The Undiscovered Country

By Philip Young ,  29 April 2020

In ordinary times the lead article in our firm’s quarterly newsletter is a commentary on a recent and important case or on some topical development of legal practice. The times are extraordinary and so, for this newsletter, I’m charting a radically different course. Instead, I’m going to express some personal views on what I envisage to be the country’s macroeconomic future in the medium term. Hamlet may have described the future as the undiscovered country but I believe it is possible to glimpse it from afar.

For some years I’ve been increasingly convinced that the ever growing sovereign, corporate and personal debt mountain that has been built up since 2007/8, fuelled by excessively low interest rates, would and could not remain manageable. In early February of this year, at a dinner with an eminent London hedge fund, I asked the fund’s partners whether coronavirus was the shock that would bring the mountain down. They thought it possible. So did I.

Events are unfolding that show this is exactly what is happening. The UK economy – indeed the economy of the whole world – has been caught in an event unprecedented in our business lifetimes: an exogenous shock causing the simultaneous collapse of both aggregate demand and supply in a highly leveraged economic system.

At the beginning of the world crisis there was much talk by more excitable, and optimistic, market commentators that it would be a V shaped recovery. More recently the consensus has begun to shift towards it being a U shape. Since February I have been saying that we’ll be lucky if it is a L shaped recovery and I have remained a Bear, rather than a Bull, about the macroeconomic prospects.

The truth of the matter is that we are still only at the beginning of this economic event. It might be that lockdown in the UK can begin being eased in a few weeks’ time. That will come as a relief but will not be a panacea. The lessons from Italy, China, Singapore and Hokkaido in Japan are salutary.

First, aggregate demand will not instantly resume where it left off. It is going to be materially suppressed for a while. The populace of the UK has received a terrible shock both psychological and economical. Some people who have been living from pay-cheque to pay-cheque will be in dire financial straits. A huge number of people have already lost their jobs and, alas, substantial further job losses are still to come. After lockdown is eased, even people in a more fortunate financial position will, overall, inevitably be more cautious with their expenditure. Consumer consumption will therefore be lower. People’s behaviour will be different to how it was before. To misquote Jaws, even if the Government declares the beaches open, people will be less enthusiastic about going deeply into the water. In other words, people are going to continue to practice some form of social distancing for some time to come. All of this will have obvious knock-on implications for the retail, leisure, travel and tourism sectors as well as the restaurant and hospitality sectors. Whereas I suspect that once lockdown is eased a lot of people will make a bee-line for that vital staple of British life, namely the pub, and well-known and well-loved brands like Harvester will always be popular, other sectors will see harder times for much longer. In Wuhan the rates of people spending money in retail and eating out are materially lower than they were before and overall consumption is considerably reduced. Similarly, it is difficult to imagine closely packed Cinemas or concert events or other mass participatory events for some time to come.

Secondly, a lot of businesses – big and small – are going to fail. That short statement does not begin to convey the trauma to people of losing their jobs, their livelihoods, part of their social network and the longer term risks for them of becoming exposed to the job market at a less than propitious time. It does not convey the ripple effect on families and local communities, nor the systemic impact on an economy of a large number of business failures.

Thirdly, most businesses which do not fail will nevertheless witness their capital substantially eroded from the survival challenge of having to meet recurring expenses but with no, or reduced, income. They cannot simply spring back to life exactly as they were before. As I say above, consumption will be lower and that will have a cascading effect down the supply chain. Moreover, re-expansion requires capital. It is in shorter supply. As I say below, banks can read the writing on the wall and are drawing back their lending. Higher risk translates into higher cost and, for those larger companies able to borrow or to tap the capital markets, they will have to pay more for their lending – in some cases a lot more. An eye-catching recent example of this was Carnival. Prior to the pandemic it was a strong company but its experience has been a particularly unhappy one. Recently, it managed to issue three year debt to help it stay afloat (no pun intended) but has had to accept distressed rates of circa 11.5%. Even if its business model survives, it and other companies who have to borrow, will see their performance impacted for some time to come by the higher servicing cost of the additional debt.

