The Figure-It-Out Economy

By John Mauldin

Market sentiment reflects human sentiment, which lately has been quite negative—understandably so, given the great uncertainty surrounding the coronavirus pandemic. A month ago, we didn’t know where all this was going but it was potentially serious.

I can almost begin to sense sentiment changing. New drug therapies are being announced and dozens of vaccines are in development. There is a high probability one or more will work by the end of the year. Deployment will be difficult, but doable. This change in sentiment, combined with generous fiscal support and liquidity injections, gives investors more confidence, so we see stocks rising.

I am not generally one to “fight the tape,” but I really wonder how long this can last.

Looking at it not as an investor, but as an entrepreneur and small business owner, I think some are greatly overestimating how fast the economy can recover. Entire industries, no longer viable in their current forms, must now figure out new ways to do business.

They will figure it out, too, because that’s what entrepreneurs do. But they don’t do it overnight, or even in a few months, nor do they take direct paths from here to there. I am bullish on the American entrepreneur. Betting against not only the American entrepreneur but entrepreneurs worldwide in relatively free-market societies has always been a losing proposition. That doesn’t mean it will be easy or fast.

The rules have changed. As I wrote two weeks ago, we are in the process of Repricing the World. And I mean everything will get repriced. It is not clear how this will happen. Will landlords be forced (by the market) to take lower rents from restaurants? Will the cost of our restaurant food go up? Haircuts? A thousand other things we buy?

Today we’ll look at how this may work, and what it means for stock investors. For an even deeper discussion, register for my upcoming Virtual Strategic Investment Conference, an online event running over five days between May 11–21 for 4–5 hours a day. You can watch it live and ask questions, or watch the presentations at your leisure and personal time frame from your home or office. You’ll get written transcripts, too.

I can honestly say we have never had a lineup as powerful as this SIC. I have personally constructed it to answer the questions on our minds.

  • How deep a shock is the current recession going to be, and what will recovery look like in the near term?

  • What is the longer-term impact on the economy, the markets, and society?

  • What profit opportunities will emerge from the rubble, and how do we seize them?

What will the impact be on the post-vaccine society? We will be talking geopolitics, lots of technology, specific investment ideas from some of the world’s greatest investment minds, the inside baseball of politics coming up, looking at China, Europe, and emerging markets, the fallout in the energy industry, and so much more.

This crisis has given me a chance to bring together almost twice as many speakers as I normally do, and bring them to you in the comfort of your own home or office, at a price that is a fraction of normal. Look at just a few of the names of the faculty:

Ian Bremmer, Leon Cooperman, Peter Diamandis, Niall Ferguson, George Friedman, Louis and Charles Gave (from France), Neil Howe, Lacy Hunt, Michael Pettis from China, Matt Ridley, Felix Zulauf from Switzerland, and last but not least, Ross Beaty, one of the world’s most successful gold miners.

There will be lots of short presentations combined with lots of panels and discussion. This conference is intended to give you the answers you need.

I have designed this conference to be the best roadmap I can possibly imagine for our journey into the future. I’ve tried to hit all the high points to make sure you walk away with specific, investable ideas. It will be inspirational and at times a little troubling. But that is what our future will bring. Better to have a roadmap with an idea of where to go than simply to walk into the future without a plan.

Join me. You know you not only want to, but you need to. This will be a once-in-a-lifetime event, and you don’t want to miss it.

I have written a very personal letter about this conference, outlining not just its purpose but giving you the details of every speaker and why they’re there. I am giving you the opportunity to see the “why” of every speaker.

There are some famous names but also some less famous but brilliant thinkers you need to hear from right now. You can read that letter here. I think you will find it extraordinarily helpful as you make your own personal plans for the future, for your investments, your family, and your business.

I can almost guarantee you will be like the thousands of conference attendees who have over the years told me, “This has been the best conference ever.” I can tell you there will never be another one like this. Be there!

Still Bullish

The US economy contracted an annualized 4.8% in Q1, according to the first estimate released Wednesday. This same economy was growing (slowly) as of early March. For two or three weeks to pull the entire quarter down that far is unprecedented.

Fans of symmetrical bell curves will point out an economy that falls so fast can bounce back equally fast, particularly when monetary and fiscal authorities are injecting so much rocket fuel. We see this in the latest Barron’s Big Money Poll of 107 top money managers. Asked to forecast the stock market this year, 39% were bullish, 20% bearish, and 41% neutral.

So adding together the bullish and neutral, 8 out of 10 money managers see at least some chance of positive equity returns between now and year end.

They are even more confident for 2021, with 82% bullish and only 4% bearish.

The Barron’s panel has tons of bullish quotes, arguing that things will go back to normal and now is the time to buy. Which is the same thing people said in 2007–2008.

My friend Ed Yardeni is similarly bullish, largely due to Federal Reserve actions. He also thinks analysts will probably overshoot their revenue and earnings estimates to the downside, then revise them upward later in a grandly bullish surprise.

As a natural optimist myself, I admire people who show confidence in tough situations. But I also think recovery will take more than a year or two. I talk to small business owners and corporate leaders all the time, and they all say it will be a long, hard climb out of this hole.

New Models

Last week I noted Woody Brock’s observation that the service sector drives growth and employment. The coronavirus closures, though necessary, were a kind of laser-guided missile into the service economy’s core. The numbers understate how much destruction occurred.

In 1920, 26% of the US population worked in the service sector of the economy. Today it is 86%. That is the primary reason for the extraordinary reduction in economic volatility.

The manufacturing/inventory tail no longer wagged the dog. It was seemingly impervious, until this pandemic struck. Now, 30 million people have filed for unemployment in the last few weeks and potentially 10 million more in the gig economy have lost their income.

Unlike manufacturing, retailing, or agriculture, service businesses can’t hold inventory. They can’t just close for a few weeks and then make up the lost time. There is no second chance to sell that hotel room night, plane seat, restaurant meal, haircut, Uber ride, or cocktail. Revenue has been vaporized, not deferred. So, having permanently lost weeks or months of revenue while many fixed expenses continued, service businesses are deeply in the red.

There will be no return to business as usual as long as the virus remains a health threat. Service business can’t simply open their doors again. They have to reengineer everything they do. Processes that took years or even decades to design and optimize are now unworkable. Replacing them isn’t going to happen in a few weeks. And making processes efficient enough to match previous profit margins will take even longer.

