From Liquidity To Solvency

John Leiper – Head of Portfolio Management – 1st May 2020

In the early stages of the Corona Crisis of 2020, the global economy faced a liquidity crisis.

In a liquidity crisis, companies cannot access the cash, or credit, needed to survive.

The Fed resolved this problem in dramatic fashion by launching QE5 and opening fx swap lines and repo facilities across the globe. This brought an end to the dramatic dash-for-cash into the US dollar and lay the groundwork for the resulting recovery in risk assets.

As a result, the S&P 500 is now just 13% below the pre-crisis peak, trading where it was in October 2019. The risk is equities may have gotten ahead of themselves and could turn south for a re-test of the lows.

Companies are now reporting earnings and (with a number of exceptions) the numbers aren’t good. With earnings falling the price earnings ratio has risen dramatically meaning equities are now expensive again. The market is justifying these lofty valuations by looking-through the crisis to the V-shaped recovery that is to follow. But what if that recovery isn’t V-shaped but U or L-shaped? In that scenario the probability that equities have overshot to the upside is high.

Source of Data: Bloomberg/ Tavistock Wealth.        Date of Data: 01/05/2010 – 01/05/2020.

Central to this question is whether the steps taken thus far are sufficient to ensure the ensuing recovery.

They are not and the reason why is because the liquidity crisis is morphing into a solvency crisis.

In a solvency crisis, some companies cannot survive no matter how much liquidity the Fed provides. That is to say, the problem can’t be fixed by just throwing money at it.

This is because the gap between lower than expected revenue and ongoing expenses, which also includes new loans to help see-through the crisis, will eventually need to be re-paid. This issue isn’t just affecting the most vulnerable sectors, such as airlines but all sectors of the economy that have been impacted by disruptions to supply chains and the trade in intermediate goods.

To resolve this issue, governments have temporarily suspended bankruptcy procedures. This prevents the transfer of assets from debtor to creditor. Countries that have implemented this strategy thus far include France (where bankruptcy law has been extended from 45 days to 3 months), Germany, Australia, India, Spain and the United Kingdom, amongst others.

Governments are also looking into ways to restart the economy. This will likely require debt-restructuring which will involve writing-off portions of debt. This is because as economic growth has slowed, the total value of global debt has exploded. By the end of 2019, total global debt stood at $255 trillion or 322% of GDP. That is 40% higher than at the start of the sub-prime mortgage crisis in 2008 and increasingly concentrated in the hands of corporations.

On mobile: review chart in landscape mode

Key Technical Level
S&P 500 Equity Index

Source of Data: Bloomberg/ Tavistock Wealth.        Date of Data: 10/02/2017 – 01/05/2020.

The chart above shows the S&P 500 equity index since 2017. We are currently at a confluence of key technical levels including the 61.8% Fibonacci level (the percentage retracement from the low to the prior high) and a series of resistance and support levels identified by various coloured lines. The fact this is an important level is not subject to dispute. The question is whether this level coincides with the market’s collective perception of this crisis and whether or not that perception is about to morph from a crisis of liquidity to a crisis of insolvency.

This investment Blog is published and provided for informational purposes only. The information in the Blog constitutes the author’s own opinions. None of the information contained in the Blog constitutes a recommendation that any particular investment strategy is suitable for any specific person. Source of data: Bloomberg, Tavistock Wealth Limited unless otherwise stated.  

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