The Fed's Only Choice - Exacerbate The Wealth Gap, Or Else

by: Lance Roberts


- According to the Economic Policy Institute, the top 1% take home 21% of all income in the United States, the largest share since 1928.

- A big contributor to the "wealth gap" was the rise in the stock market fostered by trillions of liquidity injected into the markets by Federal Reserve.

- For 90% of Americans, there has not been, nor will there be, any economic recovery.

"Gradual inflation has a numbing effect. It impoverishes the lower and middle class, but they don't notice." -Andrew Bosomworth, PIMCO Germany, as quoted in Der Spiegel

The rise of populism, evidenced by the success of Donald Trump, Bernie Sanders, and Alexandria Ocasio-Cortez, is rooted in the emergence of the greatest wealth and income inequality gap since the roaring '20s.

According to the Economic Policy Institute, the top 1% take home 21% of all income in the United States, the largest share since 1928.

There are a variety of social, political, and economic factors driving this growing discrepancy, but one critical factor is ignored - The Federal Reserve.

The Fed has inserted itself into a key role in economic growth and, along with that, their contribution to the rising imbalances between economic classes.

The Wealth Gap Explodes

Over the last decade, as stock markets surged, household net worth reached historic levels. If one just looked at the data, it was clear the economy was booming.

However, for the vast majority of Americans, it really wasn't. This was previously shown in data from the WSJ:

"The median net worth of households in the middle 20% of income rose 4% in inflation-adjusted terms to $81,900 between 1989 and 2016, the latest available data. For households in the top 20%, median net worth more than doubled to $811,860. And for the top 1%, the increase was 178% to $11,206,000."

Put differently, the value of assets for all U.S. households increased from 1989 through 2016 by an inflation-adjusted $58 trillion. A full 33% of that gain - $19 trillion - went to the wealthiest 1%, according to a Journal analysis of Fed data.

What policy-makers, and the Federal Reserve missed, is the "stock market" is NOT the "economy."

This "wealth gap" can be directly traced back to a decade of monetary policy that almost solely benefited those who either had money to invest in the financial markets or were directly compensated  through increases in corporate asset prices. However, those policies failed to produce substantial rates of either wage growth or full-time employment.

"But Lance, the media said that employment was at historic lows."

True, but this was because of a large number of individuals no longer counted as part of the labor force. If we take a look at "full-time employment," which are the jobs supporting families, and strip out those over 54-years of age to remove the "but boomers are all retiring" nonsense, we see a very different picture of employment. The weak increase in full-time employment is a key factor behind why both economic and wage growth remained weak.

The New York Times recently went further into the numbers:
"America's economy has almost doubled in size over the last four decades, but broad measures of the nation's economic health conceal the unequal distribution of gains. A small portion of the population has pocketed most of the new wealth, and the coronavirus pandemic is laying bare the consequences of the unequal distribution of prosperity."
Of course, a big contributor to the "wealth gap" was the rise in the stock market fostered by trillions of liquidity injected into the markets by Federal Reserve. As NYT noted:
"The affluent, of course, do tend to own stock, and the median net worth of the richest 10 percent of households rose 13 percent from 2007 to 2016 (the last year for which the Fed has released data).

Another way to view this issue is by looking at household net worth growth between the top 10% and everyone else.

Since 2007, the ONLY group that has seen an increase in net worth is the top 10% of the population, which is also the group that owns 84% of the stock market.

This is not economic prosperity.

This is a distortion of economics.

The Fed Did It

This can all be tied directly back to the Fed's monetary interventions. From 2009 to 2016, the Federal Reserve held rates at 0% and flooded the financial system with 3 consecutive rounds of "Quantitative Easing" or "Q.E.," and ensured that financial conditions remained extremely accommodative. 

In return, banks were supposed to use the low-rate environment to loan money to businesses, which would in turn expand capacity and hire workers, who would increase consumption boosting economic growth.

Unfortunately, it didn't work out that way as monetary policy is a "disincentive" for banks to lend. Instead, liquidity was recycled into the stock market, through which they have a direct and vested interest. While stock prices rose, the bottom 90% of the economy struggled to make ends meet, which capped economic growth.

Of course, given the banks didn't push the money into the economy, but bottled it up for their own financial interests, monetary velocity steadily declined.

If we assume a 15% decline in GDP in the second quarter, the disparity between the Fed's interventions, the stock market, and the real economy becomes abundantly clear. For 90% of Americans, there has not been, nor will there be, any economic recovery.

Not understood, especially by the Fed, is that the natural rate of economic growth is declining due to their very practices.
"Low, to zero, interest rates incentivize non-productive debt. The massive increases in debt, and particularly corporate leverage, actually harms future growth by diverting spending to debt service."
The rise in corporate debt, which in the last decade was used primarily for non-productive purposes such as stock buybacks and issuing dividends, has contributed to the retardation of economic growth.

The Federal Reserve Act requires that monetary policy achieve maximum employment, stable prices, and moderate long-term interest rates. The problem is the Fed targeted a small, but consistent 2% rate of inflation. 

What they didn't realize was those policies were creating a debt bubble which slowed economic growth and created deflationary pressures. The result was an increasing set of dynamics which harmed the poor and middle class while enriching the wealthy, and widened the inequality gap.

The Fed Has No Choice But To Make It Worse

With the economy now on the brink of an "economic depression," and in the middle of an election year, the Federal Reserve had a choice to make.
  1. Allow capitalism to take root by allowing corporations to fail, and restructure, after spending a decade leveraging themselves to hilt, buying back shares, and massively increasing the wealth of their executives while compressing the wages of workers. Or,
  2. Bailout the "bad actors" once again to forestall the "clearing process" that would rebalance the economy, and allow for higher levels of future organic economic growth.

Obviously, as the Fed's balance sheet heads toward $10 Trillion, the Fed opted to impede the "clearing process." By not allowing for debt to fail, corporations to be restructured, and "socializing the losses," they have removed the risk of speculative practices and have ensured a continuation of "bad behaviors."

Unfortunately, given we now have a decade of experience of watching the "wealth gap" grow under the Federal Reserve's policies, the next decade will only see the "gap" worsen.

While there are many hoping for a "V-shaped" recovery in the economy following the "restart" of the economy, the reality is that recovery may take much longer than expected.

Furthermore, given that we now know that surging debt and deficits inhibit organic growth, the massive debt levels being added to the backs of taxpayers will only ensure lower long-term rates of economic growth. The chart below shows the 10-year annualized run rates of economic growth throughout history with projected debt and growth levels over the next decade.

History is pretty clear about future outcomes from the Fed's current actions. 

More importantly, these actions are coming at a time where there were already tremendous headwinds plaguing future economic growth.
  • A decline in savings rates
  • An aging demographic
  • A heavily indebted economy
  • A decline in exports
  • Slowing domestic economic growth rates
  • An underemployed younger demographic
  • An inelastic supply-demand curve
  • Weak industrial production
  • Dependence on productivity increases
The lynchpin, like Japan, remains demographics and interest rates. As the aging population grows becoming a net drag on "savings," the dependency on the "social welfare net" will continue to expand. The "pension problem" is also going to require further bailouts and more government debt.

Yes, another $4-6 Trillion in QE will likely be successful in inflating a third "bubble" to counteract the deflation of the last.

