Post-Mortem Research Notes For the First Half of the Year 2020

The COVID19 pandemic has led authorities around the globe to take unprecedented measures to contain the spread of the virus to save lives while attempting to maintain a functional economy. Although containment measures have differed across the world, on a global scale, the shut down of activities in early March 2020 involving large crowds or human contacts have resulted in the largest swing in economic activity in living memory. Many economies have contracted by 25-40% in a single quarter and have experienced double-digit levels of unemployment two months in the crisis. 

Amid surging coronavirus caseloads as economies have started to re-open, mostly in early May, various countries and US states have begun imposing a rollback of their reopening plans. In the future, historians might consider the health crisis as a defining moment of the 21st century. This report provides a post-mortem analysis of the macroeconomic patterns that unfolded in the first half of 2020 and gives a forward-looking deep dive for the rest of the year. 

• A Global Panic Started As the Virus Spread in Europe: 

Given their forward-looking nature, traditional financial markets reacted faster than the real economy. The beginnings of lockdowns in late January in China received scant attention in the world press and as such, markets barely moved. When the virus was christened COVID-19 by the WHO and surprisingly started to hit the wires in Europe in February 2020, a flight to safety turned into a scramble for cash as investors fulfilled margin calls following the early signs of a market downturn. Equity markets buckled, volatilities and correlations spiked while bond yields bottomed akin to the 1929 stock market crash. For example, the S&P 500 plummeted 34% from February 19 to March 23. Additionally, panic drove global investors to withdraw more than $80 billion in emerging market economies.

• This Crisis Is Strengthening the US Dollar Hegemony: 

The Federal Reserve has had to act in its time-honored role of lender of last resort by supplying needed liquidity in offshore US-dollar borrowing, notably via FX swaps, to ease dollar funding shortages. Many non-US financial institutions and firms outside the United States cannot raise USD-denominated funds directly in US money markets, as such, they rely on FX swaps. According to the Bank for International Settlements (BIS), US dollar liabilities of non-US financial institutions experienced a 194% growth in almost 20 years from about $3.5 trillion in 2000 to around $10.3 trillion by the end of 2019.

Additionally, the Fed reactivated many currency swap lines that had expired since the Great Financial Crisis, specifically for 14 central banks from both advanced and emerging economies and particularly utilized by the Bank of Japan and the European Central Bank. This allowed central banks to borrow US dollars directly from the Fed using their holdings of US Treasuries as collateral. It is safe to say, so far, this health crisis has amplified the US dollar hegemony as the world’s dominant currency.

While inflation has always been a concern when it comes to quantitative easing measures implemented by central banks, it is important to recognize the reliance of USD-denominated assets by financial institutions outside of the United States. As such the FX swaps metric is a quintessential indicator for USD demand from non-US banks.

• A Wider Reality Gap between Financial Markets and Real Economies: 

Central banks such as the Federal Reserve have 4 main tools at their disposal: 

1. Short-term interest rates
2. Lending to financial institutions
3. Outright asset purchases and sales
4. Regulatory adjustments affecting financial markets 

First, given the unprecedented consequences triggered by the current crisis, central banks deployed their full arsenal of tools especially as firms and households bore the brunt of the fallout. The Federal Reserve has cut interest rates in an attempt to reduce the cost of borrowing for the entire financial system. Other countries such as the UK, Switzerland, and Sweden set up new lending facilities targeted at SMEs.  

Secondly, as previously mentioned, the Fed alleviated USD-specific pressures through foreign exchange swaps to non-US banks. In addition, the Fed launched in early April 2020 the Paycheck Protection Program Lending Facility (PPPLF) to lend money to commercial banks, which they, in turn, loan money to small and medium-sized enterprises through the $659 billion Paycheck Protection Program (PPP). Other examples in Switzerland and Germany, governments have fully guaranteed SME loans to counter financing difficulties faced by small businesses due to their relative lack of external financing options when compared to large firms. 

Thirdly, the Federal Reserve alongside other central banks such as the Bank of Japan and the European Central bank (ECB) have engaged in purchases of individual corporate bonds alongside corporate bonds ETFs. For example, the Fed added $1.59B in individual corporate bonds such as Apple and AT&T as well as snapped up $7.87 billion in 16 corporate bonds ETFs in partnership with the world’s largest asset manager, BlackRock. 

And lastly, central banks around the world softened capital and short-term liquidity regulations and encouraged banks to make full use of existing buffers beyond regulatory minima. As an example, the Fed’s reserve requirements were eliminated (ie, cut to zero percent) for all depository institutions in late March 2020.

