A random walk
Edition 9. When the world is collapsing, why is the stock market rising? Can Tiger Woods help?
The big news of the week has been the oil price. For the first time in its traded history, the futures turned negative, leading to a barrage of jokes.
Amidst the memes, this tweet caught my eye
The world is apparently collapsing, and the stock market does not seem to care. Here is the performance of Dow Jones industrial average (an index of 30 large listed companies in the US) over the past month
which led to gallows humour.
Of all the accounts of the recession of 2008, I have found the ones chronicling the days leading up to the Lehman Brother’s crash and the aftermath, the most insightful. It is thrilling to observe the raw human emotions and on the edge decision making. You realize that things could have been a LOT worse if the people at the centre of the global financial system (central banks) did not rise to the occasion while being completely blindsided.
I recommend this excellent article in the Blomberg and a summary in the Guardian to understand what really happened behind the scenes in the days leading up to the Lehman Brothers collapse and what transpired immediately after.
The initial economic shock and stock market crash related to COVID-19 also pressed these central actors in service. Let’s look at how history informed their actions, what they did and how that might have contributed to the way the stock market is reacting now.
Adam Tooze, a historian who has studied the inter-war years and financial crashes, has written this nail-biting piece.
How coronavirus almost brought down the global financial system
He writes
At the low point on 23 March, $26tn had been wiped off the value of global equity markets. What the markets were reacting to was an unthinkable turn of events. Built for growth, the global economic machine was being brought to a screeching halt. In 2020, for the first time since the second world war, production around the world will contract. It is not only Europe and the US that have been shut down, but once-booming emerging market economies in Asia. Commodity exporters from Latin America and sub-Saharan Africa face collapsing markets.
The survival of the economy depends on credit. It allows businesses to invest, and consumers to consume and pay it back over time at a certain price (interest). If this price increases, it becomes more expensive to invest and consume, and when it decreases, it becomes more attractive. While consumers take loans from the bank, businesses (like the government) can issue bonds which is a financial instrument on which the issuer (business in this case) promises to pay certain interest to the subscriber or lender (investors).
The central banks play around with the interest rate (price of credit) by reducing it to stimulate the economy by making it cheaper for commercial banks to borrow from it or to cool the economy by increasing the rate (if there is runaway inflation). Bond prices are impacted by this too.
What makes this entire cycle interesting (or scary) is the reinforcing mechanism.
Consumption and investment decisions are made with an optimistic view of the future – business will grow, I as a consumer will continue to earn and hence will be able to pay back the loans. What happens when an unexpected shock takes place? What happens when a pandemic destroys all economic activity? Consumers may lose their jobs, revenues for businesses might drop and loans cannot be paid back, making them ‘bad’. Rising bad loans disincentivize banks to lend more due to the risk. Lower lending in the economy further reduces economic activity which makes more loans go bad. So the cycle continues.
In 2008, Lehman Brother’s collapse froze the credit market since banks were unsure who might go bankrupt next. This was a major driver of the recession that followed.
So, what did the central banks do when COVID-19 took over the world?
For this, let’s turn the clock back to see what the central banks learned from the depression of 1920s and the recession of 2008.
Central Banking grows up
The roaring 1920s in the USA created a stock market bubble. The mania led to people taking loans to invest in the market believing that share prices will keep rising. Concerned, the newly formed central bank (est. 1913), the Federal Reserve (Fed), raised interest rates to make it more expensive for businesses and consumers to borrow. Major global economies followed suit including the UK and France. The move backfired - the stock market crashed spectacularly, and the economic activity contracted, pushing countries into recession.
By 1931, a few banks were starting to be considered insolvent. Depositors, fearing that they would lose their money, withdrew cash in bulk.
The entire edifice of the financial system rests on trust. Banks take deposits and give it out as loans. Depositors trust that if needed, they can go to the bank and withdraw their deposits. If a majority of investors demand their money from a bank at the same time, there is no way it can call back its loans. It is then left with two options - depend on the central bank (like the RBI supported Yes Bank) or go bankrupt.
The Fed, in its wisdom, allowed the banks to fail and further raised the interest rates creating mass panic and even more withdrawals and bank failures. The direct impact of people withdrawing their money out of the system was that there were fewer loans to go around and lesser money flowing through the system. While sounding arcane, the impact was devastating.
Record unemployment, the rise of the Nazi party were the aftermaths of this period. The central banks did not come out of this looking well.
Those who do not learn from history are bound to repeat it.
Circa 2008, the markets are wobbly again. Lehman Brothers, a 150-year-old Wall Street institution, goes down. Markets panic, credit dries up, the memories of 1929 are resuscitated.
However, Ben Bernanke, the head (governor) of the Fed, was a scholar of economic history. He resolved to not repeat the mistakes the Fed made in the 1920s, unleashing the entire financial might of the Fed to make sure that money kept flowing through the system. Interest rates were cut to near 0% making it almost free for banks to borrow from the Fed. Yet, this did not move the needle. The Fed was stuck since the interest rates cannot go below 0%. Why?
Money in a bank account pays interest while cash does not. This is a good reason to avoid stockpiling large quantities of cash as long as interest rates are positive. But if rates became negative, the situation would flip. It would make more sense to have stacks of hundred-dollar bills than to keep money in a bank account. Trying to push rates negative, in other words, might lead to mass withdrawals of money from banks.
So, what did the Fed do? In a breathtaking move, it started to simply print money and invest it in government bonds. This mindblowing act got a rather dull name – Quantitative easing (QE). Other central banks followed.
The road to recovery was long and painful but these actions saved the financial system from imminent collapse. The Fed had learned from its mistakes of the past and emerged a force renewed.
What does it have to do today?
When the COVID-19 impact hit, the central banks went all in using the tools of 2008.
Interest rates were cut by the Fed to near 0%. QE commenced at a scale greater than 2008. Yet the markets continued to fall.
What was different?
Unlike in 2008, this crisis did not start with the financial sector. The lockdown brought all economic activity to a standstill. Even Apple was finding it hard to borrow at affordable rate of interest. Banks, risk-averse, were not willing to lend to companies given the uncertainty. The businesses faced a credit squeeze which could have put their survival at risk.
Adam Tooze writes
On 23 March, 90 minutes before markets opened, Fed announced that it would buy highly rated corporate debt, or at least any debt that the ratings agencies were still willing to declare investment-grade. In effect, the Fed was establishing itself as the backstop to the trillion-dollar corporate bond market.
It was an extraordinary move to widen the scope of central bank intervention into the corporate economy. And it was understood as such by the markets. Since the start of the year, the S&P 500 and the Dow Jones, as well as the FTSE 100, had lost 30% of their value. That day, they began to recover.
The Fed with its unlimited financial resources, (because of the ability to print money) in an unprecedented move, became an investor in company debt. It signalled that no measure would be too far for it to ensure that the US and the global economy weather this.
Check out this graph again, it is the same Dow Jones index with a slightly longer timeline.
Notice the market falling off the cliff as news of the devastation of COVID-19 spreads. And notice the change from March 24th after the Fed’s announcement. Is it a mere coincidence? Unlikely.
Each economic crisis has expanded the toolkit policymakers have used to bring relief. The current economic crisis is the one where they have ventured the farthest. Will it help? Let’s hope.
Of course, it is always good to remember, no one really knows how the markets will perform. If someone makes predictions, show them this chart.
Yes, it shows that Tiger Wood’s performance is probably the best indicator of the stock market.
That is all for the current edition. If you like it, earn good karma by sharing it with others who might like it too. Feel free to send suggestions on twitter at @romit_ud or at romitnewsletter@gmail.com. Stay safe!