The problem is that, after a decade of pulling forward future consumption to stimulate economic activity, a further expansion of the wealth gap, increased indebtedness, and low rates of economic growth, will weigh on future economic opportunity for the masses.

Supporting economic growth through increasing levels of debt only makes sense if "growth at all cost" uniformly benefits all citizens. Unfortunately, we are finding out there is a big difference between growth and prosperity.

An inflationary policy that minimizes concern for debt burdens, while accelerating the growth of those burdens, is taking a serious toll on economic and social stability.

The United States is not immune to social disruptions. The source of these problems is compounding due to the public's failure to appreciate why it is happening. Until the Fed's policies are publicly discussed and reconsidered, the policies will remain, and the problems will grow.

But, for now, it seems the Fed simply has no other choice.

Can the USO fund collapse?

By: Izabella Kaminska

© Bloomberg

This is a quick follow-up post on the USO piece out earlier as the fund has just announced it will be suspending new creations because it has run out of preregistered shares to provide to authorised participants.

Please excuse typos, et cetera (we are out of babysitting time and encumbered by a two-year old).

So what does it all mean?
ETFs (or rather ETPs, because the USO is actually an exchange traded commodity product) have to preregister shares in bulk to avoid having to go through a regulatory process every time a share is offered to the market.

They effectively retain this preregistered stash which they provide to APs whenever they deliver underlying basket constituents to them for creations.

This is not dissimilar to how some cryptocurrency ICOs retain coins with a view to selling them into the market over time.

The USO has now run out of registered shares to offer to APs and is thus suspending creations, but not redemptions which can still go ahead. Until its request for the registration of 4bn of new shares is approved, this will probably remain the case.

As the USO stated in its filings in anticipation of such a scenario:

In the event that there was a suspension in the ability of Authorised Purchasers to purchase additional Creation Baskets, management believes that Authorised Purchasers and other groups that make a market in shares of USO would still continue to actively trade the shares. However, management believes that in such a situation, Authorised Purchasers and other market makers may seek to adjust the market they make in the shares.

Specifically, these market participants may increase the spread between the prices that they quote for offers to buy and sell shares to allow them to adjust to the potential uncertainty as to when they might be able to purchase additional Creation Baskets of shares. In addition, Authorised Purchasers may be less willing to offer to quote offers to buy or sell shares in large numbers.

The potential impact of either wider spreads between bid and offer prices, or reduced number of shares on which quotes may be available, could increase the trading costs to investors in USO compared to the quotes and the number of shares on which bids and offers are made if the Authorised Purchasers were to still be able to freely create new baskets of shares.

In addition, there could be a significant variation between the market price at which shares are traded and the shares’ net asset value, which is also the price shares can be redeemed with USO by Authorised Purchasers in Redemption Baskets.

The foregoing could also create significant deviations from USO's investment objective, i.e., for the daily changes in percentage terms of its shares’ per share net asset value (“NAV”) to reflect the daily changes in percentage terms of the spot price of light, sweet crude oil delivered to Cushing, Oklahoma, as measured by the daily changes in the price of a specified short-term futures contract on light, sweet crude oil called the “Benchmark Oil Futures Contract,” plus interest earned on USO’s collateral holdings, less USO’s expenses.

Management believes that any potential impact to the market in shares of USO that could occur from the Authorised Purchasers’ inability to issue new Creation Baskets would not extend beyond the time when additional shares would be registered and available for distribution.

So what we can expect — in the event inflows remain constant — are greater tracking deviations for the fund, wider spreads, and a growing disconnect between the price of the ETF and its underlying net asset value. The ETF will probably trade at a premium.

This will also have an impact on the ETF’s influence on the underlying WTI market in which it is already overly dominant. Any buying support the fund had been offering to Front-month futures thus far will in effect be removed. This could lead to yet more weakness for oil prices.

Two quick specific follow-ups to our screencast we published this morning about the USO based on informed feedback (which, of course, we greatly value).

We showed a chart in which compared the USO’s shares outstanding to assets under management, and noted it was interesting that the former was growing more quickly than the latter. It’s fair to say, this is mainly due to the falling share price which will be impacting the value of legacy assets in relative terms. So no mystery there after all.

On the create-to-lend function which we discussed, we want to add that, in theory, the mechanism has the capacity to increase short interest in the fund without necessarily adding to shares outstanding. This is because of the way flows are internalised and offset by APs/PBs.

Back in 2010, Andrew Bogan et al explained how this sort of (effective naked) short selling creates a type of rehypothecation effect where the very same shares appear to be owned by many multiples of owners.

As he noted back then:

While an ETF owner believes their ETF shares represent ownership of the underlying shares of stock in the index that the ETF tracks, that stock is not always all there. Because of explosive short interest in some ETFs, owners of ETF shares often far outnumber the actual ownership of the underlying index equities by the ETF operator. One might ask how that can be possible, but the creation and redemption mechanisms inherent to ETFs mean that short sellers need not be concerned about the availability of shares outstanding when they sell an ETF short—since they can always create new shares using creation units to cover short positions in ETFs in the future. In essence, there appears to be no risk to being naked short an ETF since the short seller can always “create to cover”. This has led to some ETFs having shockingly large short interest as compared to their number of shares outstanding and for every additional ETF share sold short, there is another owner of that share.

As stressed above, the industry never viewed this as a risk because in theory there is no limit to creations if and when a short-covering run emerges in the market.

It is not at all clear that this is behind the recent growth of the USO, and indeed, better secondary market liquidity in the US means shares can often be located for shorting easily without the need for a create-to-lend mechanism. But in theory, anyone taking an exceptionally large short position or wanting a bit of discretion (remember the Paulson CDO short?) might still be inclined to engage in a create-to-lend contract specifically.

For more on how naked short-selling may lead to under appreciated operational risk in ETPs and ETFs do see this paper from 2016.

As it concluded:

Thus, the unique structure of ETFs and the AP’s ability to sell shares on an intraday basis that have not been created (or at least the underlying basket of securities has not been delivered) can lead to improvements to trading in individual ETFs but, at an aggregate level, it can create greater counterparty risk that has potentially destabilising effects in the broader market for not only ETFs but also the underlying securities held by these ETFs.

FYI we’ve reached out to USO APs and the USO fund managers to gain more clarity on what they think is driving the growth but are yet to speak to either.

No doubt buying interest from retail investors is a big part of the USO destabilisation story. But it’s possibly not all of it.

The United States Oil Fund mystery, revived

By: Izabella Kaminska

© Tanawat Pontchour/Dreamstime

What has happened before will happen again (as someone on a sci-fi TV show once said).

In 2008/9 the USO ETF (United States Oil Fund) roiled the oil market when its assets under management mushroomed in size in response to apparently epic inflows from passive long investors.

The issue at hand was the fund’s obligation to invest in front month WTI contracts which — under its investment mandate — it was charged with rolling over in a predictable manner every month.

Rolling contracts in such a way exposes fund investors to two possible scenarios: 1) disproportional outperformance because the market is discounting the future versus the front-month (a structure known as a backwardation), meaning it becomes cheaper to maintain the same position over time which leads to gains on a per ETF unit basis 2) disproportional underperformance because the market is pricing the future in at a premium relative to the front-month (known as a contango), meaning it becomes more costly to maintain positions over time which leads to losses on a per ETF unit basis.

