I will avoid posting about intra-day price movements on this blog, but today’s market crash had an important lesson for everyone. The lesson is that Liquidity Matters. There is a reason why they say, ‘Cash is King’. When people desperately need cash, they sell everything and anything that has a bid. Period.
In this brief note, I will provide a 30,000 feet view on a few important themes. Eventually, I will try to tie them together such that you can wrap your head around what is going on in the macro world. Let’s go.
Coronavirus
Coronavirus is the black swan event that has taken the world by surprise. Businesses around the world have cut their travel to bare minimum, people are postponing vacations, organizations are cancelling sports events, countries are closing down shops and restricting international travel, cities and nations are being locked-down, people are working from home and avoiding restaurants, and so on it goes. To summarize, coronavirus has strongly pumped the brakes on global demand.
Federal Reserve did an emergency cut last week of 50 basis points, but investors communicated via markets that it is not going to increase demand that has fallen because of coronavirus. Investors started taking refuge in sovereign bonds which led to falling yields across maturities. Falling yields puts pressure on Net Interest Margin of banks (borrow short term, lend long term at higher rates & make money) and their stocks went down. Simultaneously, coronavirus deaths and infections will increase liabilities of the insurance sector. Put together, this is a massive blow for financial sector as well.
Oil Price Wars
Over the last weekend, Russia and Saudi Arabia shocked the entire world by starting an oil price war. Initially, Russia rejected OPEC’s request to reduce oil production such that oil prices can stay at a higher level. Saudi Arabia, in response not only promised the world more oil but also at discounted prices. Saudi Arabia’s cost of producing oil is significantly lower than Russia’s cost. But, with prevailing prices both are still profitable. Now, what about the rest of the world?
Enters American shale industry. American energy companies have a much higher cost of oil production. This price war will eat into their profit margins and might as well put them in loss. In such a situation, these companies will require more funding and they face credit downgrades. They will go ahead and exhaust their credit lines and some of them may default. But, stocks of these energy companies were trading at prices corresponding to high profit margins. As a result, oil price wars in combination with coronavirus led to even more stress in energy sector and energy stocks sold off massively.
Financing
Because of dampened demand, businesses will struggle to make profits and will need cash to keep lights on. Sequoia Capital, a renowned American venture capital firm, warned their portfolio companies to prepare for tough times ahead. Major private equity companies have advised their portfolio companies to raise cash as soon as possible if they are to survive the downturn. If companies do not have cash to fund their expenses, it will lead to bankruptcy in extreme cases. Solid business models can go down just because of poor cash management. This has led a lot of companies to max out their credit lines at banks. Billions of dollars are getting out of financial sector. Credit markets have started showing signs of stress. This is one of the reasons why cash is in high demand.
US Treasury and Eurodollar (offshore dollar) markets are among the most liquid markets in the world. Today, even these markets started showing signs of depleting liquidity. Hence, you saw Federal Reserve step in and inject massive liquidity in the system. To put simply, Federal Reserve is committing to inject more than $5 trillion in the financial system in the coming month to keep short term borrowing rates from spiking. To put it into perspective, $5 trillion is roughly twice of India’s GDP and about a quarter of USA’s GDP. Federal Reserve also indicated that it would start purchasing government securities beyond 3-month maturities as well. This is massive. In addition to monetary stimulus, governments across the world including USA have promised hundreds of billions of dollars in fiscal stimulus. After all of this, S&P 500 Index was down 9.5% at close, the most since 1987 stock market crash. Investors probably want more fiscal stimulus as monetary stimulus is clearly not working to calm down the markets. A darker scenario is that investors may think that its too late to control the impact of coronavirus. That will be really bad.
Leverage
So, as investors go on their selling spree, prices of securities go down fast. Now, there are a lot of investors, traders and speculators out there who are using very risky financial instruments and high leverage. By leverage I mean that for a small change in the price of a security, they may make or lose a lot of money – that in simple language is leverage. Institutions that allow market participants to trade on leverage have margin requirements – where one needs to deposit a certain amount of cash or securities to be able to obtain leverage. When markets move against your position, you need to deposit more cash/securities or you risk getting liquidated by the institutions (they sell your securities). When this happens, no one checks the price. They just hit the next available bid. Now, to avoid getting liquidated, market participants go out in search of cash. They either get it from their bank account or by selling something they own like other stocks, bonds, commodities, etc. When they sell these securities, they do not have the luxury to wait for high prices. They sell at whatever is available out there i.e. they go hunting for bids. They even sell gold – a traditional safe haven asset!!!
A tangent: For Bitcoin community — one needs to realize that the concept of bitcoin as a safe haven is only popular within the community. Only a tiny percentage of world population today believes in the premise of Bitcoin whole heartedly. These are what we call hodlers (long term holders). These people have already invested and can may be buy some more when the price looks attractive. But, majority of people are speculating in bitcoin. These speculators are likely to have high risk appetite. They are probably also speculating in traditional markets, altcoin markets as well as employing leverage. When they get stopped out, they have no choice, but to sell and get liquidated. And in such stressful times, when everyone is looking for cash (read current medium of exchange to pay bills), hardly anyone has the courage to buy an alternative asset — that in their perception is very risky. Especially, when a super majority has never invested in bitcoin till date. This too shall pass!
How it all ties together and makes Cash the King?
Coronavirus has dampened global demand massively across all sectors. Oil price wars have exacerbated situation of several companies by putting them at the brink of collapse. As a result, all businesses are aggressively looking for financing to fund their ongoing operations and avoid bankruptcy. Fiscal and monetary measures taken by governments and central banks have done little to satisfy investors globally. As these investors are exiting their positions simultaneously, it is putting a lot of strain in global financial markets, which in turn is forcing other investors, traders and speculators, who use massive leverage to exit their positions or raise cash to fund them. As a result, businesses, investors and retail all are frantically searching for cash to survive this downturn. Until this phase passes, no security is safe, not even bitcoin and not even gold. Beware of catching falling knives!
In fact, during 2008/09 global financial crisis, gold had sold off ~35% before resuming the rally in the aftermath of all the fiat liquidity injection. I expect the same this time around once we whether the storm and move past it, hopefully soon. Once we move past this crisis, my belief is that the world will wake up to the fact that we really need a new monetary system (a topic that is out of scope for this post). Then Gold and Bitcoin will shine. Rationality will come back. Until then let the markets be irrational and you be safe – physically and financially.