By early June, market conditions, especially US equities, had improved to the point questions were raised about whether they had become entirely disconnected from what was happening in the real economy. The market rally was driven by some genuine news about monetary and fiscal policies reminiscent of the actions taken to counter the Great Financial Crisis (GFC). In addition, the narrative around regrets of not buying the bottom in 2009 or in late 2018 drove opportunistic buyers to go back in, starting with hedge fund traders and mutual fund managers. FOMO (fear of missing out) alongside government actions have eventually helped market participants in traditional financial markets gain confidence, leading to all-time record highs for the NASDAQ 100 index, which rose by 51% since the market crash in March 2020. 

The decoupling of traditional financial markets from the alarming consequences of the COVID19 pandemic in real economies has significantly widened especially in the US. This health crisis is causing activity to collapse exceptionally and unemployment to soar, triggering one of the worst job crises since the Great Depression. In fact, massive layoffs and wage cuts have reached levels unseen before with over 40 million workers claiming unemployment benefits between March and June. The International Labour Organization (ILO) estimated that, in the absence of income support measures, the earnings of informal workers in the first month of the crisis declined by up to 60% globally. 69% in Europe and Central Asia, and dropped more than 80% in Latin America and Africa — resulting in a pushing back of poverty alleviation efforts. This revenue fallout is concurrent with the projected decline in remittances to fall by about 20% in 2020 according to BIS.

As of July 13, with an average of 8,000 new daily cases, the state of California announced a statewide closing of indoor operations. Similarly, to stem a new outbreak originating from nursing homes and taxi rides, Hong Kong has banned gatherings of more than four people. This pattern is important to note as consequences of containment measures such as reductions in consumer demand will likely make the path to inflation unlikely in the near term. Nonetheless, asset price inflation is undeniably reflected in financial markets with the current market rally amid surging new coronavirus cases, especially in some US states.

COVID19 Cases

Source: New York Times

• Accelerated Adoption of Digital Solutions Including Bitcoin: 

In times of crisis, the need for a sense of urgency has historically led to a fundamental change in people’s behavior. Job losses and uncertainty have put a strain on consumer spending and have led to a record amount in households’ saving rates. For example, in the UK, deposits increased by a record of £25.6 billion. 

As public concerns about viral transmission from cash have risen, this health crisis has accelerated the trend towards digital payments such as contactless payments. The companies in the private sector such as CashApp played an important role to facilitate direct transfers to households and firms as part of the $2 trillion Coronavirus Aid, Relief, and Economic Security (CARES) Act.

In a similar vein, a quite different picture starts to emerge as investors have begun to seek a digital version of gold, especially in light of the biggest gold-counterfeiting scandal in modern history where roughly 4% of China’s gold reserve turned out to be gold-plated copper. According to a recent survey conducted by Fidelity, 6 out of 10 investors believe digital assets such as Bitcoin have a place in portfolios, while 91% of the surveyed institutional investors plan to make allocations to Bitcoin within five years.

Forward-Looking View for The Rest of the Year 2020: 

With new coronavirus clusters emerging around the world raising uncertainty over the pandemic evolution, disinflationary pressures are likely to prevail for some time especially in some of the hardest-hit sectors sensitive to social-distancing rules. A V-shaped recovery seems out of reach as higher precautionary savings to build buffers and repay debt could continue to dampen expenditures on the consumer demand side partly due to lingering worries of infection. This would put further pressure on both monetary and fiscal policy buffers especially in scenarios where insolvencies and capital misallocation prevail. Additionally, heightened uncertainty could lead to a somewhat difficult exercise for governments to distinguish insolvent but viable firms as pre-existing business models might no longer be defensible over the long run. Early discoveries of capital misallocation by governments have started to emerge with PPP fraud charges in the US or fraudulent filings by companies to benefit from the furlough scheme in France. 

In preparation against worst-case scenarios, central banks such as the Federal Reserve and the ECB are already in discussion of new coronavirus relief packages accounting for additional amounts worth trillions of dollars. It is safe to say that this could lead to debts overhang in various economies, especially when insolvencies will start to kick in. The question remains whether central banks and financial institutions will make capital allocation adjustments and shift resources towards the more promising sectors and firms. Only time will tell whether the Federal Reserve’s and other central banks’ intervention will prove successful and at 21Shares, we will closely follow what the future holds on all fronts.