We’ve all heard the maxim “when the US sneezes, the world catches a cold.” In the last few weeks, the truth in this saying has made itself evident, although in this case, China did more than sneeze. In our interconnected world, when a highly contagious disease such as the novel coronavirus emerges, the damage, both human and economic, can quickly take on a global scale. Globalization provides economic leverage that can cause the gearing to rapidly spin out of control across supply chains, and downside risk suddenly becomes reality. Could this new virus be the catalyst to a Minsky moment?
Even before COVID-19 entered the picture, we were already concerned about the year ahead. Indicators across four channels—the macroeconomy, credit conditions, capital markets, and politics—are flashing warning signs. These escalating vulnerabilities, moving the markets closer to an inflection point, were worrisome enough, but the coronavirus epidemic may be the tipping point that triggers the what’s-this-worth question asked by many investors all at once. The creation and spread of an unsettling narrative (Shiller, 2019)1 could precipitate a self-fulfilling crisis (Merton, 1948).2
The last 10 years have produced a growth-dominated, monetary-policy-fueled US bull market—the longest in the nation’s history—that almost no one saw coming (Wang, 2019). Remember what it was like back then? A decade ago we had just realized that money market funds could “break the buck.” That’s the kind of thing you don’t want to try at home. It tests your faith in the system on a good day. Credit markets were frozen like a new Ice Age had descended on the capital markets. The S&P 500 Index flashed the “sign of the beast,” and investment banks went bust over various weekends. Those were the final symptoms of serious trouble, suggesting to some investors that the patient could be terminal and that we didn’t have a financial system we could lean on the next day.
Move the clock forward by a decade. By the beginning of 2020, the US economy had stretched into a record-setting growth cycle as capital-market asset prices steadily trended upward. Against this backdrop, few investors appeared worried about the intrinsic value of their investments. When “bad times” are far enough in the rearview mirror, complacency reigns and the price-setting mechanism that prevails in the capital markets tends to boil down to a simple question: Is the next investor in this asset willing to pay the recently struck price or even bid it up? Adopting this mentality is far easier and more comfortable than 1) assessing the worth of a series of uncertain future cash flows and its residual value today, and 2) maintaining the margin-of-safety discipline to put protection in place before the risks become self-evident.
Unfortunately, as history has shown, this behavior tends to encourage capital allocation to enterprises and securities that do not deserve funding, leading to the dangerous territory of NINJA asset pricing reminiscent of the “no income, no job application” granting of mortgage loans.3 Directing capital to undeserving entities at scale and for an extended period of time not only has negative societal implications, but also has precarious investment implications. Inevitably, an economic shock or catalyst shakes investors out of their complacency by forcing the fateful question: “Oh my! What’s this stuff really worth?”
Let’s explore a few warning signs we see in the four arenas of the macroeconomy, credit, capital markets, and politics. Then we’ll offer a few thoughts on the possible impacts of the viral epidemic (at this stage not officially a pandemic) and conclude with a summary of the potential investment implications for the years ahead