COVID-19 and global financial markets

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Recorded 27 March 2020

Richard Portes, founder and honorary chair, CEPR

Torsten Slok, chief economist, Deutsche Bank Securities

Tim Phillips, CEPR (moderator)

 

 

Tim Phillips:

Welcome from the Centre for Economic Policy Research to another of our special COVID-19 webinars. My name is Tim Phillips. Every day the graphs are spiking and plunging, and the two questions we should ask about that are, what's going on? And what does it mean? We've got two of the people with us today who are most likely to be able to give us an answer.

Tim Phillips:

Torsten Slok is the Chief Economist of Deutsche Bank in New York. He joins us today. Hello Torsten. I believe you're in a church?

Torsten Slok:

I am indeed. Good morning.

Tim Phillips:

I can hear the echo. And Richard Portes is Professor of Economics at the London Business School, and of course he is the founder and the honorary president of the Centre for Economic Policy Research. Hello Richard.

Richard Portes:

Hello Tim and Torsten, indeed. I hope you're not having to pray for all of us right now, Torsten.

Torsten Slok:

It may be needed.

Tim Phillips:

Now for both of you, just before we get started, for policy to be effective then investors and regulators and governments, we all need a level of common understanding of what's going on, what these market signals mean. As of today, do we have that shared understanding, Torsten?

Torsten Slok:

So I think that we've gotten to a point in the crisis where at least the central banks have reacted at the theories of the ECB with a number of different initiatives that have been helpful. We have finally also seen the Americans come along with a fiscal package, at the last, of all the major countries. So we are relatively confident that we are beginning to move in the right direction. There's still a lot of things in financial markets that are not quite as calm as we all would like, but the short answer is that we are feeling more optimistic than we have done at least for quite a few weeks.

Tim Phillips:

Richard, do you feel as optimistic?

Richard Portes:

Not as optimistic, but maybe that's because I'm sitting in Europe. The policy responses on the European side are mainly limited, so far, to the European Central Bank. The regulators haven't acted. I think what we have seen, as an academic I can say very confidently, an explosion of academic writing and even new research on all the issues related to this from the health policy issues, and the epidemiology, but also into the finance and economics of it. A lot of that is beginning to appear and is, I think, very enlightening. Some of the academics understand what's going on in the markets, and some of the policymakers understand what's going on in the markets. I speak to the policymakers a lot because I'm involved with the European Systemic Risk Board, which is the systemic stability macro prudential authority for the European Union. That involves also interchanges with the national regulators and so forth, so I see both sides of that. I don't see, except for talking with people like Torsten, I don't see that much directly of the markets, so I hope this interchange will be fruitful on both sides.

Torsten Slok:

Let me just add to that. It's clear that markets, of course, have been trying to figure out a framework for thinking about what's going on, and obviously you and everything that's been going on from the academic side has been incredibly helpful. The speed with which everyone is moving and communicating with each other has certainly been most helpful also for financial markets here.

Tim Phillips:

And that's of course why we're here today. So Torsten, I believe you have some charts to show us of what is going on, that you can interpret for us. So please, take it away.

Torsten Slok:

So one way to think about what's been going on, at least from a very simple perspective, is to think about what was the impact of the virus once it came along. And in particular of course, what was the relatively severe impact that we saw on the corporate sector, when suddenly retailers started shutting the doors, factories started standing still, and assembly lines were no longer running.

Torsten Slok:

The number one impact, of course, of shutting your doors to your store is that you no longer have any revenue. What you see on the first picture here is, of course, that there has been a need to try to raise more cash. This has shown up in various forms. First of all, of course, in the amount of currency in circulation, both in the US and euro area. We've seen a modest increase in the amount of cash in the economy as both corporates that no longer have revenue begin to raise more cash.

Torsten Slok:

And also households, which unfortunately as we got the unemployment numbers in the US and the jobless claims, as you know, went up by more than 3 million. That of course also means that households have also been trying to raise more cash to, so to speak, build a bridge over the virus, and make sure that cash holdings were big enough in this situation, where the revenue and wages and salaries was suddenly no longer at the same level, at least at the macro level, as it was before.