Fourthly, there is going to be some form of financial crisis and unfortunately I expect a nascent banking crisis. The evidence of this brewing is everywhere, if you care to look. Look at the fundamentals of what is happening in the real economy, as that will filter through to the lofty heights of the banks and financial markets. In April the percentage of Americans who didn’t pay rent in the first week increased to 31% – nearly a third. The number of US mortgages in forbearance grew to 6.4% as of 24 April, from 0.25% over a month earlier, with 3.4m home owners seeking to delay mortgage payments. The weekly unemployment figures published in America over the past few weeks have been so bad they have been off the scale by historical standards. Some weeks back commentators were expressing anguish that there might eventually be 15m unemployed in the States but that was a substantial underestimate – by the end of this week the figure will be closer to 30m. The UK’s unemployment figures, although bad, fortunately have not been as terrible largely because of the furloughing scheme. Banks will eventually start to take substantial credit losses – that is inevitable. Already the largest US banks have set aside USD 25bn to cover unpaid loans in forthcoming months and that figure is only going to increase dramatically.[1] Banks have drawn in their lending programmes and are being more cautious in what new debt they underwrite. In many cases they are being left holding debt they don’t want that was going to be syndicated or securitised. For example, it was reported in early April that certain US and European banks had found themselves self-funding about USD 1bn of hung bridge loans they had provided to finance LBO transactions. At the same time it was reported that over the quarter to the end of June there may be USD 30bn in junk rated debt that lenders may be forced to keep on their balance sheets if the LBO market remains frozen. There is also plenty of evidence of larger companies drawing heavily on their facilities as lifelines to try to keep them afloat.[2] As the riskier parts of the debt mountain cease being serviced and start defaulting, the mountain will start to topple over. As I have said elsewhere, I agree with other longsighted commentators that a proportion of residential and commercial mortgages will default with obvious implications for the holders of securities in the lower tranches of RMBS and CMBS. While I was writing this article, it was reported that borrowers representing 17% of the USD 584bn commercial mortgage-backed securities market have contacted loan servicers to explore potential relief. The same will occur with CLOs,[3] the high yield bond market, leveraged loans, car loans,[4] etc. We are talking hundreds and hundreds of billions in defaults, and probably a lot more. To the extent that securities or loans are held on a bank’s balance sheet and they default, so they deplete the bank’s capital. Against all of this, it is fair to say the Fed has been keeping itself occupied, massively increasing its balance sheet by buying lots of assets, including, surprisingly, some high yield bonds, some static CLOs and leveraged loans. However, even the Fed’s deep pockets are not endless and even it has not yet crossed the Rubicon of buying the riskiest class of assets.[5]

In addition, sovereign debt is not looking too great either. There is now an incipient crisis in the emerging country and developing country markets, at least in part driven by the collapse in global commodity prices. More than 100 countries have now approached the IMF for short term emergency assistance and I think that is a record. It is more than double the number that called on the fund during the 2008 crash. Argentina is heading for no less than its ninth sovereign debt default in modern times. There is also the Eurozone debt crisis that for a long time was quiescent like a long dormant volcano but is now awakening from its slumber due to the travails of poor Italy, with plenty of banks in the Eurozone exposed to those risks. Before I leave the topic of sovereigns, however, I should mention the most eye-catching loss that I saw for the quarter. This accolade belongs to Norway’s sovereign wealth fund who managed to lose 14.6% in Q1, translating into a record USD 113bn loss. In fairness this wasn’t due to rash trading or investment decisions but rather the need to realise some assets in an unfavourable market as a consequence of the oil price shock.[6]

The inevitable consequence of higher defaults, reduced lending and falls in asset values is that banks’ capital will be severely impaired, conceivably to the point where the banking sector needs government support. This is a risk that policymakers appear already to be very alive to and that explains why regulators in the UK and USA have taken steps to shore up banks’ balance sheets by, for example, discouraging the issuance of dividends, fiddling capital adequacy requirements and re-opening the central bank lending and asset buying programmes last used in the previous crash. It is also why some more far sighted banks have already begun obtaining more equity, i.e. National Australia Bank is trying to raise A$3.5bn in a share sale after its first-half earnings plunged.

It is worth adding that although the investment banks’ profitability appears to be holding up so far, that is probably a result of better than expect trading profits (generated by all of the volatility in the markets) offsetting some of the credit losses already suffered. Whether that continues to be the case remains to be seen.

Moreover, everything I’ve said above assumes, optimistically, that there is no risk of second or third coronavirus outbreaks leading to repeated lockdowns. Unfortunately, the experience of other countries that are ahead of us does not look promising. Hokkaido in Japan ended its state of emergency and reopened schools and parts of its economy on 19 March but is now experiencing its second lockdown in three months as a result of a second outbreak. Singapore is likewise struggling with what looks like a second outbreak. China has quarantined Harbin. The expectation of repeated lockdowns will further depress economic activity as it will likely cause both consumers and companies to adopt a more cautious attitude to their finances. Charts of economic activity in China show that since lockdown in Wuhan was eased, overall Chinese economic activity is about 20 index points below where it normally is in the annual cycle in a pattern that already looks a lot like a L rather than U or a W.