Restaurants and other service businesses make money by filling a defined number of chairs with a defined number of people who spend a defined amount of money in a defined length of time. Interrupt any part of that formula and everything falls apart. That is what these businesses will return to when they’re allowed to reopen.

South Korea is a few weeks ahead of the US and the picture there is grim, according to this WSJ report.

When meeting in an office, people will wear masks. At meals, diners will sit next to each other or in a zigzag pattern, not directly across. Hotel rooms will be ventilated for 15 minutes after travelers check out. Visitors at zoos and aquariums must stand 6 feet apart. Shouting and hugging will be discouraged at sporting events. So will high-fives…

…Kwon Sae-min, 29 years old, who works at a bakery in Seoul, is now taking shoppers’ temperatures at the entrance and asking them to sanitize their hands and swipe their credit cards themselves.

“It’s a lot of extra work to manage customers now,” Ms. Kwon said.

Ms. Kwon puts her finger on the problem. Everything will be a lot of extra work now. The US may give businesses more flexibility than South Korea’s government is, but it’s not the only constraint. Customers have to feel safe. Governors can lift their lockdown orders but they can’t make people shop, nor can they make businesses open.

It’s not just Korea. Here is what Simon Hunt tells us from his sources in China:

A friend of ours left Shanghai for his home town in Hunan province. Shanghai airport was empty as was the airport in his home town in contrast to the usual hubbub at this time of year. Taxis were non-existent in his home town because there were so few visitors. Moreover, the taxi driver, who eventually appeared after an hour’s wait, told him that the high-speed train station was empty as well.

This example of life across China confirms our thesis that the average household will keep their hands in their pockets to rebuild savings and regain confidence. It thus won’t be until the 4th quarter that consumer spending will become the third driving force behind the economy’s recovery, the other two being infrastructure and building.

That is echoed in John Browning’s Letter from Shanghai #451:

But as here in Shanghai we are perhaps in week 15 of the pandemic and the US in week 7 or 8 perhaps we can discuss the challenges that lay ahead. I note online grocery shopping has taken off in a big way, and one of my local supermarkets has closed seemingly for good. But the small local shops are thriving, and there is a genuine sense of localism, as throughout the pandemic they have earnt the gratitude and goodwill of the community, a change I suspect that will be permanent. Indeed, I have no desire to travel across town, anywhere I cannot walk is too far. Which also means for my bigger ticket items, online shopping is the way to go.

The lesson of China is that fear of a second wave of infection and nagging job insecurity encourages people to stay at home and save. Mr. Powell already recognizes the Fed-engineered recovery is unlikely to bring the US economy “quickly back to pre-crisis levels” and “there will still be a level of caution… that might remain for some time.” If I can paraphrase for a moment, if we are wearing masks, consumption will not be as it was before.

I hear the same from other sources in China. Businesses are coming back but consumers remain cautious.

In parts of the US, restaurants are being allowed to reopen at lower capacity, usually 25% or 50%. They can’t turn a profit that way, even without all the extra costs. So often the financially smartest thing they can do is stay closed, and many are. Maybe they will open in a few weeks, if the virus and associated restrictions ease. But meanwhile, workers stay unemployed and everyone’s spending remains muted.

The same applies in retail. Macy’s is beginning to reopen its stores but one executive told WSJ he expects less than a fifth of normal sales volume at first.

There are multiple problems:

  • Customers are reluctant to return

  • Those who do return will spend less

  • Serving them as now required and/or expected will cost more.

That math is not consistent with a V-shaped recovery, even with all the stimulus funding. You don’t have to search long to realize that the money supposedly flowing to Main Street isn’t getting down to the smallest businesses. Even if they represent only 10 or 15% of the economy, that is enough to spark a severe, prolonged recession.

Do we come back? Absolutely. The question is when and how?

Let me pull out this snippet from Danielle DiMartino Booth of Quill Intelligence (one of my daily must-reads). Notice the chart. American consumers are behaving exactly like the Chinese consumers described above. Human beings react to uncertainty the same all over the world. They become cautious.

Spending cuts exceeded income gains in March, generating a moonshot for personal savings; the backlog of unemployment filings signals a sustained improvement in consumption will elude absent a labor market recovery as unapproved claimants are deprived of any income.

Jet Fuel Market

I think businesses will figure this out, given time. The problem is that losses keep accumulating and the hole gets deeper. That isn’t good for corporate earnings, and not just at service businesses. A kind of reverse trickle-down effect will affect almost every consumer and business.

Many stock market bulls recognize this but think it won’t matter as the Fed keeps injecting more jet fuel. I am not sure that’s a good assumption. The Fed has done quite a lot and pledges even more, but Main Street needs customers. The Fed can’t create them.

Nonetheless, the jet fuel has succeeded in pushing stock benchmarks and valuations back near their old highs. Clearly, and probably rightly, investors are willing to look past the second- and possibly even third-quarter earnings, which everyone acknowledges will be dismal.

But what happens when earnings are dismal in the fourth quarter?

With the Fed in the mix, I suppose new market highs are possible this year or next, but I can’t imagine it lasting long. The animal spirits that drove well-known names higher are seriously weaker than they were in February, and I don’t foresee them coming back.

Two big points:

1.   Some businesses, both small and large, are going to do extremely well in this environment. Their earnings will rise. They will help pull the indexes up. Likewise, we are going to lose more businesses than most currently think. They will have the opposite effect. This is going to be a stock picker’s market. Index investors, as I have been saying for several years, will get their heads and their 401(k)s handed to them.

2.   Again, I readily grant that the market is looking past the next two quarters. But are investors going to look past the fourth quarter? Even if we get a vaccine by year-end, it will be a miracle if we all get it by the end of 2021’s first quarter. And balance sheets have been destroyed for so many businesses. There will be opportunities for startups everywhere, as seasoned management will need capital.

It is entirely possible that investors simply become disillusioned with looking past the next few quarters’ earnings. At some point, the attitude will change to, “Show me the money!” Then again, who knows what the Fed will do. If the market starts turning down will they start buying stock ETFs like Japan is? Dear gods, I hope not. But right now, there is simply no way to predict what they will do.