Richard Portes:

So we'll see, I hope, how the various different ways in which corporates are raising cash, very liquid assets, and I think that is quite important. It covers a number of dimensions.

Torsten Slok:

And this is also what you see in the next slide, that the most active players in money market funds are exactly corporates. So corporates have tried to raise more cash, with the uncertainty about how long time this will last. It has not been sort of disorderly in any dramatic ways as we also will see in some of the following slides, but it's been enough to see last week a drop in the total assets in money market funds, or prime money market funds in the US of roughly around 10%, which is a relatively significant drawdown driven of course by redemptions, but also driven by some potential decline in the underlying value of the assets that the money market funds have been holding.

Torsten Slok:

So this theme of trying to substitute revenues for corporates and trying to substitute wages for households is, at least very broadly speaking, a very important reason behind most of the things that we have seen in financial markets over the last few weeks.

Richard Portes:

I believe that Goldman had to bail out one of its prime funds a few days ago, and that is something that we are worrying about most as academics and policymakers. We're worried about the possibility of runs, not just on money market funds, but on other investment vehicles that do maturity transformation in one way or another.

Torsten Slok:

And one important aspect of this is also how we have seen generally an attempt to raise cash outside of the money market system. In this next slide, we see that the stock market obviously has gone down. This is a very big picture number namely, what is the total global market value of global stock markets? And as you can see in round numbers, the total value of global stock markets has gone down from around 90 trillion to now roughly around 60 trillion, as you can see. It's a little bit difficult to see in the chart, but it's rebounded of course a bit here in the past few days. But, generally speaking, one important reason also why stocks sold off so much was of course that investors reassessed the underlying cash flows for corporates going forward, but an added reason also was that equities is one of the most liquid markets. Liquid markets have been selling off more simply because it was an easier way both for households to raise cash, and also for corporates to raise cash.

Richard Portes:

Note that that decline in market cap means a decline in the values of pension fund holdings, of insurance company holdings of equities, and of individual household holdings of equities even if through their retirement plans, whatever, whatever. The result of that, I suspect, is going to be a significant drag on consumption if equity market levels stay well below what they were before, and people will feel a negative wealth effect.

Torsten Slok:

And this of course adds to the challenge that the virus is not only closing doors to stores and keeping factories quiet, but it's also the financial market turbulence has the risk of also having a quite significant negative impact on GDP. And of course, as exactly as you say Richard, consumer spending and what the implications therefore will be if we stay at these relatively low levels of where we still are.

Torsten Slok:

The next slide shows nuance in terms of the issues of this need to raise some more cash, namely in commercial paper markets. The blue line is the commercial paper for financials. The red line is commercial paper for non-financials. One interesting aspect here is that as we saw in 2008 and 2009 there a lot of the distresses in markets were in the financial system, as you can see today. Now the red line is actually higher than where it was in 2008 and 2009 meaning non-financials is now the area where you're seeing some more distress. This of course is exactly why the Fed decided here very recently to do the commercial paper funding facility. Unfortunately that will only be up and running here in the first half of April. We have already seen signs that the facility that the fed has been doing will also begin to help out for any of the stresses that we've seen in commercial paper markets.

Richard Portes:

Part of the European Central Bank paid 750 billion euro package was indeed a provision for the ECB to buy commercial paper issued by non-financials. The legalities of that have now been sorted out, and I believe that it's actually in force as of today so that this will be a potential source of liquidity for firms. If they issue CP they can sell it straight away to the ECB.

Torsten Slok:

And with that backdrop, of course, other funding markets and other ways of trying to look at whether there is distress in the financial system is to look at the next page, which shows you. The blue line is LIBOR-OIS, the red dotted line is FRA-OIS. The thin black line is the euro-dollar basis swap. These are essentially different measures of funding markets and short term money markets. The quick conclusion from this chart is that yes, there is distress, but a lot of institutions that the Fed has been dusting off from the financial crisis have certainly been most helpful.