As the fund’s open derivative positions began to dominate front-month open interest in what was then a contango — and thus loss-inducing — market, the rolls became game-able. The wider market soon realised that if it too piled into the contracts ahead of the fund it could profit at its expense by ensuring it would cost the USO ever more to rollover its positions.

In turn this front-running exacerbated the contango, which increased the profitability of buying physical oil and putting it into storage while selling it simultaneously for a guaranteed profit at some point in the future.

Much debate was had on the topic of whether index funds — due to their passive nature — had the capacity to distort the underlying physical market as a result. To calm concerns, regulators soon introduced stricter position limits on derivative contracts to limit the possible impact of outsized positions on physical markets.

From the get-go the fund’s transparency was a key part of the problem. It was just too easily anticipated in the market.

And yet, what people really wanted to know was how come — given the overall bearish sentiment at the time — retail investors were so keen to pile into the oil market so intensively at this point? How come they had so much more risk appetite for bottom-hunting than managed money investors or other institutions?

Over the course of the next few months and years, FT Alphaville discovered that attributing that sudden growth of the fund solely to bullish retail investors was probably too simplistic.

Things happening again

In March 2020, the USO fund once again began to mushroom in size as it did back in 2008/9 and again when oil collapsed in 2014. And, once again, people are asking how come ETF investors are so bullish when everyone else is still seemingly so bearish? Why do they have so much risk appetite for bottom hunting when no one else does?

The growth of the fund this time round is no less impressive. Since the end of January 2020 assets under management have grown from approximately $2bn to $4.2bn, with the fund occupying an increasingly dominant share of open interest in the front month contracts.

To expand on some of the less appreciated factors at play we thought we would wrap our insights into a 30 min screen cast:

The video looks at some of the arbitrage mechanisms in play, how authorised participants and market makers operate in the market, and how in some cases shorting demand can actually perversely encourage fund growth (as long as someone is prepared to finance the offsetting position).

An ETF’s AUM growth/ contraction is thus not solely determined by buying interest alone, but whether that “buying” is overpriced or underpriced relative to the indicative value of the underlying holdings of the fund.

We explain how ETF premiums over and above the indicative net asset value of the fund drive creations (and thus fund growth). But also how these premiums manifest both when there is excessive demand for an ETF relative to its underlying but equally when there is more selling pressure in the underlying than the respective ETF.

In the latter situation, the creations are not the result of “retail demand” but, to the contrary, the outcome of a desire to offload overpriced ETFs to potentially unsophisticated investors who don’t recognise the mis-valuation.

In conclusion, the driver of the AUM growth doesn’t have to be a rush of retail demand. Somebody somewhere has to buy the ETFs being created by the market. This is true. But it is the terms on which they are buying that matters.

ETFs, it turns out, are structurally designed to grow whenever the ETF unit is overpriced relative to the underlying, and contract when it is underpriced relative to the underlying. This makes them countercyclical by design. It is also what makes them so good at calling bottoms, irrespective of what underlying investor sentiment really is.

That’s not to say explosive growth can never mean explosive buying interest among ETF investors. But it can also mean explosive collapse in the underlying — with ETFs structurally and automatically positioned to counteract that selling pressure by absorbing excess supply into themselves via the arbitrage mechanism.

Investors and traders who understand this are better positioned than most to pre-empt explosive fund growth. This can be useful if a fund’s sudden growth goes on to influence its underlying markets disproportionately (à la the USO’s fund rolls) because the fund is now the dominant and supporting presence in those markets.

Resumption of Public Life in Germany

Scientific Experts Release Proposals for Loosening the Lockdown

The Leopoldina National Academy, Germany’s academy of sciences, recommends that schools be reopened soon. Businesses and public authorities are also expected to be reopened gradually. Travel should also be permitted under certain conditions, according to the report, which DER SPIEGEL obtained in advance of publication.

By Gerald Traufetter

The Pestalozzi primary school in the town of Dettenheim, Germany, is closed until further notice because of the coronavirus.
The Pestalozzi primary school in the town of Dettenheim, Germany, is closed until further notice because of the coronavirus. Markus Gilliar/ picture alliance/ GES

In her final public appearance before the Easter holidays, Chancellor Angela Merkel stated very clearly which scientific advice she intends to consider in steering further action in response to the novel coronavirus pandemic.

"For me, a very important study will be that of the National Academy of Sciences, the Leopoldina,” Merkel said at a press conference on Thursday. The chancellor said it was important to be "on firm ground” in making the upcoming decisions. Merkel said this is the only way that the many drastic restrictions on public life can be lifted again.

The report is now complete, and it appears that the Halle-based research institute has lived up to expectations. In their 19-page ad hoc statement, the scientists and experts considered the medical, economic, constitutional and psychological factors and provided precise recommendations for the next actions to be taken by the German government.

"Criteria and strategies” need to be developed "for a gradual return to normality beyond the acute restrictions that have been imposed on basic rights such as the freedom of movement,” the researchers at the Leopoldina National Academy of Sciences write in their position paper, which was provided to DER SPIEGEL in advance of its reléase.

The 26 scholars spent hours over the Easter holidays discussing the current status in Germany before coming to an agreement on the recommendations they submitted to the German government. Highly regarded scientists including the Lars Feld, the chair of the German Council of Economic Experts, which advises the government on economic issues, ethicist Claudia Wiesemann, legal philosopher Reinhard Merkel and sociologist Armin Nassehi, among others, agreed on the language via conference calls and came up with clear standards for lifting the restrictions currently imposed in Germany.

"We wanted to adopt a calm and balanced approach in the heated political debate, and we wanted to give people an optimistic outlook,” Leopoldina President Gerald Haug told DER SPIEGEL.

The overriding priority is "the protection of every single person” from getting infected with the coronavirus.

"We have to avoid a second wave of infection at all costs,” he said. "The basic rule must be that we continue to observe the (social) distancing and hygiene measures that we have learned.”

The loosening of the lockdown, he said, would be based on the following principles: That people will need to keep a distance of 2 meters (about 6.5 feet) from each other or wear a protective mask when that isn’t possible.

"Optimal health and the rapid resumption of a social life that has largely been put to a stop are not fundamentally incompatible with each other, but they are mutually dependent on each other,” the scholars write. They also argue that the drastic measures taken by the German government and the federal states during the hectic early phase of the pandemic were justified, even in light of a dearth of scientific data.

But those measures now need to be dramatically overhauled, they write. The scholars are also calling for research to be conducted into the "infection immunity status of the population” through appropriate random tests to determine how many people have already been infected by the disease and how many have already recovered.

They argue that it should be possible to monitor the epidemic in real time and make forecasts that can predict what will happen in a week or two. That would make it possible to assess whether the number of infections remains under control or whether adjustments would need to be made if the ban on social contact is loosened.

The scholars also expressed subtle criticism of shortcomings in the collection of important data and the fact that some of it hasn’t been made available digitally at a national level.

To help with those efforts, the Leopoldina researchers say they support the use of smartphone apps to assist in the tracking of infections. In a program similar to efforts in South Korea, where containment of the disease has been very successful, people would "voluntarily provide their GPS data as part of contact tracing efforts,” meaning the app would communicate with other smartphones using Bluetooth technology. This would make it easier to trace people who have come into contact with a newly infected person. Those individuals could then be placed in quarantine.