3.   A bonus point. The big indexes are composed of the biggest companies. I will bet that over 100 companies currently in the S&P 500 will not be there 12 to 15 months from now.

Just a reminder: Bull markets like this one don’t just retreat to reasonable valuations. They usually overshoot to the downside just as they did on the upside. The lower bound is probably lower than many “worst-case” scenarios suggest. That will not be good for Baby Boomer retirement plans.

But in any case, this experience is going to leave deep scars on the economy, and on consumer/investor/business sentiment. This is going to scar a generation just as deeply as the Great Depression scarred our parents and grandparents. Things we once took for granted—a leisurely restaurant meal, catching a movie, sharing a concert or a ballgame with other fans—are gone now and will come back in a different form.

But they will come back. We’re moving from one world to the next—an Age of Transformation—whether we want to or not.

The letter is already running a little long, and frankly, feels as personal as my usual personal ending, so I think I will just hit the send button and wish you a great week! And sign up for the SIC. We are all going to need that roadmap, and I want you on the journey with me!

Your still optimistic for the long run analyst,

John Mauldin
Co-Founder, Mauldin Economics

Coronavirus crisis lays bare the risks of financial leverage, again

This time it is capital markets, rather than banks, that have to reform

Martin Wolf

Coronavirus exploding graph
© James Ferguson

Crises reveal fragility. This one is no exception.

Among other things, coronavirus has revealed fragilities in the financial system.

This is unsurprising. As before, reliance on high leverage as a magical route to elevated profits has led to private profits and public bailouts.

The state, in the form of central banks and governments, has come to the rescue of finance on a gigantic scale. It had to do so. But we must learn from this event.

Last time, it was the banks. This time we must look at capital markets, too.

The IMF’s latest Global Financial Stability Report details the shocks: falling equity prices, soaring risk spreads on loans and plummeting oil prices.

As usual, there was a flight to quality. But liquidity dried up even in traditionally deep markets.

Highly-leveraged investors came under severe stress.

The pressures on the financing of emerging economies have been particularly fierce.

Chart showing that government debt had already been rising before the crisis

The scale of the financial disarray reflects in part the size of the economic shock. It is also a reminder of what the late Hyman Minsky taught us: debt causes fragility.

Since the global financial crisis, indebtedness has continued to rise. In particular, the indebtedness of non-financial companies rose by 13 percentage points between September 2008 and December 2019, relative to global output.

The indebtedness of governments, which assumed much of the post-financial crisis burden, rose by 30 percentage points.

This shift on to the shoulders of governments will now happen again, on a huge scale.

Chart showing that the Covid-19 crisis brought a spike in the volatility of US Treasury yields

The IMF report gives a clear overview of the fragilities. Significant risks arise from asset managers as forced sellers of assets, leveraged parts of the non-financial corporate sector, some emerging countries, and even some banks.

While the latter are not the centre of this story, reasons for concern remain, despite past strengthening. This shock, the report states, is likely to be even more severe than envisaged in the IMF’s stress tests.

Banks remain highly-leveraged institutions, especially if we use market valuations of assets.

As the report notes: “Median market-adjusted capitalisation is now higher than in 2008 only in the US.”

The chances that banks will need more capital is not small.

Chart showing that balance-sheet pressures showed in widening spreads betweentreasury yields and swap rates

Yet it is capital markets that lie at the heart of this saga. Specific stories are revealing.

The Bank for International Settlements has studied one weird episode in mid-March when markets for benchmark government bonds experienced extraordinary turbulence.

This happened because of the forced selling of Treasury securities by investors seeking “to exploit small yield differences through the use of leverage”.

This is the type of “long-short strategy” made infamous by the failure of Long Term Capital Management in 1998.

It is also a strategy vulnerable to rising volatility and declining market liquidity.

These cause mark-to-market losses.

Then, as margin is called in, investors are forced to sell assets to redeem loans.

Chart showing that pre-Covid-19, hedge funds took increasingly leveraged positions

Another story elucidated by the BIS tells of emerging economies. An important recent development has been the rising use of local currency bonds to finance government spending.

But when the prices of these bonds fell in the crisis, so did exchange rates, increasing the losses borne by foreign investors. These exchange-rate collapses worsen the solvency of domestic borrowers (notably businesses) with debts denominated in foreign currency.

The inability to borrow in domestic currency used to be called “original sin”.

This has not gone, argue the BIS’s Augustin Carstens and Hyun Song Shin. It has just “shifted from borrowers to lenders”.

Yet another significant capital-market issue is the role of private equity and other high-leverage strategies in increasing expected returns, but also the risks, in corporate finance.

Such approaches are almost perfectly designed to reduce resilience in periods of economic and financial stress.

Governments and central banks have now been forced to bail them out, just as they were forced to bail out banks in the financial crisis.

This will reinforce “heads, I win; tails, you lose” strategies. So vast is the size of central bank and government rescues that moral hazard must be pervasive.

Chart showing that the ‘original sin’ of foreign currency debt has returnedin foreign-exchange markets

The crisis has revealed much fragility. It has also demonstrated yet again the uncomfortably symbiotic relationship between the financial sector and the state.

In the short run, we must try to get through this crisis with as little damage as possible.

But we must also learn from it for the future. A systematic evaluation of the frailties of capital markets, comparable to what was done with banks after the financial crisis, is now essential.

One issue is how emerging economies reduce the impact of the new version of “original sin”.

Another is what to do about private sector leverage and the way in which risk ends up on governments’ balance sheets.

I think of this as trying to run capitalism with the least possible risk-bearing capital.

It makes little sense.

This creates a microeconomic task — eliminating incentives for the private sector to fund itself so heavily via debt; and a macroeconomic one — reducing reliance on debt to generate aggregate demand.

Chart showing that local currency finance does not mean greater independence

The big question now is whether the essential systems that keep our societies running are adequately resilient.

The answer is no. This is the sort of question the OECD’s New Approaches to Economic Challenges Unit has dared to address. Inevitably, it has created much controversy.

Yet it is admirable that an international organisation is daring to do so at all.

The crisis has shown us why.

We cannot afford complacency.

We need to reassess the resilience of our economic, social and health arrangements.

A focus on finance must be an important part of this effort.

Pandemic geopolitics

Is China winning?