Torsten Slok:

The initiatives from the ECB also more recently have also been helpful. And as you can see the basis, meaning the black line, now looks like at least liquidity is back because of the swap lines. And you also look at the both the red and the blue line and you conclude that it's worse than what it was in 2011, and also back in 2010, and 2011 with the euro crisis, but again, we're nowhere near the systemic risks and the types of stresses that we saw in 2008 and 2009 when it comes to funding markets. We are relatively optimistic still that things are now moving in the right direction, thanks to all the initiatives that the central banks have taken up to this point.

Torsten Slok:

Turning to a broader measure of distress in financial markets, the red line shows you VIX, which, as you all know, is implied vol in equity markets. The blue line is a similar measure for implied volatility in rates markets and treasury markets. Here though, you suddenly can see that the level of distress is now similar to what we were in 2008 and 2009. Of course implied volatility, as the chart shows, literally out of the blue jumped up too for VIX, the highest level that we have ever seen before.

Torsten Slok:

Of course it takes some time, remember many quant models and many investors have an exponential memory where they put a relatively high weight to recent history, and they put less weight on more distant history. So that means that it will probably take some time before VIX, both for equities and vol measures for treasuries, begin to come down. But the big picture is that it was obvious distress, but because of the initiatives that Richard and I spoke about on the previous pages that have been implemented, it does look like at least on some of the indicators that we saw here, that things are getting better and you should also therefore expect general measures of volatility also to get better over the coming weeks.

Richard Portes:

Do you think the spike in vol has negatively affected the quant funds, that as you say, whose models are based mainly on recent data rather than historical data?

Torsten Slok:

I do think this has played an important role, as you and I have talked about over the years, where negative interest rates in the euro area this has create a hunt for yield among investors. One very popular strategy was the risk parity strategy, or essentially different versions of a carry trade. A lot of those strategies simply assumed that if you ran a regression on data for the last five, six, seven, eight years, then you would generally have assumed that VIX would always be low. You would generally have assumed that interest rates would always be low. You would generally assume that there will basically be no volatility in financial markets.

Torsten Slok:

So, given the virus has caused so much of a surprise in jump in measures of volatility and surprise in so many different parts of financial markets, any quant strategy that was relying on a regression of data for the last five, six, seven years would of course have been very surprised. And in finance terms would have been underperforming because something happened that simply was not assumed in the model. So that's why some of the correlations including between treasuries and rates markets have been breaking down simply because things were not trading based on the historical relationships, but certainly things were trading based on what was liquid. What could I liquidate to quickly raise some cash?

Torsten Slok:

The whole new dimension was not incorporated in many of the econometric models, or many of the quant models, or principal component models that tried to exploit various opportunities in markets that have been there for five, six, seven years, but just have not been there for the last few weeks. This has of course spread to discussions about credit risk, which is a much more systemic issue, which Richard knows much more about it than I do.

Torsten Slok:

This specific chart here shows you, if you look at the blue line, this is the number of distressed issuers that are trading with more than a thousand basis points over the benchmark Treasury rate. In other words, this shows you the number of bonds that are trading at extreme levels of yields. You don't get the Nobel prize in economics for the correlation in this chart here, but we are of course quite worried when a number of corporates suddenly are trading at very distressed levels. It does raise an important point, that Richard mentioned just before, namely that if this continues to trade at these very distressed levels then it will have more broad based implications for wealth effects, for capex decisions, for finance decisions, for the corporate sector because the implications of course would be severe if the costs of financing for any loan for corporates continues to be as expensive as you're seeing in this shot here.

Richard Portes:

Let me grow that out a bit. The prospect of a major wave of ratings downgrades for corporate bonds. These bonds are held, in good part by pension funds, by insurers and so forth. If those bonds, and there's a lot of triple B paper out there, hundreds of billions, both in Europe and in the United States, if those bonds suddenly go below investment grade, the institutions typically will be forced to sell them. That will be a fire sale situation. How do you see that playing out?

