Bracing for a downturn
COVID-19 could trigger an economic downturn every bit as bad as the financial crash of 2008. It could even be worse, but it can only be hoped it will not drag on as long. The financial crash was a top-down crisis. At the very top of the financial pyramid traded derivatives on sub-prime mortgages crashed. It lead to a liquidity crisis in the banking system.
Illiquidity filtered down to banks, real estate, borrowers, employers and ended up with people losing jobs or taking pay cuts.
Covid-19 is a bottom-up crisis. The impact of containing and controlling the virus affects people’s behaviour immediately as consumers and employees. It starts with the local café, restaurant or hotel and may then contaminate higher up the economic chain to international financial markets.
The problems of the local corner shop are shared with the problems of the indebted international airline. The virus feeds up the corporate chain and can then undermine confidence in the wider financial system.
The potential scale of the economic challenge means governments around the world are going to have to spend enormous sums of money to counteract the cost.
Central bankers can do a certain amount. The Bank of England has cut rates. So too has the Federal Reserve. But with rates already so low in the eurozone, the ECB says it is up to governments to introduce a fiscal stimulus to stem the tide.
The difference between a central bank intervention and a national government one is taxpayers end up footing the bill at some point in the future, through higher sovereign debt, which has to be serviced and presumably paid back at some point.
By Wednesday there were already signs of strain at the top end of the financial system. The US government bond market came under strain during the financial tumult. Some analysts said the market became “overwhelmed by liquidity concerns”.
Bank of America noted illiquidity could stop the Treasury market from functioning. This is a $50trn marketplace where the US government raises its borrowing. It is also used as a benchmark for a raft of other assets around the world. Poor liquidity or extreme volatility here could have a domino effect.
Closer to home, the Government stepped up measures to protect people. The greater the protection needed, the greater the cost will be. So far the Government has pledged a package of measures totalling €3.1bn.
The bulk of this is made up of enhanced illness benefit payments. The rest is to support businesses. Yet already small businesses are moving to lay people off as their trading income has collapsed.
Can the State afford to compensate businesses for loss of earnings while also paying sick pay to those laid up or forced to stay at home because of the virus?
We are likely to see a battle between big businesses caught up in massive short-term cash-flow difficulties and smaller firms that risk disappearing. Examinerships are likely to make a return. So too will closures.
The Government has to be swift in implementing its business support schemes but must also be careful in how it drafts terms and conditions. You could end up with a situation where large firms, deemed to be “strategically important” can qualify for compensation or other support, while smaller businesses cannot. The state will not be able to support every business in the country.
Already this crisis has echoes of 2008 and 2009. Banks will have to apply forbearance on debt. Landlords will have to consider the same thing on commercial rents. Airlines will have to talk to leasing companies about how much they pay for planes sitting unused on the tarmac. The Government will come under pressure to cut Vat rates, local authority rates or delay tax payments. Cutting Vat now won’t be enough to encourage people to go out and shop, especially when advice is to separate.
There are few people poised to benefit from this crisis. One is Roy Niederhoffer of a New York-based computer-driven hedge fund firm.
RG Niederhoffer Capital Management’s flagship fund — one of the world’s oldest quant hedge funds — gained 37pc this year, after losing 28pc in 2019 when markets rose.
Niederhoffer summed it up when he told the Financial Times: “This is a sad situation that has created the ultimate in conditions for our strategy.”
Another might be US President Donald Trump, who staked his political reputation on the economy’s performance. With the US economy already showing signs of weakening, the explosion of Covid-19 has given him something to blame. Trump will throw any amount of money at the problem — other people’s money, that is. Having already racking up a deficit of $1trn a year and presiding over an increase in the US national debt to $23trn, this crisis comes at a bad time for US federal coffers. Citizens will pick up the tab and pay the price at a later date, long after Trump has left the White House.
So much of business is about psychology. Consumer confidence, investor confidence, risk v opportunity, are what makes business work. There are already a number of signs this economic shock will have longer-term implications, when the dust settles:
1. Changing consumer demand: Tens of millions of people around the world will spend the next few weeks at home in self-isolation. They will spend less money and buy fewer things. They will also worry not only about their health but also their finances. They may well question the need to buy “all this stuff ” when this is over, especially if their financial situation has been weakened.
2. Oil price and climate change: One of the economic buffers in the crisis is that oil prices have fallen dramatically. It helps people through an economic downturn if the cost of driving, transport and home heating is cheaper. The cheaper fossil fuels are the more we use them. The oil price fall may well set back initiatives around climate change.
This would of course be a very short-term perspective on a very real problem, but people think short-term in a downturn.
3. Working from home: Covid-19 has provided the circumstances for a massive corporate experiment — having more people work from home. Millions around the world are now working sitting in their living room considering what to do all day. This will enable businesses, big and small, to see whether it is better and cheaper to operate this way.
Smaller service companies may be the ones to make a fundamental shift after this experience rather than corporate giants. It will also provide direct feedback, in perhaps a cruel way, to managers about people’s motivation, discipline and output.
One boss of a small company I spoke to said some of his employees had done “shag all” working from home. He had evidence one of them did little more than make two phone calls.
Another small firm owner, with around 25 employees, told me they are all at home and everything is working very well. He is thinking of ditching the office or keeping a smaller space and sub-letting the rest.
The causes of this economic shock are completely different to the financial crash. Yet some implications will be similar. It will expose vulnerabilities investors chose to ignore.
Staff will expect their employers to pay them while they are at home minding children who are off school. Big companies may be able to do this for a while. But it will prove impossible for some employers brought to the brink by this crisis.