Leopoldina President Haug said he’s aware of the legal issues, particularly in regard to the storage of GPS data. "That’s why use of the apps has to be voluntary and the data must be deleted after four weeks,” he told DER SPIEGEL. He argued that awareness needs to be raised about the logic and usefulness of the app and that this is the only way of generating acceptance and motivation for using it.

"This app is crucial to ensuring a detailed forecast of the course of the pandemic,” said Haug, who is also a director at the Max Planck Institute for Chemistry in Mainz.

Software companies are currently developing the app for the German government.

Once that app is in place, the academy recommends a return to normality "as soon as possible.”

The ad hoc statement from the academy focuses on three areas: education, public life and future economic policy.

Daycare, Schools and Universities

The researchers at Leopoldina are pressing strongly for schools to be reopened "as soon as possible,” because forcing children to learn at home further exacerbates pre-existing social inequality in education. Since this applies foremost to the primary school level, where curricula are generally taught in a classroom environment, the experts argue that those schools should reopen first, starting with the upper classes in which pupils are preparing to make the transition to secondary school.

But they recommend that students be required to wear masks, and that they should initially be given instruction in the basic subjects of German and mathematics in a "group size of a maximum of 15 pupils.” They propose that recess for students should also be alternated between subjects, so that the pupils have separate times.

In secondary schools, they recommend that foreign languages be taught in addition to German and mathematics, and that here, too, resumption of classes should start with those students preparing to graduate or move to higher levels of education. For students in their final years in high school, however, the scientists propose that a greater emphasis be placed on "self-organized learning using digital media.”

General, however, they noted that it is important "to maintain opportunities for examinations at all stages of education,” meaning written and oral tests, including the Abitur high school graduation examinations that are required for entry to university, which they said should not be neglected due to the pandemic.

However, the academy has recommended keeping daycare centers and kindergartens closed "until the summer holidays” for all children except for those of key workers.

The reason provided is that young children are unable to use protective masks, and the danger of the virus spreading to parents and grandparents is too great. At universities, the academy recommends that the summer semester should be completed "largely as an online/home-learning semester.”

Public Life

The scientists also provide the German government with a clear mandate for pursuing policies for lifting the lockdown on public life, if only for "constitutional reasons.”

If the number of new infections remains stable and at a low level, both corona and normal patients could be cared for in hospitals, they argue, and if people adhered to hygiene measures, then there would be nothing to stand in the way of a normalization of public life.

Stores and restaurants could reopen as well as general businesses and municipal and government offices.

But for this, too, they recommend a mask requirement.

"Every person should carry one with them in the future and wear it whenever they are unable to maintain the minimum distancing,” Haug said.

That would apply at the supermarket, where people come into close contact, at public offices and also in places of work.

The academy also recommends that people continue working from home in all instances where this is possible.

If working from home isn’t possible and work needs to be done in shifts, the academy has recommended that those shifts always be scheduled with the same personnel and that greater space be created between workspaces to ensure correct social distancing.

It also recommends that those same working groups would need to sit together in workplace cafeterias and that the groups should not mix.

Can Latin America Afford to Fight COVID-19?

Owing to the missed opportunities of the post-2008 period, most Latin American and Caribbean governments have very limited fiscal space with which to manage the COVID-19 pandemic. Nonetheless, if their limited ammunition is well-aimed, it could go a long way toward mitigating the crisis.

Alejandro Izquierdo , Martin Ardanaz

izquierdo2_ Alexis LloretGetty Images_coronavirusbankofargentinasocialdistance

WASHINGTON, DC – Confronting a pandemic is a grueling trial even for the most advanced economies. For indebted governments in Latin America and the Caribbean, it is harder still. Many countries’ fiscal positions are worse now than they were when the 2008 global financial crisis erupted.

Worse, stimulus policies that work in normal times will not work against the fallout from COVID-19, and financing is becoming increasingly scarce as investors flee to safer assets and markets.

Between 2008 and 2019, Latin America and the Caribbean’s average overall fiscal balance slid from -0.4% of GDP to -3%, and average public debt grew from 40% of GDP to 62%. These numbers are a consequence of missed opportunities, particularly during and after the “Great Recession” in the United States.

In 2008-09, most governments in the region increased expenditures to sustain aggregate demand. Fiscal packages averaged 3% of GDP, but differed across countries. Those with low debt levels were able to implement substantial stimulus measures, whereas those with high debt had to undergo an economic contraction.

Given today’s higher debt levels, the region will be able to respond with a fiscal expansion of only around half the size of that in 2009, on average. Whereas Chile and Peru have room for spending, Argentina, Ecuador, and other countries will struggle.

Another issue will be the composition of fiscal stimulus, which can have far-reaching implications for the future. True counter-cyclical policies call for only transitory expenditures. But in the 2009 fiscal expansion, almost two-thirds of spending went toward higher salaries and permanent transfers, which are difficult to reverse, and thus not sustainable. By ratcheting up these current expenditures, many countries baked in future fiscal deficits.

Yet another issue is access to financial markets. The region is already paying 700 basis points over US Treasuries, on average, to service its debt. And while investors are still open to buying assets from the region, a flight to higher-quality assets is already underway.

According to the Institute of International Finance, cumulative outflows from emerging markets since January have surpassed the levels observed during the global financial crisis. For countries like Argentina and Ecuador – with credit spreads above 4,200 basis points – the only option is to secure loans from multilateral institutions.

Owing to these circumstances, the overall size of the region’s fiscal packages will have to be smaller than in the past, unless countries are willing to assume additional macroeconomic risks, or to cut other outlays to make room for programs to fight COVID-19. Obviously, limiting the spread of the virus, boosting health expenditures, and avoiding a health-infrastructure collapse are immediate priorities.

The time for achieving sustainable, broad-based growth will come later. Besides, standard macroeconomic stimulus policies may not even be effective now. While capital expenditure is typically the best instrument for counter-cyclical policies (because it has the largest fiscal multiplier), it will not necessarily work at a time when construction sites and many other workplaces have become hubs of contagion.

Policymakers designing pandemic-response packages also will need to ensure that expenditures are temporary, so that they can be dialed back when the crisis passes. Many people will lose income as a result of self-isolation, so subsidy programs for the poor and those who rely on the informal economy are imperative. To avoid permanent increases to existing transfer programs, these subsidies should be channeled through separate accounts with clear sunset clauses.

Moreover, governments can increase the efficiency of spending. A recent report from the Inter-American Development Bank finds that much of the social spending intended for the poor has actually been going to the non-poor, and that there are significant inefficiencies in public-sector wages, and goods and infrastructure procurement.

All told, this waste amounts to 4.4% of GDP, which is substantial enough to cover much of what is needed for the current emergency. To be sure, these resources would not become available quickly. But one option is to front-load crucial additional expenditure in, say, health care, while immediately adopting policies to cut waste, thus ensuring fiscal sustainability in the future.

Tracy Wen Liushares harrowing first-person testimonials from the front lines of the COVID-19 outbreak in China.

Governments with the fiscal space to do so could go further. For example, they could offer temporary tax deferments for households, firms, or even entire regions struck hard by the coronavirus. The point is to provide as much liquidity as possible while avoiding tax holidays, in order to preserve future sustainability.

Finally, governments will need to step in to sustain credit markets. Many firms will find it difficult to refinance even short-term loans, which will raise the risk of massive layoffs. To prevent liquidity problems from becoming solvency problems, governments can intervene with asset-purchase programs.