Torsten Slok:

This is what we see on the next chart. This shows you the market cap of different parts of the credit stack in terms of credit quality. In the grey area, exactly as you just mentioned, the amount of BAA or triple B outstanding is much bigger today than what it was before and the risk of a fallen angel situation, or the risk of a situation where bonds get downgraded, would be very serious, of course, for those that are holding those bonds.

Torsten Slok:

It's particularly serious because if you look at the IG index today, it used to be the case that 25% of the IG index was triple B. Triple B is the lowest rated course you can have in investment grade, but today it's around 50% of the investment grade index that is triple B. Meaning the amount of bonds inside the index which are lower rated has unfortunately gone up quite significantly. And many institutions both in, of course, US and Europe are not allowed to hold high yields and can only hold investment grades. So if you have a downgrade of the lowest criticals down to high yield, the risks would indeed be important for the global financial system.

Torsten Slok:

Limiting the negative impact on the macro economy is critical, of course. Most importantly to make sure that people don't lose their jobs and to make sure that people get some compensation in the form of unemployment benefits or other things. But it's actually also very, very important to make sure that we avoid this risk that you are mentioning, which is very important, Richard, that we have a downgrade problem on our hands where suddenly you could have a fire selling or forced selling amongst some investors if you see a downgrade of the investment grade index that they are holding. So we don't believe we will get into that situation and we don't believe that this problem will create any systemic risks, but this is obviously something that needs to be watched very carefully.

Richard Portes:

It would hit the corporate bond funds too, and the ETFs, no?

Torsten Slok:

It would indeed. We have seen a bit of that in the flows. If you look at US mutual funds and ETFs that are invested in corporate credit, we don't really know very well why we have seen redemptions. It could of course be because households need cash to pay their bills now that many people have lost their jobs. It could also be that people worry about the underlying quality of credit. But in the last few days we have seen, thankfully, quite a rally, quite an improvement in investment grade credit, Also, even a high yield, we've also seen quite a rally, suggesting that investors are beginning to come back to corporate credit, that this will be a more temporary shock.

Torsten Slok:

The next page shows the global ramifications of that important point that you are raising, namely that if you look at the question of who are the holders of US corporate credit? The red line in this chart here shows you that the biggest holder of US corporate credit is foreigners. If you look very carefully at the chart you can see that the red line, this is the percentage of US investment grade and high yield held by different entities. The red line shows you foreigners started increasing the share that they were holding of US corporate credit in 2014 when ECB introduced negative interest rates. When interest rates turned negative global investors, in particular in Europe and Japan, began hunting yields. One area that there was significant hunt for yield was in US credit, which is what you can see in the red line here.

Torsten Slok:

It's been a little bit more bumpy more recently when the Fed began to raise rates in 2015. And we began to see in '18 also of course, more appetite for buying the risk free asset, meaning rates rather than corporate credit. Then they've paid of course the below rates so now the red line has been going up. But the bottom line in this, from a systemic issue of course, is that a lot of US corporate credit is held abroad, which is basically bringing me to the bottom line that US corporate credit challenges are not just an issue in the US but it's also an issue for the rest of the world because of this significant ownership abroad.

Torsten Slok:

And this brings me to the final chart that I brought along here, namely the overall measure of financial conditions. There are various indicators. We at Deutsche Bank also have our own measure, but these two are the ones from the office of Financial Research, which is part of the US Treasury, as you know. The red line is the Bloomberg measure of financial conditions. These indicators are daily. Sometimes when macro investors ask me what's going on, how distressed are things, show me a picture that tries to summarise everything that we're thinking about, this chart here is one way of doing that. Namely, to look at, well overall and the way this is calculated, it is important is that you throw into the kitchen sink all the measures that we have spoken about on the previous pages, that have daily numbers, and you then do principal components, and ask the question, what is the variation that these measures have in common?