The geopolitical consequences of covid-19 will be subtle, but unfortunate

THIS YEAR started horribly for China. When a respiratory virus spread in Wuhan, Communist Party officials’ instinct was to hush it up. Some predicted that this might be China’s “Chernobyl”—a reference to how the Kremlin’s lies over a nuclear accident hastened the collapse of the Soviet Union. They were wrong.

After its initial bungling, China’s ruling party swiftly imposed a quarantine of breathtaking scope and severity. The lockdown seems to have worked. The number of newly reported cases of covid-19 has slowed to a trickle.

Factories in China are reopening. Researchers there are rushing candidate vaccines into trials. Meanwhile, the official death toll has been far exceeded by Britain, France, Spain, Italy and America.

China hails this as a triumph. A vast propaganda campaign explains that China brought its epidemic under control thanks to strong one-party rule. The country is now showing its benevolence, it says, by supplying the world with medical kit, including nearly 4bn masks between March 1st and April 4th. Its sacrifices bought time for the rest of the world to prepare.

If some Western democracies squandered it, that shows how their system of government is inferior to China’s own.

Some, including nervous foreign-policy watchers in the West, have concluded that China will be the winner from the covid catastrophe. They warn that the pandemic will be remembered not only as a human disaster, but also as a geopolitical turning-point away from America.

That view has taken root partly by default. President Donald Trump seems to have no interest in leading the global response to the virus. Previous American presidents led campaigns against HIV/AIDS and Ebola. Mr Trump has vowed to defund the World Health Organisation (WHO) for its alleged pro-China bias (see article). With the man in the White House claiming “absolute power” but saying “I don’t take responsibility at all”, China has a chance to enhance its sway.

Even so, it may not succeed. For one thing, there is no way to know whether China’s record in dealing with covid-19 is as impressive as it claims—let alone as good as the records of competent democracies such as South Korea or Taiwan. Outsiders cannot check if China’s secretive officials have been candid about the number of coronavirus cases and deaths. An authoritarian regime can tell factories to start up, but it cannot force consumers to buy their products.

For as long as the pandemic rages, it is too soon to know whether people will end up crediting China for suppressing the disease or blaming it for suppressing the doctors in Wuhan who first raised the alarm.

Another obstacle is that China’s propaganda is often crass and unpleasant. China’s mouthpieces do not merely praise their own leaders; some also gloat over America’s dysfunction or promote wild conspiracy theories about the virus being an American bioweapon.

For some days Africans in Guangzhou were being evicted en masse from their homes, barred from hotels and then harassed for sleeping in the streets, apparently because local officials feared they might be infected. Their plight has generated angry headlines and diplomatic rebukes all over Africa.

And rich countries are suspicious of China’s motives. Margrethe Vestager, the EU’s competition chief, urges governments to buy stakes in strategic firms to stop China from taking advantage of market turmoil to snap them up cheaply. More broadly, the pandemic has fed arguments that countries should not rely on China for crucial goods and services, from ventilators to 5G networks.

The World Trade Organisation expects global merchandise trade to shrink by 13-32% in the short run. If this turns into a long-term retreat from globalisation—which was already a worry before covid-19—it will harm China as much as anywhere.

More fundamental than whether other countries are willing to see China supplant America is whether it intends to. Certainly, China is not about to attempt to reproduce America’s strengths: a vast web of alliances and legions of private actors with global soft power, from Google and Netflix to Harvard and the Gates Foundation. It shows no sign of wanting to take on the sort of leadership that means it will be sucked into crises all across the planet, as America has been since the second world war.

A test of China’s ambitions will be how it acts in the race for a vaccine. Should it get there first, success could be used as a national triumph and a platform for global co-operation. Another test is debt relief for poor countries. On April 15th the G20, including China, agreed to let indebted nations suspend debt payments to its members for eight months.

In the past China has haggled over debt behind closed doors and bilaterally, dragon to mouse, to extract political concessions. If the G20’s decision means the government in Beijing is now willing to co-ordinate with other creditors and be more generous, that would be a sign it is ready to spend money to acquire a new role.

Perhaps, though, China is less interested in running the world than in ensuring that other powers cannot or dare not attempt to thwart it. It aims to chip away at the dollar’s status as a reserve currency.

And it is working hard to place its diplomats in influential jobs in multilateral bodies, so that they will be in a position to shape the global rules, over human rights, say, or internet governance. One reason Mr Trump’s broadside against the WHO is bad for America is that it makes China appear more worthy of such positions.

China’s rulers combine vast ambitions with a caution born from the huge task they have in governing a country of 1.4bn people. They do not need to create a new rules-based international order from scratch. They might prefer to keep pushing on the wobbly pillars of the order built by America after the second world war, so that a rising China is not constrained.

That is not a comforting prospect. The best way to deal with the pandemic and its economic consequences is globally. So, too, problems like organised crime and climate change. The 1920s showed what happens when great powers turn selfish and rush to take advantage of the troubles of others.

The covid-19 outbreak has so far sparked as much jostling for advantage as far-sighted magnanimity. Mr Trump bears a lot of blame for that. For China to reinforce such bleak visions of superpower behaviour would be not a triumph but a tragedy.

Next in line

Which emerging markets are in most financial peril?

Our ranking of 66 countries shows which are in distress, and which are relatively safe

WHAT TO WEAR? The question puzzles many people shaken out of their routines by the pandemic. It also troubles investors. The world is full of “dirty shirts”, as Bill Gross, a legendary bond trader, once put it, when contemplating the bonds on offer from heavily indebted governments. But you have to wear something. Thus many investors buy Treasuries, despite America’s less-than-sparkling public finances, because it is the “least dirty shirt”.

The grubbiest garments are found elsewhere—among the world’s emerging markets. They collectively owe $17trn of government debt, 24% of the global total. Eighteen of them have had their credit ratings cut in 2020 so far by Fitch, more than in the whole of any previous year.

Argentina has missed a $500m payment on its foreign bonds. If it cannot persuade creditors to swap their securities for less generous ones by May 22nd, it will be in default for the ninth time in its history.

The laundry pile also includes Ecuador, which has postponed $800m of bond payments for four months to help it cope with the pandemic; Lebanon, which defaulted on a $1.2bn bond in March; and Venezuela, which owes barrelfuls of cash (and crude oil) to its bondholders, bankers and geopolitical benefactors in China and Russia.

