mitigate – and then we will have a real financial, economic and societal crises.   Recent vision from the streets of US cities given some insight into what that can cause.

But to quote Alexander Pope again:

‘Hope springs eternal in the human breast’