It’s been a bloody week for the market. But it’s important to remember that the S&P 500 is down only about 3% so far in 2020. And believe it or not, the market is still up 10% over the last year.
I think we could be headed a lot lower. Even before the novel coronavirus happened, the market was fragile. Profits were slowing, as was the market before central banks lowered rates and brought back quantitative easing (QE).
In my view, the Fed’s low rates and easy money were the only things keeping the U.S. bull market alive (more on that here).
Low interest rates and “not QE” (the Fed has refused to call this round QE) have worked well to keep stock prices elevated. But debt has also soared, creating leverage and risk.
The world today has a completely unprecedented amount of debt. The total is now more than $252 trillion. That’s a staggering 322% of global gross domestic product (GDP). Here’s a summary of the situation from the Institute of International Finance’s Sonja Gibbs, as reported in the Financial Post…
High and rising debt-to-GDP ratios are making debt service and refinancing more challenging, and the 2020s are likely to see a greater incidence of debt distress and restructuring.
So that’s where we were before the past month. Now we have to deal with the fact that the novel coronavirus, and its associated disease COVID-19, is a potential black swan event. The disease, and associated quarantines, are spreading around the world.
The novel coronavirus’s health effects are clearly worrying. But let’s set those aside here and focus on the virus’s effects on the global economy.
We are already seeing global supply lines disrupted. Much of China is on hold, and millions of tons of goods, like steel, are piling up around the country. Japan and Hong Kong are basically on lockdown, with schools closed until further notice.
Microsoft, Apple, PayPal and Mastercard have all warned that the virus could impact their earnings.
We don’t know how long the outbreak will last or how far it will spread. But it’s already hurting the global economy.
The one thing I can say with certainty is that this is all happening at a very bad time.
Most modern economies today are fueled by debt. And it’s possible that the combination of a falling stock market and worldwide pandemic could freeze up credit markets. Many companies would not be able to roll over their debt, forcing them to go bankrupt. It’s a major risk that we must consider.
It’s early, but it looks like credit markets are already taking a hit. On Wednesday, Bloomberg ran an article titled “Global Credit Market Seizes Up as Coronavirus Halts Bond Sales.” Here’s an excerpt…
Credit investors have been rattled by the potential impact on company earnings from disruption caused by the virus, which has seen huge parts of global supply chains shutting down. While markets have yet to see any panic selling, a derivatives index that gauges credit market fear in the U.S. had its biggest jump in more than three years on Monday as investors rushed to hedge against a wider selloff.
If credit markets do start to freeze up, central banks will print money like no tomorrow (they may anyway). Even if central banks manage to pump enough liquidity into the system, a lot of companies will likely bust in a widespread economic slowdown.
Another big factor I’ve been watching is buybacks. Buybacks, combined with the Fed, are the primary forces driving the market (more on that here). But if credit dries up and the cost to borrow rises sharply, many companies will have to cut back or eliminate buybacks. And if buybacks come to a halt, the market will not react well.
Central banks will likely attempt to print their way out of trouble. Needless to say, printing won’t help us solve the COVID-19 problem. But that doesn’t mean they won’t try.
Make no mistake, the market is in a perilous situation. I’ve significantly reduced my exposure to tech stocks. I’ve also been buying gold, silver and a few miners. As you probably know, I’m not normally a huge fan of cash. But in this type of situation, cash is good.
I have a large number of long-term stocks that I’m not selling (mostly emerging markets), of course. So I’m not saying dump everything, by any means. But taking some precautions is simply smart, as I noted last week.
In short, I’m preparing for a more inflationary, volatile and risky environment.
Here are some related articles…
- “Nassim Taleb: Today Is Riskier Than 2007“
- “Are Stocks Divorced From Fundamentals?“
- “How Will We Deal With All the Debt?“
Source: Early Investing