These defaulters may soon be joined by Zambia, which is seeking to hire advisers for a “liability-management exercise”, an agreement to pay creditors somewhat less, somewhat later than it promised.

As the pandemic wreaks havoc on economies and public finances, the natural question is: who’s next? More than 100 countries, including South Africa, have asked the IMF for help. It has already approved 40 of the quick, small loans it provides after natural disasters. Some countries are repeat customers. Egypt is also seeking a new bail-out only nine months after it drew down the final instalment of a loan agreed on in 2016.

When the virus first jolted financial markets, the threat of a full-blown emerging-market crisis loomed. Since January foreign investors have withdrawn about $100bn from emerging-market bonds and shares, according to the Institute of International Finance (IIF), a banking association. That is over three times what they yanked out over an equivalent period of the global financial crisis (although these numbers do not cover all capital flows, and emerging economies have grown significantly since 2008).

The sense of panic has since begun to abate. The Federal Reserve’s swap lines to 14 central banks—including those of Brazil, Mexico and South Korea—have helped ease a global dollar shortage. Capital outflows have subsided and emerging-market bond yields have fallen. This tentative reprieve invites a more discriminating assessment of emerging-market finances.

The Economist has ranked 66 countries using four indicators of financial strength (see chart).

Some, such as Russia, Peru and the Philippines, look relatively robust. About 30 are in distress, or flirting with it. The alphabet of alarm runs from Angola to Zambia. But these 30 account for a relatively small share of the group’s debt and GDP.

Covid-19 hurts emerging economies in at least three ways: by locking down their populations, damaging their export earnings and deterring foreign capital. Even if the pandemic fades in the second half of the year, GDP in developing countries, measured at purchasing-power parity, will be 6.6% smaller in 2020 than the IMF had forecast in October.

The damage to exports will be acute. Thanks to low oil prices, Gulf oil exporters will suffer a current-account deficit of over 3% of GDP this year, the IMF reckons, compared with a 5.6% surplus last year. When exports fall short of imports, countries typically bridge the gap by borrowing from abroad.

But the reversal of capital inflows has been matched by higher borrowing costs. In March the risk premium that emerging markets must pay buyers of their dollar bonds rose to distressed levels (over ten percentage points) for nearly 20 governments—a record number, says the IMF.

To weather the crisis, emerging economies may need at least $2.5trn, the fund reckons, from foreign sources or their own reserves. One way to ensure countries have more hard currency is to stop taking it from them. The G20 group of governments has said it will refrain from collecting payments this year on its loans to the poorest 77 countries (though the borrowers will have to make up the difference later).

The G7 group of countries has urged private lenders to show forbearance too. A group of over 70 private creditors supports the idea, while noting its “complexity” and the “constraints” lenders face.

A sweeping debt standstill may also be less necessary than it seemed even two weeks ago, as investors have calmed somewhat. That may reflect over-optimism about the course of the pandemic. But even false optimism can be of true help to emerging markets, by allowing them to refinance debt on affordable terms.

The relative calm also allows for a more discerning look at emerging-market strains. Some have wide fiscal or external deficits; others have high debts. In some the weak link is the government; elsewhere it is the private sector. Debt may be largely domestic, or it may be owed to foreigners—and sometimes in foreign currency, too.

Our ranking examines 66 economies across four potential sources of peril. These include public debt, foreign debt (both public and private) and borrowing costs (proxied where possible by the yield on a government’s dollar bonds). We also calculate their likely foreign payments this year (their current-account deficit plus their foreign-debt payments) and compare this with their stock of foreign-exchange reserves. A country’s rank on each of these indicators is then averaged to determine its overall standing.

The strongest countries, such as South Korea and Taiwan, are overqualified for the role of emerging markets. Many bigger economies, including Russia and China, also appear robust. Most of the countries that score badly across our indicators tend to be small. The bottom 30 account for only 11% of the group’s GDP, and less than a quarter of both its foreign and its public debt.

The ranking also reveals the vast differences in the source and scale of potential weaknesses.

Countries like Angola, Bahrain and Iraq have public debt that some reckon will exceed 100% of GDP this year. But about half of the economies we examine have debts below 60% of GDP, the threshold that euro-zone members are supposed to meet (and which few do).

The Asian financial crisis of 1997 showed that strong public finances are not enough to protect an emerging economy if private firms borrow heavily abroad. Mongolia’s public debt looks manageable (less than 70% of GDP) but its foreign debt (public and private) is almost twice GDP. Conversely, the well-known fiscal frailties of Brazil and India are mostly confined within their own borders.

Bond yields, meanwhile, show how costly foreign borrowing will be. Sixteen of the economies in our group must offer yields of over 10% on their existing dollar bonds to find takers. But over 20 have hard-currency bonds yielding less than 4%, the kind of cheap finance that used to be the preserve of rich countries. Some, like Botswana, have no dollar bonds at all, preferring to borrow in their own currency.

Over the course of 2020, the 66 economies in our exercise will have to find over $4trn to service their foreign debt and cover any current-account deficits.

Excluding China, the figure is $2.9trn. But this leaves out the buffers that emerging economies have accumulated.

The governments in our exercise hold over $8trn in foreign-exchange reserves (or almost $5trn, excluding China).

Half have enough reserves to cover all of their foreign-debt payments due this year and any current-account deficits.

The rest (including 27 of the bottom 30) have a combined reserve shortfall of about $500bn.

By far the largest gap in dollar terms is in Turkey, which has swiftly depleted its reserves by intervening to prop up the lira.

The calculations for the reserve shortfall ignore the risk of capital flight, when a country’s own citizens decide to take their money out of the country. But they also assume that countries will attract no foreign direct investment and fail to roll over any of their foreign debt coming due this year.

In March such a scenario seemed all too plausible. Now it looks too gloomy.

Indeed, in recent weeks 11 emerging economies have been able to sell over $44bn-worth of bonds between them, says Gregory Smith of M&G Investments, an asset manager.

Even Panama, with large external debts and a big reserve shortfall, issued bonds at a yield of less than 4% at the end of March. The sale was three times oversubscribed. In a world of dirty shirts, some investors fancy a Panama hat.

Picking off the weak

How deep will downturns in rich countries be?

