Fiscal Bazooka, Liquidity and Solvency – May Recap

Brief Introduction to May 2020

There were also constructive news headlines related to effective coronavirus therapies and positive data on some early-stage results for COVID-19 vaccines that added to the bounce. Despite the first steps being taken to exit lockdown and some positive news on a potential vaccine, it’s still too early to say with confidence how the public health outlook will evolve. Volatility declined and the more moderate market moves compared to April suggest that investors are being watchful of how the situation develops.

The S&P 500 climbed to end the month 4.8% higher, just 10% below the February peak, with the last boost obtained at the closing of the month when the markets reacted positively at Trump conference, despite the escalating tensions between the US and China.

The infection rate across the major European economies has fallen significantly, though the infection rate in the UK still remains high relative to its European peers.

The European Commission proposed a €750 billion recovery package to support EU countries most affected by Covid-19.

Fiscal Bazooka, Liquidity and Solvency

US equities rose in line with other world equity indices. All sectors in the S&P 500 rose with materials and industrials, more cyclically-exposed, performing strongly. IT stocks were once again notable outperformers. Consumer staples and energy lagged behind the wider market but still made positive progress.

The months post Covid-19 have been characterized by super expansive monetary policies from the major central banks – EUR, USA, Japan, etc. – which have been boosting the V shape recovery of the stock markets.

The last episode has been the Recovery Fund in Europe, which resembles the Marshall Plan – the EU bazooka for €750 billion – where Italy is the country that benefits the most.European Commission president Ursula von der Leyen called for the power to borrow €750 billion for a recovery fund to support those EU regions that have been worst affected by Covid-19.

This would be in addition to the €540 billion rescue package agreed in April. She also proposed a new suite of taxes to pay back the debt. The plan still needs the approval of member states, with the recovery fund expected to be on the agenda for the 19 June European Council summit. In addition, comments from European Central Bank (ECB) board members suggested that the ECB’s asset purchase target could be increased at the June meeting..

Financial markets place great trust in Central banks in solving crises with operations based on liquidity injections (Quantitative Easing) and for this reason they move to disruptive speculative excesses, in the belief that the liquidity is the solution. But things are not that simple. This way of thinking and to operate, with the support of the “regulators”, does confuse the difference between liquidity and solvency.

The solvency of a system depends exclusively on risk propensity of those who provide credit (Banks, Funds investment and investors) and much of the liquidity that circulates in the system therefore depends only on the propensity to risk of banks and investors and may therefore not turn into credit for those who need it.

It is no coincidence that all the time that M2 explodes in conjunction with the crises, credit to the economy shrinks.

It is necessary to distinguish between liquidity, credit and solvency. Another obvious example of the difference between liquidity and solvency is the Lehman Brothers bankruptcy, which took place in September 2008, with the Fed’s QE in full power and with the financial crisis already underway for nine months. With all the liquidity that circulated in the system, Lehman shouldn’t have failed. But also, in this case liquidity had not turned into credit for some and many intermediaries, including Lehman, have gone bankrupt during QE.

The Hertz’s recent chapter 11 occurred in conjunction with the purchase by the Fed of Corporates Bonds which were part of the “Secondary Market Corporate Credit plan Facilities ”, and now the FED is a creditor in Hertz bankruptcy which, precisely thanks to this plan, it should not have failed but it is failed.

Excessive euphoria is essentially driven by the print money, but fundamentals are far from being great. Looking at the EPS, the market is pricing future earnings from the corporates. Earnings that are expected to be published at the end of next month and that might force investors to face the reality. That might be the moment that this V shape recovery will have a brutal stop.

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In the government bonds, the 10-year US Treasury yield was little changed at 0.65%, trading in a relatively tight range throughout the month. The two-year yield finished slightly lower.

In comparison, European government yields saw meaningful moves, reflecting developments around potential fiscal support. Germany’s 10-year yield rose from -0.59% to -0.45%. Looking at the yield curve, this translates in a reduced spread between US and German bonds. This confirms a gradual repositioning of the investors on the currency market, in favour of the single currency, which could lead the EURUSD pair to 1.20 before the end of the year.

On the equities market, by the end of June, in correspondence of the earnings, we could expect new short corrections, if not new lows for the year.

In the commodity market, Gold after the selloff in march has renewed the period highs. We could expect from these levels, a correction on the metal, down to 1,600 area, to go back above 1,700$ per ounce. To be mentioned, between the precious metals, Silver has shown more relative strength compared to the gold and we could expect similar behavior in the next months.

For a look at all of today’s economic events, check out our economic calendar.

The article was written by Rosario Pisana, Chief Trader and Analysist at MayfairBrooks