In this article, I will deal with three examples of how the effects of Covid-19 are not immediate. They will take time to work their way through the system, like slow-motion dominoes falling. These three examples include (a) bankruptcies; (b) effects on banking system; and deficits/burgeoning debt/monetary expansion.
We are at the very beginning of a long series of bankruptcies caused by Covid-19. According to the Financial Times, as of mid-August 2020, 45 companies with more than $1 billion in assets have declared bankruptcy, compared to 39 in the same period during the 2009 recession2. As the virus grinds on, as companies consume their capital reserves, the number of bankruptcies is only likely to accelerate, with further domino effects on banks (see below), medical costs, unemployment and hence deficit spending.
(b) Effects on the banking system
Banks are better capitalized than in the 2008 crisis (see my earlier blog on the subject3). However, as the Covid-19 crisis drags on, the financial toll on banks will only increase. Bankruptcies create non-performing loans, hence capitalization may yet prove inadequate, triggering a crisis of confidence.
The amounts of derivative contracts held by many of the “too large to fail” banks (e.g. Citibank, JP Morgan) are each measured in the tens of trillion of dollars4. Reminding me of Warren Buffet’s famous statement that derivatives are financial weapons of mass destruction5.
Many countries have declared moratoria on debt payments, mortgage payments, rent payments, etc. Banks typically do not recognize loans subject to moratoria as being in default. But what happens when the moratoria expire? Moratoria and creative accounting cannot be extended indefinitely.
What will happen in countries like India, Nigeria and Brazil, where there are many millions of Covid cases, and the banking system may be less able to withstand bankruptcies?
(c) Deficits and Money Printing
The world was already facing a huge debt bubble prior to Covid-196. Government responses to Covid-19 have been to massively increase spending, including unemployment payments, “helicopter money”, bank guarantees, etc., which only serve to increase debt. Global debt (households, non-financial corporates, government, financial sector) has reached a new record of 331% of GDP in Q1 2020, up from 320% in Q4 2019 and continues to increase rapidly. Gross debt issuance also hit a record of $12.5 trillion in Q2, an increase of 127% respect the quarterly average of $5.5 trillion in 20197. The money printing machines are working overtime. Forty percent of US spending is already financed by the issuance of new debt/money printing8. References in the media to a dollar crisis, massive inflation or deflation, or a global financial reset are becoming increasingly frequent. The debt bubble and fiat currency debasement will be further accentuated as Covid-19 grinds on.
Given the massive amount of debt, monetary expansion, etc., we are guinea pigs to a vast experiment. The debate going on among economists as to whether we might experience massive inflation or deflation demonstrates how little we know where this experiment will lead.
Some concluding comments
A vaccine might arguably help stop further shocks to the financial system, but would not stop the domino effects from existing damage working its way through the financial system. Will we ever have an effective vaccine? My own view is that many of the flu strains with us over the past years are also forms of coronavirus, and the vaccines against them provide at best partial effectiveness, and that viruses constantly mutate. Chances are that we will find ways to reduce the spread of Covid-19 and treat it better, but there will be no magic bullet, (e.g. like a smallpox vaccine that totally eradicates the disease) in the coming year or two.
Given the logistics of producing billions of vaccines, objections of large swaths of the population against taking them, etc., even if a semi-effective vaccine were to be found, it will take time to roll it out. We should plan to live with Covid-19 for at least the near- and mid-term, and brace ourselves for the financial aftermath.
Bottom line: expect turbulence and volatility ahead. Liquidity will help you survive a downturn and take advantage of opportunities.
4https://www.occ.gov/publications-and-resources/publications/quarterly-report-on-bank-trading-and-derivatives-activities/files/pub-derivatives-quarterly-qtr3-2019.pdf, pg. 37
5https://www.berkshirehathaway.com/letters/2002pdf.pdf, pg. 15