The challenge for Latin America is to do this at the necessary scale, transparently, and with clearly targeted programs. Otherwise, loans could turn into grants that the region cannot afford.

Meanwhile, larger, systemically important countries in the region may be able to secure access to swap lines from the US Federal Reserve. Smaller countries will have a better chance of getting loans from multilateral institutions, but that will be challenging for larger, non-systemically important countries, given the limited resources available. As such, multilaterals should have their capital increased.

Despite the current constraints, fiscal policies can still play an important role in saving lives and mitigating the economic costs of the coronavirus in Latin America and the Caribbean. Ammunition is scarce. But if it is well-aimed, it could go a long way.

Alejandro Izquierdo is Principal Research Technical Leader at the Inter-American Development Bank.
Martin Ardanaz is Fiscal and Municipal Management Specialist at the Inter-American Development Bank.

Will We Flunk Pandemic Economics?

Our government suffers from learned helplessness.

By Paul Krugman

Members of the House of Representatives after passing a $2 trillion coronavirus rescue package.Credit...Susan Walsh/Associated Press

Just a month ago Donald Trump was still insisting that Covid-19 was a trivial issue, comparing it to the “common flu.” And he dismissed economic concerns; after all, during flu season, “nothing is shut down, life & the economy go on.”

But pandemics come at you fast. Since Trump’s blithe dismissal, something like 15 million Americans have lost their jobs — the economic implosion is happening so quickly that official statistics can’t keep up.

In our last economic crisis the economy shrank around 6 percent relative to its long-run trend, and the unemployment rate rose around five percentage points. At a guess, we’re now looking at a slump three to five times that deep.

And this plunge isn’t just quantitatively off the charts; it’s qualitatively different from anything we’ve seen before. Normal recessions happen when people choose to cut spending, with the unintended consequence of destroying jobs. So far this slump mainly reflects the deliberate, necessary shutdown of activities that increase the rate of infection.
As I’ve been saying, it’s the economic equivalent of a medically induced coma, in which some brain functions are temporarily shut down to give the patient a chance to heal.
While a deep slump is unavoidable, however, good policies could do a lot to minimize the amount of hardship Americans experience. The problem is that the U.S. political landscape has long been dominated by an anti-government ideology that left us unprepared, intellectually and institutionally, for this crisis.

What should we be doing? Serious economists have already reached a rough consensus over the appropriate policy response to a pandemic. The bottom line is that this isn’t a conventional recession, which calls for broad-based economic stimulus. The immediate mission, beyond an all-out effort to contain the pandemic itself, should instead be disaster relief: generous aid to those suffering a sudden loss of income as a result of the economy’s lockdown.

It’s true that we could suffer a second round of job losses if the victims of the lockdown slash spending on other goods and services. But adequate disaster relief would address this problem, too, helping to sustain demand.

So it’s all about helping the economic victims of the coronavirus lockdown. How are we doing?

The good news is that thanks to Democratic pressure, the CARES Act, the $2 trillion not-a-stimulus bill that became law less than three weeks after Trump dismissed the notion that Covid-19 might pose an economic problem, is mostly focused on the right things. The core provisions of the legislation are aid to hospitals, the unemployed and small businesses that maintain their payrolls; these are exactly the kinds of things we should be doing.

What’s especially remarkable is that we got mostly sensible legislation even though the president was talking nonsense, pushing for — what else? — tax cuts as the solution for the economy’s problems. Actually, I can’t think of any other recent example in which Republicans agreed to major fiscal legislation that mainly involved spending to benefit the needy, without any tax cuts for the rich.

The bad news comes in two parts.

First, the bill falls far short of what’s needed on one crucial dimension: aid to state governments, which are on the front line of dealing with the pandemic. Unlike the federal government, states have to balance their budgets each year. Now they’re facing a surge in costs and huge revenue losses; unless they get a lot more aid, they’ll be forced to cut spending sharply, which will directly undermine essential services and indirectly deepen the overall slump.

And it’s not clear when or whether that hole will be filled. Senate Republicans are hostile to the idea of another rescue package; White House officials are reportedly still talking about tax cuts.

Second, decades of hostility to government have left us poorly positioned to deliver even the aid Congress has voted. State unemployment offices have been underfunded for a long time, and red states have deliberately made it hard to apply for benefits. So the surge in unemployment is overwhelming the benefits system; Congress may have voted disaster relief, but the money isn’t flowing.

The loan program for small businesses is also, by all accounts, off to a shambolic start. And those $1,200 checks everyone is supposed to get? Many Americans won’t get them for weeks or months.

It doesn’t have to be like this. Canada has already set up a special web portal and phone system to provide emergency unemployment benefits. Germans have been pleasantly surprised by how quickly aid is flowing to the self-employed and small businesses.

But decades of conservative attacks on the idea that government can do anything good have left America with a unique case of learned helplessness. And this is combined with utter lack of leadership from the top.

We know what we should be doing in terms of economic policy, and Congress passed a relief bill that, while flawed, was better than I expected. But right now it looks as if our response to the economic emergency will fall far short.

A Season of Trouble for the Economy

Business usually picks up in the spring, when warmer weather kicks off seasonal work but the novel coronavirus crisis is cutting that work short

By Justin Lahart

The new coronavirus has dealt a blow to some sectors, such as real estate, that ordinarily register a seasonal bump in the second quarter. Photo: Elise Amendola/Associated Press .

Spring is supposed to be the season of renewal, not just in nature but for many businesses. That will make the blow to the economy from the novel coronavirus crisis even heavier.

Economic data often give the impression that U.S. business is a steadily moving thing, but that isn’t entirely the case. Rather, different parts of the economy wax and wane in a regular way throughout the year.

During the holiday shopping period in November and December, for example, retailers register a jump in sales. The government and other data providers use statistical methods to seasonally adjust for such swings and better capture the economy’s underlying trend.

Take away those seasonal adjustments and the second quarter, more than any other time, is when the economy really surges. Consider real estate, where the spring selling season would now typically be under way.

In the second quarter of last year, the National Association of Realtors’ pending home-sales index, which is based on when home sales go into contract, was on average 2.6% higher in the second quarter than in the first on a seasonally adjusted basis. But take away that seasonal adjustment and it was 32% higher.

Similarly, the second quarter is when spending on construction surges as work on building everything from houses to bridges picks up. Construction spending in the second quarter of last year was flat on a seasonally adjusted basis with the first quarter, according to the Commerce Department, but without that adjustment it was up 20%.

There also is a great deal of seasonal job growth in the second quarter, including workers who get hired on for summer work such as line cooks in beach town restaurants and housekeepers in resort hotels. From March to June of last year, the leisure-and-hospitality industry added 30,000 jobs on a seasonally adjusted basis, according to the Labor Department, but 1.13 million without seasonal adjustment.

It all adds up to a lot. Without seasonal adjustment, gross domestic product grew at a 13.6% annual rate in the second quarter of last year, according to the Commerce Department, which compares with a seasonally adjusted 2%.

It might be tempting to look at incoming data on a not-seasonally-adjusted basis and conclude that the reality isn’t as bad as advertised. When in July the Commerce Department reports that GDP contracted massively, for example, one might think it wasn’t as bad as it might have been.

But that would be getting it wrong because the absence of activity that usually occurs in the second quarter will cause a lot of damage.