In response to all of this, people of a more Bull-ish persuasion have pointed to the recent strong rallies in the UK and US equity markets, coupled with the questionable theory that the collective wisdom of market knows best, as proof that a Bearish view like mine is an excessively pessimistic view. I disagree. In my opinion, the recent rallies are largely backed by belief in the so-called Fed “put” and I do not think the markets can ignore the fundamentals nor can the Fed (or anyone else) bail out an economy indefinitely. I believe the last three week upwards movement in the equities market is what is known in investment jargon as a “sucker’s rally.” [7] If this were a horror movie, it feels like the part where all the characters believe the monster is dead only for it to re-emerge and eat the most hapless character in the next scene.

Having painted a very negative picture, it doesn’t all have to be doom and gloom. Effective action by the Government could and should substantially mitigate the economic downturn. So far, however, Government Ministers have been long on words and big promises but short on substance and action. To date, the most useful thing that the Government has done is the Coronavirus Job Retention Scheme, followed by the VAT deferral and business rates relief programmes. As to CJRS, it is important to remember that it is a short term palliative. It helps to keep people on a businesses’ payroll but that will only last as long as the businesses’ view of its short to medium term prospects means that is a better option than redundancy.

By contrast, as I have written extensively elsewhere, the Government’s supposed loan scheme to SMEs (now expanded to larger businesses) has been an embarrassing failure. It stands in painful contrast to the more effective schemes implemented by, for example, the Swiss and the US Governments. Already it will have doomed some UK businesses. Even if the Government now, belatedly, takes action to fix the scheme, the remedial time will doom further businesses. But better late than never. Separately, the Government has brought forward a programme to buy short term debt from very large companies and it is widely reported that it is considering taking equity stakes in some of them.

The fundamental problem is, as it has been in previous recessions, the Treasury, and in particular the Treasury’s almost genetic reluctance to spend money. One can understand that the Treasury wishes to safeguard public finances and, moreover, that the national debt and the annual deficit were already far too high. Nevertheless, the pandemic is a 100 year event and it should be seen and treated accordingly. In a rational world, what I believe should happen is that a wall of money needs genuinely to be poured by the Government into the real economy, to try to support aggregate demand and tide consumers as well as business over the worst of the crisis, so that as much of the economy can emerge as little harmed possible. Money in the real economy will, in turn, support the servicing of debts and, in turn, indirectly support as much of the financial markets as possible.

This quantum of money would need to be paid for ultimately by multi-generational debt that will still be being paid by our children and our grandchildren, as was also the experience of the funding of the two world wars, financed by a combination of economic growth, some inflation and some financial repression. Furthermore, I believe the argument for this to be both economic and moral. It is a moral imperative to try to preserve people’s jobs and livelihoods from an event that is entirely out of the control of anyone other than the Government, essentially because this protects people’s lives. Simultaneously with that, and as has been obvious for well over a month now, unless and until a vaccine can be identified and scaled, the testing and tracing regime needs to be scaled enormously to enable a phased reopening of the economy in as relatively a safe manner as possible as quickly as possible. I have read in some media articles anguished concern that this could cost hundreds of millions of pounds but, if so, so what? Measure that against the cost running into the tens of billions of pounds of keeping the economy closed each month. I suggest all of this is obvious. The problem is not identifying the solution, the problem appears to be both the political will and the functional ability of Government to deliver it.

I spent a lot of February and early March looking at exponential curves of infection in Northern Italy. It is my hope that the Government will now act effectively and, as a result, we will be spared having to spend May, June and thereafter looking at exponential curves of business and economic failure.

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[1] The Bank of England has asked banks to try not to make very large bad debt provisions as it will impact on their ability to write loans. Leaving aside that this appeal to imprudence is surprising, the point is that it is telling as to the size of the loss provisions that the BoE fears banks may make and their impact.

[2] As I was writing this article I noticed that seven major US corporations have today announced they have drawn on their credit lines, before the US market opens, in the amount of USD 10.5bn. When I last looked on 13 April, US corporates had drawn at least USD 215 billion since 5 March.

[3] The CLO market entered this year both vastly larger than it was during the 2007/8 crash and also with a record proportion of loans rated B or B3, one notch above the junk tier. Lots of CLOs are already approaching their WARF test, if they haven’t already done so.

[4] For example, Ally Financial Inc. has reported that 25% of its auto-loan customers have asked for payment deferrals, representing about 1.1m borrowers. More than 75% of them had never asked for a deferral before and 70% of them had never previously made a late payment.

[5] Otherwise, whither moral risk? There is a fundamental issue here. Why should the average taxpayer effectively bail-out buyers of highly speculative debt?

[6] This was before May WTI crude oil contract fell to a record low.

[7] As a percentage of market cap, about half the S&P 500 is now concentrated in only five companies: Microsoft, Apple, Amazon, Alphabet and Facebook. If you chart the S&P 500 but without Amazon, the S&P 500 has arguably been falling since about mid-April, despite the apparent upwards movement in the market.