Torsten Slok:

They have a nuance in how this is calculated that sometimes you then ask okay, I want those measures, and I'd want that variation, to be captured in this series, but I want that series to be correlated with GDP, or correlated with the unemployment rate. But no matter how you look at it, no matter how sophisticated methods that you do, you end up with a picture at the moment that things today are not as distressed as they were in 2008 and 2009, but they are more distressed than what they were during the euro crisis in 2011.

Torsten Slok:

So the main conclusion to Richard's good point earlier is that the longer this lasts, of course the distress in financial markets will have a longer lasting impact on the economy. But given what the Fed has been doing, given what ECB has been doing, we do believe that financial distress will begin to come down. In other words, we will see these stresses ease over the coming week or two. That should also therefore limit the negative impact of the distress from financial markets on the economy, both in the US and in the euro area, in our view.

Richard Portes:

Going back to 2008/2009, that period when the red line was above, or either line was above where it is now, roughly speaking, how long did that last? When I'm looking at the graph, it's hard for me to tell.

Torsten Slok:

That's true, and it is a good point. So I made the argument here that this is going to be read to be short lived. The argument for this to be short lived today is that the reason why we had 2008 and 2009 was that we had some imbalances in the economy that had been building up. We had some imbalances in 2006 and 2007 with the housing market. If you go back to the recession in 2000 we had some imbalances because of the IT sector and technology sector having over invested too much investment in technology. And if we go back to 1990 we had imbalances because of the commercial real estate sector.

Torsten Slok:

So one logic that I think about the situation today is that this distress we're experiencing is not driven by an imbalance in housing or IT or commercial real estate. It really literally, the virus came out of the blue, and there were not that many imbalances, at least broadly speaking, in the economy from a GDP perspective, which also therefore through your good question, makes me somewhat confident that it will not last as long. We just need the virus to go away. So I know this is of course what it's all about, but in some sense these pictures here is that the policy initiatives have been able to flatten out, if you will, the recession curve. And now what we just need to wait for is to see a flattening out of the virus curve.

Torsten Slok:

It will surely be bumpy still, but at least the support, both for monetary policy and fiscal policy, has been much more aggressive, much quicker out of the box this time around, which also gives me some more confidence that this will be more short lived, relative to what we saw particularly in 2008 and 2009.

Richard Portes:

I think that there's some reason for that optimism, although I think that the original feeling that this is going to be a really V-shape affair, and there'd be one quarter in which there'd be a sharp shock, and then you'd see a recovery in the next quarter. It's going to be at least two quarters, and we don't know how much further than that it's going to extend. As you say, it depends on the spread of the virus, the impact of the virus, and how long productive capacity will be shut down in various ways.

Richard Portes:

Some of that productive capacity won't come back of course, and that's something to bear in mind that a lot of the service sector is shaky. Some of it is closing down already. Some of it has forcibly closed down. Some of that will just not come back. Some airlines will be eliminated. Some air transport capacity will be eliminated overall. The planes won't go away, but you will find demand for travel down. I mean, this is just an example. You'll find demand for travel down for a long time. So we have to bear in mind that turning the corner on the GDP side is not going to be that easy.

Richard Portes:

Can I go back, Torsten, to discussing some of the financial issues now? One thing that concerns me, I mentioned there was a run on a Goldman prime money market fund. That was just one fund. We could, however, think about the possibility that people really will get spooked and that there will be runs on a number of investment funds of one kind or another. The natural response to that would be redemption gates. But there are no consistent policies, I believe, from the regulators about how and when to use redemption gates. Is this likely to happen in the US do you think at all?

Torsten Slok:

So the important part of that question is that it's difficult to assess why we are seeing these withdrawals. We're seeing these withdrawals because there is just a simple need to have some precautionary savings. I just need to have some more cash as a household or as a corporate. Or is there really a worry about profound insolvency or panic in financial markets, or a much more distressed fear of what's going on? But you're right, it is important to monitor the out flow situation across all kinds of funds, to figure out how significant these issues are because this creates fire selling, this recreates false selling.