That will be particularly true for those businesses and workers that depend on the second-quarter surge. For some of them, it is a period that can make or break the year. For some of them, even in a best-case scenario, in which the virus has been contained by the start of the summer and the economy starts to regain its footing, the lost season could mean losing everything.

Bad Blood

by: The Heisenberg
- "Generational event" is about the closest one can come to capturing the gravity of what's going on both in markets and in society more generally.

- There is no modern precedent for the situation in which we find ourselves, and in keeping with that, the policy response has been unprecedented.

- We've quite obviously passed the point where comparisons to Lehman are adequate to convey the scope of the crisis.

- "Where to from here?" is a question no one can currently answer.
"How bad do you think it's gonna be?," Al Pacino's Michael Corleone asks Clemenza, in one of the many iconic exchanges from The Godfather.
"Pretty bad," Clemenza remarks, matter-of-factly, before shrugging off the coming war as a kind of Schumpeterian necessity.
"That's all right," he says. "These things gotta happen every five years or so. Ten years. Helps to get rid of the bad blood. Been ten years since the last one."
I) No atheists in foxholes
It's been more than ten years since the last crisis, so Clemenza would probably say we're due.
Even as the vast majority of market participants have adopted some form of the old "There are no atheists in foxholes" adage when it comes to dropping their usually strident defense of Libertarianism (even Cliff Asness admits we need government in the fight against the pandemic), there are some intelligent arguments for allowing the current crisis to "help get rid of the bad blood."
Goldman, for example, recently argued that the oil shock will be a game-changer for an energy industry which has long needed a reset. In a note dated March 30 that found the bank discussing "the largest economic shock of our lifetimes," the bank's Jeff Currie wrote the following:
We believe the current oil crisis will see the energy industry finally achieve the restructuring it so badly needs. We have long argued that it is the supply and demand of capital that matters, not the supply and demand of barrels; as long as there is capital, companies can withstand difficult periods and the barrels always come back. The difference between today and 2015/16 is that shale and high-cost oil producers were already facing sharply higher costs of capital over the past year due to persistently poor shareholder returns. Indeed, these capital restrictions have only been exacerbated by recent events, whereas in 2015/16 capital never dried up – making the likelihood of capitulation by US E&Ps and EM producers much higher today.
Goldman pegged the near-term daily demand destruction at 26 million b/d. Oil demand, you'll note, almost never declines on an annual basis. But it will in 2020. The only question is by how much.
(Heisenberg, data from BP's historical study)
Russia and Saudi Arabia (at Donald Trump's urging) are tentatively working towards some manner of production cut deal, and the promise of an emergency OPEC+ virtual meeting next week helped push crude to its best weekly gain on record. But, on Friday and Saturday, Riyadh and Moscow traded barbs, underscoring the intractability of the stalemate.
Even an agreement on a 10 million b/d cut (a figure floated by Trump, Vladimir Putin and unnamed OPEC delegates) would fall well short of offsetting the unprecedented demand destruction brought about by the travel restrictions and other containment measures adopted globally in the fight against the coronavirus.
This is obviously devastating for many US producers, who won't take any comfort in the notion that their sacrifice is part of a broader economic reset that will help purge years of misallocated capital.
The oil story isn't merely a sideshow to the pandemic. The price war (narrowly construed) is tangential, but the potential for the collapse in prices (which fell the most in history during the first quarter) to make an already bad economic situation worse, is real indeed.
"While many consumers, companies and countries benefit from lower oil prices, there are serious repercussions for others," Howard Marks wrote, in his latest memo, before laying out the knock-on effects as follows:

  1. Big losses for oil-producing companies and countries
  2. Job losses: the oil and gas industry directly provides more than 5% of American jobs (and more indirectly), and it contributed greatly to the decline of unemployment since the GFC
  3. A significant decline in the industry’s capital investment, which recently has accounted for a meaningful share of the U.S.’s total
  4. Production cuts, since consumption is down and crude/product storage capacity is running out
  5. The damage to oil reservoirs that results when production is reduced or halted
  6. A reduction in American oil independence
If you're ever looking for a corner of the market where almost no one with a vested interest is willing to make any arguments about the relative merits of purging "misallocated capital," it's in the U.S. oil patch.
At a higher level (i.e., for corporate America as a whole), the "scourge" of misallocated capital is to a large extent the product of post-crisis monetary policy. This is a point folks like myself have been making for years, and it's neatly encapsulated by Marks in the same memo linked above. To wit:
Many companies went into this episode highly leveraged. Managements took advantage of the low interest rates and generous capital market to issue debt, and some did stock buybacks, reducing their share count and increasing their earnings per share (and perhaps their executive compensation). The result of either or both is to increase the ratio of debt to equity. The more debt a company has relative to its equity, the higher the return on equity will be in good times, but also the lower the return on equity (or the larger the losses) in bad times, and the less likely it is to survive tough times. Corporate leverage complicates the issue of lost revenues and profits. Thus we expect to see rising defaults in the months ahead.
This speaks to the irony of the Fed's multi-pronged corporate bond buying program announced late last month alongside a raft of additional measures. We are in no position to allow misallocated capital to be "purged."
A microcosm of this is what happened last month to the iShares iBoxx $ Investment Grade Corporate Bond ETF (LQD), which, in the course of free-falling, traded extremely wide to NAV. It was, colloquially speaking, "broken," something fixed income ETF critics have long warned would happen eventually. When the Fed announced its foray into corporate bond purchases, it said the following about ETFs:
The SMCCF will purchase in the secondary market corporate bonds issued by investment grade U.S. companies and U.S.-listed exchange-traded funds whose investment objective is to provide broad exposure to the market for U.S. investment grade corporate bonds.
That was on March 23. Almost immediately thereafter, LQD surged to the largest premium over NAV in a decade (see the visual).
It traded at a slight discount as of Friday, but you get the point.
Just to drive it home, short interest on LQD now sits at just 1.48%, according to data from IHS Markit. It was 17.6% on March 12. "The short base collapsed in speculator fashion… after the Fed’s credit backstop programs," JPMorgan's Nikolaos Panigirtzoglou remarked, in a Friday note.
Meanwhile, high yield funds saw their largest inflow on record in the week through Wednesday, according to Lipper data.
Although junk isn't eligible for Fed buying, renewed confidence in high yield (which, as a whole, now trades back below the "distressed" threshold of 1,000 basis points) is clearly down to the central bank backstop for credit markets and the government's $2 trillion stimulus package.
Amid the cacophony on places like Twitter and various blogs, it's important to note that most of the actions taken by the Fed are necessary. I talked at length about this in my last post for this platform, and I've documented the specifics of each and every Fed emergency facility elsewhere, but I want to quickly touch on the foreign repo facility rolled out this week.
Long story short, the facility allows foreign central banks to post their Treasurys for dollars, which can then be made available to entities in other locales. As the Fed explained, "the facility reduces the need for central banks to sell their Treasury securities outright and into illiquid markets, which will help to avoid disruptions to the Treasury market and upward pressure on yields."
The Treasury market effectively broke last month and became extremely illiquid in the process.
With data for the full month now available, we know that foreign central banks sold nearly $110 billion of Treasurys in March. That's the most on record - and it's not even close.
That speaks to the March market mantra which, summed up, was "sell everything that isn't tied down to raise USDs."
Although the Fed’s swap lines were extended last month to include Australia, Brazil, Denmark, Korea, Mexico, New Zealand, Norway, Singapore and Sweden (in addition to the standing arrangements with the BOC, the BOE, the BOJ, the ECB and the SNB), that’s just 14 central banks.
You have to remember that in situations like these, there are dollar pegs that need to be maintained, and during times of acute stress accompanied by USD strength, interventions aimed at stabilizing local currencies are sometimes necessary.
Throw in the USD funding needs of corporates in foreign locales, and it's apparent the swap lines either weren’t adequate, weren’t enlarged enough (i.e., the Fed didn’t cast a wide enough net) or some combination of both.
That's why the foreign repo facility is necessary.
Similarly, the decision to exempt Treasurys and deposits at Federal Reserve banks from the supplementary leverage ratio is probably necessary too, all criticism aside.
Yes, it will increase leverage at banks, but without the interim rule (announced on Wednesday to jeers from the social media peanut gallery, where everyone suddenly became a regulatory crusader), the behavior of market participants in light of recent turmoil and the effects of the policy actions taken to ameliorate that same turmoil could have ended up curtailing banks’ capacity to intermediate and lend.
In short, all of this has to be propped up, bailed out and otherwise inoculated.
If it's not, the domino effect would be catastrophic, and although the cavalier among you may be inclined to bravely parrot the "let it all burn" line, I doubt you really want that.
As you might have noticed, the $2 trillion virus stimulus bill was passed without much hand-wringing about "paying for it." That's another "no atheists in foxholes" moment, but, perhaps just as importantly, it exposes the truth behind the deficit myth.
The daily budget wrangling inside the Beltway doesn't reflect reality. There is rampant confusion in this country about how money actually works, and that confusion is at the heart of the vociferous opposition to Modern Monetary Theory. Consider the following crucial passages from Stephanie Kelton (these are from a shorter version of a more detailed piece that eventually appeared in The Intercept):