Those in central and southern Europe seem most vulnerable

AS THE VIRUS upends productive activity across the world, the question now is how bad things will get. On April 14th the IMF warned that the global recession would be the deepest for the best part of a century.

But the severity of the pandemic and the uncertainty around the duration of lockdowns are such that economists’ models, trained on business cycles in the post-war era, are of little use. Some companies, such as Starbucks and Dell, have pulled their guidance on annual earnings, declining even to hazard a guess about the future.

Amid the fog, however, one thing seems certain: some economies will suffer much more than others.

Economic crises expose and exacerbate structural weaknesses. Analysis by The Economist of five decades of GDP data finds that growth rates in rich countries tend to converge during expansions, as even the weakest economies are pulled along. Yet during downturns performance diverges markedly.

In the first half of the 2000s the average annual gap between the GDP growth rates of the best- and worst-performing rich countries was five percentage points. In 2008-12, in the recession that followed the global financial crisis, the gap widened to ten points.

This recession will be no different. Three factors should help separate the bad economic outcomes from the dire ones: a country’s industrial structure; the composition of its corporate sector; and the effectiveness of its fiscal stimulus.

The Economist has used indicators of these to rank, roughly, the exposure of 33 rich countries to the downturn. Some, such as those in southern Europe, appear far more vulnerable than America and northern European countries (see chart).

Take industrial structure first. Lockdowns will slam countries that depend on labour-intensive activities. Those with large construction sectors, such as many central European countries, look vulnerable. So do those that rely on tourism—it accounts for one in eight non-financial jobs in southern Europe.

Conversely, those with large mining industries, which require less labour, may do better. Here Canada looks relatively insulated.

Industrial structure also influences the share of people who can work from home, and thus dodge the worst disruption of the lockdowns. In a paper published on April 10th Jonathan Dingel and Brent Neiman of the University of Chicago estimate that fully 45% of jobs in Switzerland could plausibly be done from home.

Many Swiss work in industries, such as finance, where all they really need to do their job is a laptop. Others elsewhere do not have this luxury. Less than a third of jobs in Slovakia, a big manufacturing hub, can be performed remotely; home working is also difficult in southern Europe.

Research by Indeed, a job-search website, and Ireland’s central bank finds that since the pandemic began, countries where home working is less prevalent have seen bigger falls in the number of online job advertisements.

The shape of the corporate sector is the second consideration. Economies with a large share of small firms are more likely to be scarred by long shutdowns. Minnows tend to have few if any cash buffers, making it hard for them to survive a drought in revenues.

A survey by researchers at the University of Chicago, Harvard University and the University of Illinois finds that a quarter of small firms in America do not have enough cash on hand to last even a month. Nearly half of Italians and Australians work for firms with fewer than ten employees, compared with a fifth in Britain and an even lower share in America.

A third determinant of the economic pain to come is the nature of fiscal support. Rich countries have deployed stimulus on an unprecedented scale. Even by the most conservative estimate, these packages are more than twice as large as in 2008-09. But the size of the stimulus varies widely across countries.

Most tallies find that support in America and Japan is the most generous, as a share of GDP; investors, who see their assets as a haven, are happy to provide the necessary funding. Yet some euro-area governments with high debt levels are more cautious, perhaps constrained by the fear that, as members of a currency union, they enjoy only a partial backstop from the central bank.

The average fiscal boost in France, Spain and Italy, as a share of GDP, is about half of that provided in Germany.

The design of the stimulus, though, matters as much as its size. Broadly speaking, rich countries have taken one of two approaches to preserving living standards. Some are concentrating on supplementing household incomes.

America is sending cheques to families and making unemployment benefits far more generous; Japan is offering handouts to the needy. By contrast, policy in northern Europe and Australia aims mostly to maintain employment by subsidising wages.

Government pledges to protect jobs are normally a bad idea. They prevent workers moving from failing sectors to up-and-coming ones, slowing the recovery. The coronavirus recession may be different, however.

If the lockdowns are lifted soon, some European economies will be able to resume production quickly.

Elsewhere workers will have to search for jobs, and bosses to hire them.

Some American workers will even do better to stay on benefits than find work; according to Noah Williams of the University of Wisconsin-Madison, benefits in six states could exceed 130% of the average wage.

That will mean it takes longer for GDP to recover its pre-pandemic level once the lockdowns lift.

Instead of leading to a painful few months, the damage could be much longer-lasting.

Whistling Past The Graveyard

by: Eric Parnell, CFA

- The stock market rebound continues.

- Focus on quality with stock allocations.

- A key near-term downside risk looms ahead.

The U.S. stock market continues its remarkable rebound. The S&P 500 Index has now rebounded by a +35% from its March 23 lows nearly six weeks ago. In the process, it is increasingly showing the same post Great Financial Crisis (GFC) swagger that so many investors have become so accustomed over the last decade. New all-time highs straight ahead?
Maybe. We can't rule anything out. But regardless of how well the stock market may be performing as of late, it does not mean that the underlying challenges confronting the economy and markets have gone away.
Like a hot knife through butter. The S&P 500 first arrived at key resistance zone between 2800 and 3000 more than a week ago now on April 17. This range contained three key technical resistance levels in its 50-day, 400-day and 200-day moving averages.
Historically during the start of major bear markets over the past century, stocks have rebounded following an initially sharp correction, only to see these bear market rallies frequently fail and roll back over at these key resistance levels.
As a result, monitoring how the S&P 500 responded once arriving at these key resistance levels has been critically important in recent days. And what we are seeing so far is that the S&P 500 is making quick work in clearing these critical technical levels so far.
After initial hesitation, the S&P 500 advanced through its 50-day moving average late last week. And on Wednesday, the benchmark index quickly advanced past its 400-day moving average with barely a pause. The remaining hurdle among this resistance trio looms ahead in the 200-day moving average just above 3000.