Torsten Slok:

So another way of saying that is that normally we think about financial markets as pricing is driven by fundamentals, the future cashflow of a company, or the future outlook for an economy in terms of work, government bonds, or the future outlook for inflation. But if there's suddenly is some selling of assets that's not related by a fundamental consideration but by consideration about the system, or in this case, a need for cash, then you have to rewrite the issue of systemic risks, which you know much more about than me, does become very important.

Richard Portes:

No, it's an issue that concerns us. Another related phenomenon is something we have been seeing, we know we've been seeing, and that is corporates drawing on their credit lines with banks, such as your own. All the big banks have substantial credit lines available to their big clients at least, to draw upon, more or less on demand, on reasonable terms. Many corporates have availed themselves of this opportunity because they want cash, right? They are worried about their liquidity positions. Now you can imagine which firms we're talking about.

Richard Portes:

Now that then puts pressure on the banks, no? And the question is what the bank can do. One thing the bank can do is to try to get their corporate clients to, instead of drawing on the credit lines, to issue commercial paper or to issue bonds that, in the European case at least and maybe with the CPFF in the United States, would then be bought up by the Central Bank. Do you see this as a major issue, this rush for cash, getting their cash from you? Right?

Torsten Slok:

You're right. That brings us back to what is the underlying theme of everything that's been going on. I think that the different institutions that the Fed has taken out of the closets and dusted off and implemented very, very quickly in some sense. Jay Powell was quote unquote lucky that Bernanke already has created these institutions 10 years ago, and now could just open the drawer and take them out again. Those institutions are very important in that regard. It is helpful when you look at how spreads have been moving, as we spoke about in some of the pictures we showed here, that we have seen definitely signs of easing in funding market, signs of easing in investment grade and high yield markets. So it is the underlying theme, the need for cash. But the good news is that the institutions have now been built. It takes some time for things to calm a bit down, but I'm still very optimistic that we have seen a lot of the action that will be helpful, and bring us back in a more normal situation again.

Tim Phillips:

Richard, on that topic, within Europe, do you see a reason to loosen or pause some of the regulatory restrictions on banks?

Richard Portes:

Well, the banks have already been told that they can use some of their capital buffers to bolster their capital position if they're worried about that. There are other things that the regulators can do, and may do, like restricting their ability to pay dividends, like restricting their ability to pay bonuses, like restricting their ability to have stock buybacks using their capital. So that the regulators are on the one hand being flexible in certain respects, but they may well be rather more restrictive in other respects. I think we don't quite know that yet which way they'll go.

Richard Portes:

But I was hoping, Tim, that we might have taken Torsten's note of optimism there, given that we're running out of time, that we should end on a note of optimism. Regulators are there, the regulators are working day and night to try to keep the system in good shape. As Torsten said, the Fed developed tools in 2008/2009. The European Central Bank developed tools in the euro crisis, in the early 2010's, and there are a lot of experienced people out there who are trying to grapple with the financial sector consequences of this huge shock from outside the financial system. And that of course is what Torsten said differentiates it from the 2008/2009 and indeed from the 2011/2012, the euro crisis, that the shock really is coming from outside. The financial structure is somewhat better prepared, significantly better prepared to deal with it, but I hope that Torsten's optimism is justified.

Tim Phillips:

Well on that positive, well semi-positive note, we are out of time, as Richard says. So, thank you to Richard and Torsten.

Tim Phillips:

Now we are planning some more of these, so keep coming back to the COVID-19 section at VoxEU. You'll find a lot of new research, but you'll also be able to check up to see what we're planning because we're hoping to put on some live events soon. I'm sure that you would have a lot of questions when we do, so we want to make sure that those get answered for you. But now, from the Centre for Economic Policy Research, goodbye.

[END]

Topics:  Covid-19 Financial markets

Tags:  COVID-19

Professor of Economics at London Business School, Founder and Honorary President of CEPR

Chief Economist, Deutsche Bank

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