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A deluge of cash takes on a deep recession

The struggle between the wall of money and the bad economic and corporate news is an uncomfortable one for investors.

Concept of a cash injection / economic help during a financial crisis

by
John Redwood

in Features

28.04.2020

The US market has rallied from its lows thanks to an unprecedented set of large scale interventions by the Fed in markets. The US Central Bank has created more than $1 trillion in extra money and credit over the last month. Money growth (M2) was 20% in the first quarter of the year and has continued to expand. The Fed has turned round an ailing corporate bond market by buying up company debts and has offered huge support to the Treasury bond market. It's buying of Treasury bonds reached new peaks of many billions a day.  It has shown its determination to drive interest rates down and keep them down and indicated it will print and spend as much money as it takes to do this.

Money growth has accelerated dramatically with rates of growth in bank balance sheet liabilities hitting 75% annualised in March.   Shares have benefitted from this avalanche of cash. As the Fed buys up the bonds, so some of the money freed for investors and financial businesses is reinvested in shares. The share market takes its cue from the insatiable appetite of the Fed for financial assets. The inflation this amount of money generates is likely in the first instance to affect financial assets rather than most goods and services in an economy in lockdown. Whist the prices of the minority of goods and services in good demand like medical equipment, protective clothing and some foods may go up there will be weak prices for many things from holidays and hospitality to oil where demand, as well as supply, are well down.

In a way what is remarkable given this wall of money is how restrained the response of the share markets have been. That is because investors are understandably cautious about the prospects for companies in a world where a significant minority cannot trade at all, and many others face much-reduced demand and higher operating costs brought on by social distancing rules. Share buyers may ignore collapsing profits and falling cashflows for a bit as their chosen businesses can borrow to tide them over a difficult patch, and all the time shareholders think the downturn will be short-lived. Many shareholders have also been willing to look through a period of cut or cancelled dividends. What markets cannot ignore is bankruptcy or substantial financial reconstruction. Some businesses, especially in the most affected sectors like tourism, travel and hospitality, will go under, and some will face debt to equity conversion, rescue injections of new share capital and other refinancings which will greatly harm existing shareholders by their terms. Nor can markets ignore indefinitely those cases where companies will survive but will have more than one bad year of earnings and dividends as they adjust to a very changed world for their activity.

What the Fed is doing on a huge scale other Central Banks are doing as well. The Bank of Japan has produced gloomy forecasts of its economy and at the same time effectively announced it will create as many yen as it takes to buy enough bonds to keep the ten-year interest rate at zero and finance all the Japanese government’s growing need to borrow to spend. The Japanese Central Bank has long since been buying exchange-traded funds holding an index of  Japanese shares as well as bonds to prop financial markets. The European Central Bank has greatly increased its programme of bond buying with created money and has announced it will continue to accept bonds that have been downgraded recently from Investment status as collateral. The Bank of England announced a new Quantitative easing programme and has said it will make short term money available to the government if it needs it to pay the large bills of furlough and unemployment benefits without having to raise the money from borrowing in markets.

Governments have decided to spend liberally to offset some of the worst effects of the virus-induced downturn. They have added to their usual unemployment support a range of new measures to part pay wages to stave off redundancies and to help fund companies with grants and easy terms loans. This will lead governments to intervene more in dividend policy, prices and general corporate behaviour. In due course, it may also lead to higher taxes on business when governments have to reckon with their own surging deficits.

The struggle between the wall of money and the bad economic and corporate news is an uncomfortable one for investors. As the Fed and other Central Banks wind back the magnitude of their interventions it is possible markets will retreat again, paying more attention to gloomy headlines and poor figures. If the central Banks make clear their longer-term commitment to creating more money and spending it on financial assets markets could make more upwards progress.

This is why since the first announcements of massive support for markets we have recommended share portfolios concentrate on those sectors and companies that can trade reasonably well in current poor conditions, and have business models which will prosper as relaxations occur in the present draconian controls on business. Food production and food retail, medical service and supply and above all technology all offer considerable opportunities in dark days. The business world which emerges from the crisis will be working smarter, with more automation, more staff working at home, and more meetings and events taking place on the internet.

We have also suggested bond investment led by US Treasuries which still offer some income in a world of negative yields on many high-grade government bonds. Taking credit risk is more hazardous, as we still face a lot of downgrades to come as companies struggle with damaged cashflows. Two sectors which have borrowed a lot are banks and energy.  Banks will have higher write-offs as bad debts mount and oil companies will be hit by the current very low oil price.

Although there are now welcome signs of some relaxation in controls in some US states, in New Zealand and even in some European countries, the return to work will be patchy and slow. The businesses in the adversely affected areas still have tough times ahead which are not always fully reflected in their share and bond valuations.

Nothing on this website should be construed as personal advice based on your circumstances. No news or research item is a personal recommendation to deal.

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