While it remains to be seen whether the S&P 500 can clear this third test, the manner in which it has been advancing in recent days suggests that it may make equally quick work of driving past its 200-day moving average resistance as well. From there, the next major stop for the S&P 500 is at previous all-time highs.
The steady decline of the CBOE Volatility Index, or the VIX, provides added support to the notion that the next move for the S&P 500 may be higher instead of lower as it cuts its way through resistance.
Whistling past the graveyard. The fact that the S&P 500 Index has been performing so well for so many weeks now since bottoming on March 23 is extraordinary in the context of what is taking place in the world outside of Wall Street. While the strong rebound in stocks thus far is not at all surprising from a technical perspective (stocks historically have almost never gone down in a straight line even in the worst of bear markets; they almost always rebound with a comparable pace to the preceding correction), it has virtually nothing to do with fundamentals.
The economy has effectively ground to a halt for more than a month and a half and counting.
Corporate earnings projections are being slashed on a daily basis, and the clarity on forward guidance is virtually nil as most corporations really have little idea how things are going to play out from here. Sure, selected companies like Amazon (NASDAQ:AMZN), Netflix (NASDAQ:NFLX), and Zoom (NASDAQ:ZM) have been thriving during COVID-19, but these are the selected exceptions and not the norm.
And all of this fundamental deterioration is taking place at a time when stocks were already trading at historically peak valuations and are becoming increasingly more expensive with each passing day as the "P" in the P/E ratio continues to rise at the same time that the "E" implodes. Dangerous is apparently still the S&P 500's middle name.
So what explains the rally? I mean, what rational fundamental investor when looking at a market where the underlying economy is stalled and corporate earnings are collapsing with a multi-year outlook that is about as clear as a foggy day in San Francisco and stock prices that are already about as expensive as they have been in history wouldn't want to be backing up the truck to buy stocks day after day after day, right?
Umm. . . While we did see positive net inflows from retail and institutional investors into domestic equities totaling +$30 billion over the three week period ended April 15 according to the Investment Company Institute, overall domestic equity fund flows since the market bottom have been marginally negative at around -$2 billion in outflows.
In short, it's not the retail or institutional investor that is driving the rally.
Of course, the source of the rally is no secret. It is NOT the twisted-into-pretzel explanations that I've been increasingly hearing lately in the financial press including the one that I am listening to right now as I type trying to rationalize the rally.
Today's stock gains day after day after day are simply just not being driven by some notion of what earnings are going to be in 2021 or 2022 or 2025, because this is almost impossible to predict right now. Instead, the answer is the same answer it has been for the last decade. It's the Fed.
The U.S. Federal Reserve has expanded their balance sheet by an incredible $2.4 trillion over the past eight weeks. And this liquidity spillover is likely to continue for the foreseeable future.
Whether it will continue to be enough to power stocks higher as economic conditions continue to deteriorate and corporate bankruptcies continue to mount remains to be seen. But investors should be fully cognizant of the fact that stock market gains to date and further gains from here will be heavily dependent on central bank liquidity continuing to drive stocks higher despite the deeply bleak underlying reality.
FOMO? The more the stock market continues to climb, the greater the anxiety accumulates among investors that may look at the fundamental reality and think that the stock market is crazy, but at the same time are asking themselves whether today is just the latest in a long line of post GFC examples of the stock market freight train leaving the station to the upside following a breathtaking correction.
As a result, some investors may be increasingly feeling the fear of missing out and the need to increase their stock market allocations despite the fact that their instincts are screaming the exact opposite.
Discipline over emotion. It is important to remain disciplined and dedicated to your investment philosophy and approach regardless of what is taking place in the stock market or any portfolio asset class for that matter at any point in time. And for a balanced asset allocation strategy, this includes maintaining allocations across asset classes that are optimized through the ongoing inclusion where necessary of each worthwhile individual asset class including stocks at any given point in time.
In short, if you're feeling the fear of missing out on stock market upside, you should have been allocated to stocks at least to some meaningful degree throughout. With this in mind, the key question is the following: how to best maintain this stock allocation during the most difficult of times?
Quality is key. In the current market environment, an emphasis in the stock segment of your broad asset allocation portfolio on quality and low volatility is paramount. The idea of quality includes a focus on balance sheet factors such as liquidity and solvency risk as well as income statement elements such as operating consistency and profitability. And if recent early post Fed liquidity flood signals are any indication, this emphasis on quality may be particularly important going forward.
Consider the following from the high yield corporate bond market. Since the day before Good Friday on April 9 when high yield bonds popped on the news that the Fed would include purchases in the speculative grade space as part of its alphabet soup rescue programs, this area of the market has been adrift ever since.
While it has picked up a bit over the last three trading days, high yield bonds have the look of a market segment that is still drifting down.
Recent trends in bond yield spreads relative to U.S. Treasuries are even more revealing.
Although the Fed has committed it will do way beyond whatever it takes to support the financial system, we see that bond spreads remain elevated not only in the high yield space but also among investment grade BBB credits.
Moreover, it is telling that since blowing out to cycle wide spreads on March 23 and subsequently coming back down to post correction low spreads on April 17, that high yield spreads have since widened by 71 basis points while BBB spreads have only increased by 2 basis points.
This suggests that investors may be increasingly conceptualizing that while the Fed may be overwhelmingly there to supply lending, this may not include any specific issuers in the high yield space other than a select group of fallen angels. Moreover, the Fed is not in the position to drive demand and cash flow for underlying issuers to service their debt.
Put more simply, the Fed's actions will only do so much to prevent widespread corporate bankruptcies. And these defaults are likely coming in a meaningful way in the speculative grade area of the market where the Fed has much less of an incentive to defend. As we all know, when a company falls into bankruptcy, their stock price effectively goes to zero.
As a result, if you are feeling the inclination to maintain or increase stock allocations, focus on those companies whose credit ratings are at least investment grade, which is BBB or better.
From my perspective, my preference is to focus primarily on companies that are single-A rated or better as an extra layer of protection, as I continue to believe that BBB will eventually become the new high yield before it's all said and done.
Of course, don't just rely on the credit rating as a guide, however, as you must do your own homework to confirm that corporate liquidity and solvency is strong. After all, it is easy to forget that AIG was once prime AAA rated as recently as 2005 not that long before the onset of the financial crisis.
And I would contend that a number of companies currently rated BBB are in better financial shape than others that are rated in the AA and A range. As always, do your own homework and verify before making any securities purchase.
A developing and critical near-term risk to the Outlook. While everything certainly seems ducky for the U.S. stock market, a significant near-term risk is rising that warrants close attention in the coming weeks and months. And from my qualitative observation, the stock market appears to be vastly underestimating this risk to date. What is this risk? It is the lifting of "stay at home" measures.
Trying to get back to normal. States are reopening, and they are doing so soon. Some states such as Georgia have effectively reopened already. I completely understand the sense of urgency to reopen. For many people, their economic survival depends on it. For others, it is a question of civil liberties.
I also understand the argument that current "stay at home" measures may be doing more harm than good at this point along with the notion that the death rate may be much lower than originally thought and that many hospitals across the country are now struggling with being not busy enough instead of too busy.
I believe the argument makes sense to begin opening sooner rather than later if not now some of the more rural parts of the U.S. where the virus remains non-existent. And I'll even go so far as to say that I'm holding out the hope (based on nothing scientific mind you) that the upcoming hot summer weather keeps the virus in check.
But despite all of these considerations, the fact still remains that a quickly spreading virus does not care whether your livelihood is at risk, whether you have the right to assemble, or what anyone's opinion may or may not be about what to do next. All the virus cares about is finding a new host to continue its spread.
"A premature easing (of social distancing) would come at an irrevocable cost, so we should approach the issue very carefully, and invest deep thought into when and how to transition"
-- Kim Gang-lip, South Korea Vice Health Minister, April 13, 2020
WWSKD? If any country has done COVID-19 about as well as they could, it has been South Korea (I would contend that Taiwan has done even better). As a result, when it comes to how to navigate a global pandemic, I am inclined to listen to what the political officials in South Korea have to say, for unlike the United States they have done major health outbreaks numerous times in the past.
In the case of South Korea, they had their first reported case of COVID-19 on the same day that we did here in the United States. But thanks to widespread testing and tracing along with strict social distancing measures, their active cases quickly peaked in early March and had largely abated by mid-March. But despite this success, they remain continually mindful of social distancing practices many weeks after the worst was behind.
Given that South Korea has been through this before and we in the U.S. have not, we would be well served to heed the sentiments contained in the quote above.
Of course, South Korea is an exceptional case, so what about situations that are more like the U.S. for a more comparable circumstance.
Spain and Italy. These countries were among the hardest hit by the coronavirus. They are the only other nations outside of the U.S. that have more than 200,000 recorded active cases to date (we in the U.S. now have more than 1,000,000 recorded active cases btw and this doesn't include the potentially many more that remain unaccounted for). Both of these countries have made good progress over the past many weeks.
The number of new active cases in Spain peaked at the start of April and has been falling ever since.
And after a month of trending in the right direction, Spain is just now taking initial steps to relax social distancing measures.
The situation in Italy has also shown good progress. After peaking in mid-March, the number of new active cases has been steadily declining in the many weeks since. And like Spain, they are now starting to take preliminary steps to start to reopen their economy.
What about U.S.? We have arguably the best medical system in the world in this country. But we also have the highest number of active cases by 4x and deaths by 3x versus any other country in the world (the latter reading is still good on a per one million basis, but the absolute number is still high globally).
But unlike many of its global peers, the number of active cases each day remains stubbornly high to date. Unlike so many other countries that are only now just starting to reopen after weeks of declining new active cases, the U.S. is still seeing active cases come in at plateau levels to date.
Jumping the gun? This raises the question as to whether we are moving too soon in reopening many parts of the U.S.
For not only are new active cases stubbornly flat, but the two-day death total of 4,860 on April 28-29 was exceeded only twice before on April 14-15 and April 21-22. In short, we remain near highs in terms of deaths to date.
We have already seen in cases like Singapore, Japan, and Hong Kong that the threat of a second wave outbreak is real. And these took place in countries where they are experienced in dealing with virus outbreaks and had done well in driving the new active cases per day toward zero. It's not a question of whether we want to reopen. We most certainly do. Instead, it is a question of whether we are truly ready to reopen.

