Cap’n Crunch
Once upon a time…
Cap’n crunch sailed the vast sea of liquidity, which was abundant with companies supported by strong balance sheets and showing upward trending financial projections 📈. That is, until a sudden global health pandemic struck land and sea, sending these companies into a whirlwind of uncertainty.
Liquidity in crisis
The narrative of this impending global recession is changing daily, but a constant theme seems to be emerging: this crisis (should it fully materialise) will be about the absence of balance sheet liquidity, not about financial solvency (at least for now). First, let’s define the terms according to Anthony de Jasay’s article on Solvency and Liquidity :
Solvency means that the debtor has sufficient assets in cash or in such other forms that can with virtual certainty be converted into cash by the due date. Examples: 1997 Asian Crisis; 1998 Russia Crisis; 1998 Argentina Crisis (all largely a sovereign solvency issue but also have aspects of liquidity crisis)
Liquidity is an attribute of assets and signifies that the asset has a market with several active or potential participants, and can be instantaneously converted into cash at or just under the market price, or can be bought for cash at or just above the market price. Example: 2008 Global Financial Crisis (can be argued that this was a combination of solvency and liquidity issues)
Basically,
Insolvency is a debt > asset problem | Illiquidity is a cash flow problem.
The climate of today’s worry is about the expected liquidity crunch that many companies will face as a result of sudden demand-side shock. Lower consumer spending means fewer sales (U.S retail sales fell 0.5% in Feb. 2020), which translates to lower reported revenue on the income statement. While no one can predict the length and severity of this downturn, the best case scenario for companies hit with this reality is to access a short term credit line in order to mitigate the impact of a near term cash flow crunch. On March 17, the Fed announced that they are willing to be a backstop liquidity provider by buying commercial paper (short-term debt issuance) from companies to help fund ongoing operational expenses such as rent and payroll. More on this below.
Unveiling Debt by the Numbers ❗
- For the love of debt|Total debt stocks reached $229 trillion at the end of 2018 (compared to $152 trillion at the onset of the GFC), which is over 2.5x global GDP
- Fueled by private corporate debt | Total debt of developing countries — private, public, domestic and external — reached 191% of their combined GDP in 2018.
- Rising USD-denominated debt | 3/4 of total debt in developing economies is private non-financial corporate debt (of which 1/3 ex China is denominated in foreign currency and held by external creditors).
- China’s debt-fueled economy | Corporate debt in China soared from virtually nil to $590 billion (now >300% domestic GDP) driven by debt of state owned enterprises.
Focusing on the U.S in particular:
- Many U.S. small- and medium-sized firms, which have much higher debt-to-cash ratios than large-cap firms and no credit rating will not have access to the Fed’s short term credit facility. The Fed’s commercial paper credit facility (as I later describe) is primarily for large companies who can demonstrate high credit quality.
- High U.S corporate debt levels will be further exacerbated by Fed-induced “cheap capital” through near zero interest rates, monetary stimulus, and other incentives.
- Federal government debt will continue ballooning with the economy running on excessive levels of credit.
The Fed’s Liquidity ‘Bazooka’
‘Bazooka’ harkens back to the colloquial reference markets associated with former ECB President Mario Draghi’s policies on monetary easing and stimulus programs.
More recently, in the words of Nouriel Roubini:
“The Fed used all of its bazooka while the fiscal bazooka isn’t even loaded yet” (March 16, 2020)
Here’s a recap of actions the Fed has taken to abate a full blown economic recession:
- March 3 |Cuts benchmark interest rates by 50bps, lowering the target range to 1-1.25 percent
- March 15 | Cuts benchmark interest rates by 100bps, returning the target range to 0-0.25 percent and announces $700 billion quantitative easing program
- March 17 | Launches commercial paper funding facility (CPFF) and prime dealer credit facility (PDCF)
What exactly do these fancy terms mean? The Fed is willing to take on the role of “lender of last resort.”
👉 CPFF will purchase three-month debt from firms with high credit ratings (A1/P1).
👉 PDCF will extend short-term 90-day loans to banks and broker-dealers.
By injecting liquidity into the economy and extending a hand to banks and commercial business, the Fed hopes this formula will play out:
More cash or cash equivalents on the balance sheet + access to credit lines = Normalised liquidity
Trumpian Fiscal Support : Cash for every American💸
The White house is discussing a $1.2 trillion stimulus plan, which would include:
- Universal Basic Income (well, a crisis trial experiment) | Direct payments of $1,000 or more to Americans within two weeks (as part of the initial $250 billion reserved for cash payments, with a possibility for a second $500 billion injection if needed)
- $300 billion for small business loans
- $200 billion in stabilization funds
Other notable proposals include:
- Tax payment deferral for 90 days for individuals up to $1 million and up to $10m for corporations.
- Workers at companies with <500 employees can receive up to 12 weeks of paid family and sick leave
Will the Fed’s monetary stimulus combined with fiscal stimulus be enough to curtail the market’s fears?
Following the Price of Money
“Over each of the three QE periods 10-year Treasury yields rose, the opposite of what would be expected, because investors grew more confident about growth, and after each ended yields fell back” [1].
Prior to the Fed’s announcement about the $700 billion quantitative easing program, the 10 Year Treasury yield stood at 0.94. The next day, it dipped to 0.76 but has now climbed back to 1.02 on the back of new announcements about further liquidity program implementations. Time will tell whether revving up the QE engine once again will indeed boost economic sentiment and prop up Treasury yields or whether things will turn out differently this go around. The expected fiscal stimulus may also prove to be a much needed tailwind.
In the meantime, what can you and I do? Continue to #flattenthe(other)curve
Source
[1] Mackintosh, James. (2018) Don’t worry about the end of QE, worry about rates https://www.wsj.com/articles/dont-worry-about-the-end-of-qe-worry-about-rates-1533580338
