There’s a chance that the coronavirus will be contained in the United States and that fewer people will be infected than in China or Iran. But there’s also a possibility that the highly-contagious virus will spread and that there will be sporadic outbreaks across the country. If this latter scenario takes place, then the ructions in the stock market will intensify making it impossible to form a bottom or spark a relief rally. If stocks can’t find a bottom, then pressure will build on the weak players, who purchased securities with borrowed cash, to sell their good assets along with the bad in order to repay their debts. These massive selloffs can quickly turn into firesales where it’s nearly impossible to find a buyer regardless of price. This is what the financial media calls “panic selling”, a vicious, self-reinforcing downward spiral in which stock prices collapse in a frantic, disorderly selloff. The phenomenon has also been described by Pimco’s Paul McCulley as a “Minsky Moment”. Here’s a definition from Investopedia:
“Minsky Moment crises generally occur because investors, engaging in excessively aggressive speculation, take on additional credit risk during prosperous times, or bull markets. The longer a bull market lasts, the more investors borrow to try and capitalize on market moves. Minsky Moment defines the tipping point when speculative activity reaches an extreme that is unsustainable, leading to rapid price deflation and unpreventable market collapse. What follows, as hypothesized by Hyman Minsky, is a prolonged period of instability.” (Investopedia)
So, how close are we to a Minsky Moment?
In the last week alone, US stocks have shed \$3.6 trillion in market value while benchmark 10-year Treasury yields have dropped to all-time lows and the ominously-named “fear gauge” or VIX (Volatility Index) has spiked to levels not seen in more than two years. The losses have been savage and severe, but the credit markets have held up fairly well so far. Next week could be a different matter altogether though, after all, there’s only so much fat on the bone. Another week like last week, would lead to widening credit spreads, major dislocations in the corporate bond market and, very likely, a few sizable defaults. Over-extended corporations that have borrowed over a trillion dollars from Mom and Pop investors to buy back their own shares, would certainly face a day of reckoning as their cash flow vanishes overnight and their prospects for rolling over their prodigious pile of debt drops to zero. This is typically how credit cycles end, in a fetid cloud of blood and smoke.
Despite persistent warnings from the IMF and other establishment institutions, Central Banks have done nothing to curtail the 11-year orgy of debt-fueled spending or the rampant reckless speculation that has sent stock prices through the roof even while workers wages have remained flat and standards of living have continued to slip. For more than a decade the Fed has kept interest rates locked on their emergency setting while pumping trillions in liquidity into the financial system at the first sign of trouble. So now stocks are the biggest bubble in history and the Fed finds itself without the tools it needs to counter the effects of the coronavirus. This has all the makings of a major catastrophe.
So how does this end?
Well, next week the Fed will announce that it is slashing rates by 50 basis points and that it’s coordinating its action with its fellow central banks, the BoE, the BoJ, and the ECB. The Fed might also announce an additional liquidity program aimed at banks and financial institutions that suddenly find they themselves unable to borrow at the Fed’s discount rate. The announcement could ignite a relief rally, but the surge is not likely to last long since it will not have any material effect on either the virus or the disruptions to supply-lines. The Fed’s easy money will not create the Chinese-made components that laptop manufacturers need to sell their products. They won’t put skittish workers back in the factories or passengers back on airplanes or consumers back in the retail stores. The Fed’s low rates are designed to stimulate demand, but they do nothing to mitigate a “supply shock”. Regrettably, the problem is on the supply side not the demand side.
For a better understanding of how the coronavirus is roiling markets, I’ve transcribed a short interview with market analyst Mohamed El-Erian who explains recent developments and provides a window into the future. El-Erian sees the current drama unfolding in four phases.
Mohamed El-Erian — “Phase one, is the economic and corporate shock. Global growth slows, companies generate less earnings, their costs go up, and their supply chains get disrupted.” (This is already happening.)
“Phase two is financial disruptions. Now we will see pockets of illiquidity, pockets of distress selling, market dislocations, and a complete closure of markets for any kind of funding other than bank funding. These two phases feed onto each other.” (This is also happening now.)
“Phase three, the formation of a bottom which happens in finance first, then in the economy. But for that to happen, it’s not about central banks like a financial sudden stop. It’s about addressing the underlying issue, which is the virus.” (No bottom in sight.)
“Phase four, when we have to look at the longer-term (scare? inaudible) Central banks realize whatever they do, will be shown to be ineffective and the faith that investors have always had that central banks can bolster valuations, is going out the window…..The Fed will cut rates because markets will begin to dysfunction, but (rate cuts) will not deliver a better economic outcome.”
“The problem is…you need the fundamentals to stop deteriorating in order to form a bottom. But the “technicals” can not stabilize long enough to form a bottom in the face of the continuously negative news. …What we need is hope, realistic hope that we have a way to solve this issue, and a vaccine is the best way to do that but that’s not coming anytime soon.” (No vaccine, no remedy.)
Bloomberg –“Is this selloff still orderly?”
“It was until yesterday (Friday afternoon) but now we’re starting to see the things you typically see when too many people are trying to reposition themselves and their isn’t enough risk-taking capacity in the middle. So we are seeing massive price gaps, very little liquidity in certain sectors of the corporate bond markets and emerging markets, and finally people are realizing what you and I have talked about for a long time. They took on too much liquidity risk.” (Watch the whole interview on: “Mohamed El-Erian Breaks Down Coronavirus Impact Into Four Stages”, Bloomberg News)
This interview will help readers understand how hard it’s going to be to calm the markets and stop the downward slide. There are four points that need to be emphasized:
1– In order to turn markets around, a bottom must be formed. Unfortunately, forming a bottom is impossible when stocks are whipsawed every few hours by more bleak information. In short, the news cycle is driving stocks lower.
2– On Friday signs of distress began to appear as a result of the the 5-day Wall Street bloodbath. (“Financial disruptions, pockets of illiquidity, pockets of distress selling, market dislocations, and a complete closure of markets for any kind of funding other than bank funding.) These are the red flags signalling a Minsky Moment is approaching, that is, when speculative activity reaches a tipping point leading to “rapid price deflation and unpreventable market collapse”..followed by “a prolonged period of instability.” In short, a stock market crash.
3– “Markets will begin to dysfunction, but (rate cuts) will not deliver a better economic outcome.”
In other words, Wall Street is demanding lower rates, but lower rates won’t help, in fact, they will further undermine the Fed’s credibility.
4– Finally , what’s needed to stop the selloff is a vaccine. Regrettably, there probably won’t be a vaccine for another 12 to 18 months. By that time, Wall Street could be a pile of smoldering rubble.