Key missing elements. An added risk to our increasing reopening plan in the U.S. is the following: one of the primary reasons for enacting "stay at home" measures in most states across the country over the past month and a half was not only to "flatten the curve", which we have achieved thus far despite the curve's stubbornness to not start falling down the other side, but it was also to buy time so that we could be as prepared as possible with the necessary testing, tracing, and treatment so that the economy could restart most effectively once it was time to go back out.
Unfortunately and at least to date, while Gilead Sciences (NASDAQ:GILD) has provided us with some promising initial treatment readings for remdesivir, we as a country are simply nowhere close to being ready when it comes to testing and tracing. In short, we are now reopening our state economies not much more prepared than we were when we closed everything up.
Potential irrevocable cost risk. Our potential lack of readiness to reopen our economy looms as arguably the most significant downside risk to the economy and its markets in the months ahead. Consumer and business confidence has already been badly shaken by COVID-19 over the past two months. And the restart of the U.S. economy is likely to be cautious and uneven anyway.
But if we were to restart our economy prematurely only to have to head back indoors due to a major second wave, third wave, fourth wave outbreak, this would be particularly damaging for both consumers and businesses, as it would dash any notion that the worst of it all is now behind us. I would postulate that no amount of fiscal or monetary stimulus would be able to offset the economic and psychological damage of having to repeat "stay at home" measures over the coming months.
Once again, hopefully ongoing social distancing efforts and the coming hot weather keeps COVID-19 at bay - only time will tell. In the meantime, this looms as a major downside risk to the near-term outlook.

Bottom line. The S&P 500 Index is showing great determination to continue rising despite the deeply poor underlying fundamentals. Given this disconnect in an already expensive market, investors seeking to either maintain existing stock weightings or add to an existing allocation are likely to be well served to emphasize financial quality and low price volatility in their stock selection while leaning away from stocks whose underlying credit rating is speculative grade.
And amid the ongoing stock market determination to the upside in recent weeks, it will remain important to monitor the key downside risk of potential further outbreaks once "stay at home" orders are lifted.
Disclosure: This article is for information purposes only. There are risks involved with investing including loss of principal. Gerring Capital Partners and Global Macro Research makes no explicit or implicit guarantee with respect to performance or the outcome of any investment or projections made.
There is no guarantee that the goals of the strategies discussed by Gerring Capital Partners and Global Macro Research will be met.
After years of policy stimulus, stocks are now falling from record high valuations and bond yields are at historic lows. Reality is now returning to global capital markets. Do you have a plan to navigate what is left of today's bull market while also positioning for the next bear market?