What does it mean to say that Congress is “paying for” its spending? I worked in the Senate, and the phrase has a concrete meaning in the budget world. When a member of Congress drafts a bill, staffers often shop it around, looking for support from other members. 
Inevitably, the first question that staffer gets is, “What’s your pay-for?” So, for example, if you have a $1 trillion infrastructure bill, they want to know how you plan to fully offset that spending so it won’t add to the deficit. That’s what it means to “pay for” spending. 
This usually involves raising taxes. If you can bring in enough new “revenue,” you can claim that you “found the money” to fully “pay for” your spending. This is the idea behind PAYGO –Pay As You Go – don’t add to the déficit. 
When Congress passes a spending bill that is fully “paid for,” it sends two sets of instructions to the Federal Reserve. The first set of instructions tells the Fed to mark up the size of certain bank accounts (as the spending takes place). 
The second set of instructions tells the Fed to mark down certain other accounts (as people/companies pay more taxes). On balance, PAYGO is meant to result in the government subtracting away (via tax) exactly as many dollars as it adds (via spending). 
We have been misled (suckered) into thinking that this is the epitome of “fiscal responsibility.” That “paying for” your priorities shows that a politician is “serious” and that his/her plans are “credible” because the “math adds up.” That is malarky! 
Congress always has the power to pass legislation that sends only one set of instructions to the Fed. That’s what it is doing now. No one is trying to “pay for” a $2 trillion spending package to help cushion the economic blow to our economy. 
It would be insane to try to offset that spending right now. Why? Because our economy runs on spending. And right now, spending is collapsing. We want the Fed to add to bank accounts without subtracting away more.
There's a lesson here. Although there are, of course, limits to how much spending can be authorized without offsets, those limits are dictated by inflation. Quite obviously, inflation isn't something we need concern ourselves with in an environment characterized by the single largest demand shock of the past century.
"On the Austrian analysis, recessions give a chance to re-allocate ‘mal-invested’ productive factors to efficient uses [and] they should therefore be allowed to run unhindered until they have done their work," Robert Skidelsky wrote, in Money and Government.
He then reminded readers that "economists whose common sense had not been completely destroyed by their theories rejected the drastic cure of destroying the existing economy in order to rebuild it in the correct proportions."
Now, about our "existing economy" - it's disintegrating rapidly. Read on.
II) Nicci
"What do you think about all of this?," read a text message that materialized on my iPhone screen around 6:15 AM on March 23.
It was alarming. Nobody sends me text messages, let alone early in the morning. Besides that, it was annoying. As regular readers are aware, 6:00 AM is my cigar/espresso hour - interruptions are not generally welcome.
Through the pre-dawn mist on the back deck, the mechanical glow from the phone alert was hard on my unadjusted eyes.
I met Nicci on the very island I now call home when we were teenagers. She was born here, and will always consider me a "tourist," despite her having left, and me now being a property owner. She introduced me to bioluminescent tides before either of us were old enough to drink, but in that era, "age was just a number" when it came to alcohol consumption, so my first experience with a glowing ocean was amplified by cheap vodka.
As a teenager (and into her early twenties), Nicci was an idealist with a biting sense of humor - Ocasio-Cortez without the political ambition, if you like. As these things go, the flame of youth eventually flickered, giving way to a kind of dim, barely-burning candle. Somewhere along the way, she got into the restaurant industry and eventually became a sommelier.
The current economic situation has laid waste to the services sector, and Friday's jobs report (which, as you're doubtlessly aware, came in much worse than expected) showed that two-thirds of the 701,000 monthly decline was accounted for by the leisure and hospitality industry.
The 459,000 positions lost meant that nearly two years' of gains were wiped out in a single month.
Out of that 459,000 decline, 417,000 was accounted for by the “food services and drinking places” category.
Here is an astonishing chart:
Despite coming in nearly 7 times worse than the median estimate, Friday's jobs report understates the severity of March's surge in joblessness. As most readers are probably aware, the survey period did not capture the darkest days of the month for the American economy, as many of the stricter stay-at-home orders and mandatory business closures came during the latter half of March.
For that reason, weekly claims figures have become far more germane for market watchers. Indeed, in the days ahead of the March 26 release, economists across the country (simply utilizing state-level data and anecdotal accounts) warned that America was about to witness a spike that would dwarf anything seen in the history of modern economic statistics.
Nicci is no economist. She's a wine steward. But in our morning text exchange on March 23, she was unequivocal about what was coming. And not because she had been reading the finance page - rather, because she works in (or I guess with, is more accurate) the industry. Have a look:
And they did - file for unemployment, that is.
Three days later, jobless claims for the week of March 21 printed quadruple the previous record from 1982. On Thursday of this week, they skyrocketed to 6.65 million.
In short, the mighty US services sector just disappeared in the space of four weeks. It's gone.
That doesn't mean it's not coming back, but for the duration of the lockdown, it basically doesn't exist.
The unemployment rate, which, as of last month, was parked at a five-decade nadir, may well spike to 20% or higher.
When I asked Nicci what she was doing up so early, she had a simple answer: "Stress-watching Ferris Bueller's Day Off."
III) Déjà vu
On February 2, I regaled readers with a vivid, gritty account of where I was "when the world didn't end" in 2008.
It would be ludicrous for me to suggest that story was a veiled prediction of what, just three weeks later, would morph into a crisis far worse than the GFC.
And yet, parts of it do come across as prescient. For example, I noted that at the time, some of the biggest names in the business were busy declaring that the boom-bust cycle was over.
Bridgewater's Co-CIO Bob Prince, for example, said as much in Davos during an interview with Bloomberg.
"He may be right," I said. "But he may be wrong, too."
I went on to echo the same points made above about the extent to which creative destruction isn't a viable option in modernity. Here are a few passages from that post:

The vestiges of crises past always linger – creative destruction isn’t a viable option in the modern world. 
The idea of letting it all burn to the ground in order to ensure that every, last bit of misallocated capital is purged is, at best, implausible. At worst, it’s madness. 
But we should recognize that in the absence of that, future crises will be i) inextricably linked to their predecessors, and ii) likely more spectacular than those that came before.  
A defining feature of a fiat regime is a rolling boom-bust cycle that snowballs with each turn, which means that policy responses will need to grow in magnitude over time to keep pace with ever larger busts. Eventually, the busts become so large that the policy responses required to combat them become caricatures of themselves that border on absurdity.
Suffice to say that while nearly everyone recognizes that we have no choice but to pull every monetary and fiscal lever at our disposal to offset the measures needed to combat the pandemic, many market participants are still keen to point out that the scope of the rescue efforts are cartoonish.
The Fed's balance sheet has ballooned to nearly $6 trillion over the past two weeks, on its way to nobody knows where. And I mean that literally - we don't know how large it will get, and that's one reason why exempting Treasurys and deposits from the supplementary leverage ratio is necessary (there's an explainer from Bloomberg here, which is much more concise than my hopelessly opaque explanation of the same dynamic published elsewhere).
When it comes to equities in all of this, it's admittedly quite different from 2008 when it comes to making the decision to simply keep buying incrementally on down days, on the assumption that the even if there's another leg lower, it can't possibly get that much worse.
There is no analogous historical episode where the entire global economy was simultaneously subjected to an engineered shutdown. As I put it on Friday afternoon, it’s hard to invest in an environment where, for many firms, it is literally impossible to generate operating income by virtue of decrees mandating that businesses cannot operate. You can’t base an investment thesis on earnings because as things currently stand, it’s possible there won't be any earnings for lots of businesses, at least over the next month (or even two months).
One is reminded of the classic moment from Groundhog Day when Bill Murray's Phil Connors is on the phone trying to get information about a blizzard that strands him in Punxsutawney.
When the man on the other end of the line tells him "tomorrow," Phil responds: "Well what if there is no tomorrow?
There wasn't one today!"
Take, for example, the discrepancy between companies which have and haven't withdrawn or altered their guidance.
SocGen’s Andrew Lapthorne notes that consensus estimates for corporate profits are likely being artificially inflated by the fact that only some companies have issued updated forecasts to reflect the new, stark economic reality. That, in turn, means EPS estimates are probably falling “at twice the headline rate," he wrote, on Monday.
What would happen if one were to leave out those corporates that have yet to change their guidance?
Lapthorne is glad you’re curious. “Removing these stale forecasts and focusing only on estimates posted during the past 20 days (so-called 'flash' estimates) gives a more up-to-date picture," he says, adding that “globally, instead of Year 1 forecasts cut by 9.2%, so far this year, the flash estimate shows a 17.2% cut, a massive 800bp difference moving the Global 2020 P/E we calculate using the standard consensus from 14.6x to 16.1x."
(Heisenberg, SocGen)
The upshot is that even with the latest rout, stocks may still be too “rich.” Indeed, 16.1x would, depending on who you ask, represent a fully-valued market during normal times. These are not normal times.
To be brutally honest, there is absolutely no way to know what earnings are going to look like for the second and third quarters. I cannot remember (or find anyone who can remember) a time when there's been less visibility into the outlook for all corporate profits, not just one or two troubled sectors.
Do you want to see something incredible?
Have a look at the final read on IHS Markit's services sector PMI for Italy:
Show me someone who thinks they can price equities in this environment and I'll show you a liar. It's just that simple.
And yet, maybe there's no need to think too hard about it. Two months ago, reflecting on 2008, I wrote that the trick after Lehman wasn’t so much being “smart” or hewing to some amorphous Buffett aphorism about being “greedy when others are fearful.” Rather, you had to view the situation as binary – either the world was ending or it wasn’t.
Of course, that was a bit of an exaggeration. We often talk about the days following Lehman in those terms and until 2020, that made sense. Now, though, we really are facing an existential crisis. That makes it much more difficult to say, with any degree of certainty, that "40% peak to trough" is as far as it will go, for example.
I suppose it's important to remember that as bad as things are, COVID-19 isn't Ebola or Marburg. And trillions in stimulus won't simply be pulled back once the virus is under control.
The Fed isn’t going to cancel all of the various liquidity facilities and asset purchase programs put into place over the past four weeks if the spread of the virus slows. That bid (which is now unlimited in scope) will be in the market for the foreseeable future, and now it includes spread products.
Similarly, fiscal stimulus measures are being implemented rapidly. Once that money is spent, it’s spent, colloquially speaking. You can’t take the stimulus checks away from people, and you can’t repeal a bill aimed at combating a deadly virus.
IV) Epilogue
Here on the island, not much has changed. Containment "protocol," to the extent it exists here, is barely perceptible even if you're looking for it. There were some half-hearted efforts to put orange traffic cones in front of paths to public beaches, but people just walked around them.
Eventually, the cones disappeared.
Jack is fine, and so are his Porsches. As of this week, he has two parked in the driveway, each of which has a different vanity tag, but I'll refrain from disclosing them.
The local gym is closed, though, so I've taken to running again, despite the protestations of my right knee.
On Friday afternoon, a neighbor I know only as the husband of Martha (an extremely affable retiree I sometimes speak to on her evening strolls) flagged me down as I jogged.
In a previous life, he was a government bond trader and has the stories to prove it. (And I really do mean that - even in his eighties, he still talks as though he's on the desk, lingo, accent and all.)
"What are you telling your readers?," he asked. Earlier this year, Martha asked me to write down the name of the online portals where I comment so she could give it to her husband.
"Well, it's tough," I ventured.
"Ehhh," he waved his hand in apparent disgust. "There's no people. You gotta have this" - he made a "V" with his fore and middle fingers, pointed at his own eyes, then to me. He doesn't care for algos or the idea of them being involved in market making.
We chatted for a while. All three times I've talked with him he's claimed to know nothing about the proliferation of high-frequency trading and the extent to which it's paramount in Treasury market liquidity provision.
And yet, it's always abundantly clear that he accidentally knows more about it than I do. And certainly not because he's steeped in the evolution of modern market structure.
Rather, because his entire existence on this planet has been defined by the government bond market from the time he was a young man until the moment he walked out the shop door into retirement. He knows government bonds. He speaks government bonds. In some sense, he is government bonds.
The whole time we talked on Friday he stayed in his chair, rocking precariously back and forth ("precariously" because it was most assuredly not a rocking chair). He crossed and uncrossed his legs whenever he wanted to make a point.
I asked him if he could remember any period when an exogenous shock with no initial connection whatsoever to markets had such a profound impact on assets.
"Let me tell you something," he said, suddenly adopting an aggressive cadence. "You read the finance page, whatever," he ruffled the copy of The New York Times in his lap for effect.
"But it's what's right here that matters," he insisted, flipping back to the front page and tapping on the section above the fold with his fingers hard enough so I could hear it. "It's what's going on in the world that's gonna move your positions."
I nodded.
"Don't you forget that," he said.