If the economy were a monster truck.

If the economy were a monster truck, the only moving parts would be its oversized shock absorbers, each powered by an unlimited supply of welfare helium gas.

Designed with a deranged center of gravity and a fuel system that’s been pumping sugar through the fuel line for nearly 12 years, the virus has stalled the economic engine. The tap on the brakes, plus a serious amount of gas applied to the shocks has created a half reverse somersault.

And yet, people are still betting on it. Even while the truck rests on its roof, betting has been available through key starting post bookies, with NASDAQ taking most of the action and NYSE, SGX, ASX and similar world exchanges all hungry for a slice.

Millions of new day trader and Robinhood accounts have been set up with billions per day of government financed rocket fuel now being deployed and churned.

Last Wednesday, U.S. Federal Reserve (Fed) chair Jerome Powell addressed the press and gave a pretty clear, albeit grim indication of how reserve members were seeing racetrack conditions. Busted for at least two years. He’ll address Congress this week, probably with the same message. Christine Lagarde of the ECB has said pretty much the same to EU heads.

At the same time, the financial accommodation generated by the central banks has directly dislocated the equities market from the reality of the real economy. Fans are sitting in the stadium of a cancelled race placing big bets.

This may become more amplified if the first wave of the virus isn’t over. In the U.S. alone, Texas, Florida and California hit new daily highs last week. Arkansas, Alabama, North Carolina, South Carolina, Utah and Alaska have also seen surging case numbers. The CDC thinks that Arizona, Arkansas, Hawaii, North Carolina, Utah, and Vermont will have increasing death tolls this week. In China, a second wave may have begun with 57 new cases in Beijing.

However, if we can acknowledge this dislocation and some of the reasons for it, it allows us to make some plans that have a good chance of bolstering our businesses and positioning for progress, and growth.

Going long cash and shorting debt will be a good place to be for non-challenged industries. For others, alternative response will be required.

Here are some thoughts.

The Fed has three domestic roles.

In a domestic sense, the Fed has three mandates: maximum employment and stable prices for consumers, and financial system stability.

Unfortunately, the virus has made the first two extremely difficult, but the third has been made possible with massive injections of QEI and GI.

But the Fed has a fourth role, and its not mandated. It is a relic from the past. The Fed is the parent of the world’s reserve currency. In a global monetary sense, it is boss hog. That means whatever it does to influence interest rates, bonds and leverage has a big effect on the rest of the world. This includes equities and bond markets.

That said, Jerome Powell has been very clear that he is focused solely on his three mandates, and that the health of the fiscal engine is firmly in the domain of Congress and elected officials.

Whilst he has suggested that more should be done in that area, his role is to operate the shock absorber (not the engine), using whatever monetary tools he has at his disposal. And how what he does with the shock absorber effects other central banking systems and global equities is not in his opinion part of his job.

What are governments doing about the engine?

Not a lot.

Unfortunately, the economic engine stalled over 12 years ago with sub-prime and the GFC demonstrating how badly/wrongly leveraged the economy was. Inflation disappeared a few years ago.

Banks might be stronger now, perhaps, but global debt has increased by over an estimated $80 trillion. By the end of the year, the world will be close to 400% leveraged (forecast post-QE global debt over global GDP). Think of it as a $400k mortgage on a $100k house.

If you can service and pay down the debt, fine. If you cannot, you’re insolvent.

QEI has done more than preserve the steady flow of credit, it has allowed banks to super-charge the fractional banking system and in turn flood the world with leverage. These actions have blown massive bubbles across many asset classes, with the equities market being the main recipient.

But this debt has not been productive and based on a comparison of debt and GDP growth since the GFC, only around 15c in the debt creation dollar has resulted in productivity (GDP). Today, we are in a dis-inflationary world with a lot of leverage that needs to be serviced and in time repaid.

The world’s central banks have not yet found another road to travel, so they continue to buy bonds and in tandem with the various treasuries, bail out the stalled engines given governments are asleep at the wheel.

The equities Monster Jam is a by-product of QEI+GI plus welfare cheques.

Since former Fed chair Ben Bernanke started the presses in 2008 and other countries followed suit (Japan was already there), governments have decided to let central banks fix the world by supersizing the shock absorbers, i.e., pump in more liquidity to paper over the engine problems.

To make things worse, various governments are reconstructing dangerous trade barriers which had taken decades to pull down. This is nationalism, imperialism, mercantilism, and populism on steroids and there is still no resolution to the ongoing trade war, in fact it has erupted again.

Market volatility and valuations suggest we are flying too close to the sun and the weakening of bond yields has been telegraphing this for some time now.

In Australia, equities were down 3% last Thursday, following the Powell press conference. Wednesday and Thursday night in the U.S. were also down multiple percentage points. But on Friday night the millions of first time day traders seemed to be back in the market, again irrationally pushing up stocks on the hope of quick trading profits. Monday brought more carnage, but last night (and today) equities staged a return.

As you know from my last blog, there are many first time day traders and speculators sitting at home with not a lot to do. However, some now have excess liquidity from welfare cheques that allow the financing of equities betting. Imagine five or six million new punters in the U.S. alone, with $1,000 of government financed welfare cheques to spend. Call that $5-$6 billion of new equities rocket fuel that can be churned every 48 hours. Same in Australia, although smaller numbers.

On one hand fintechs would say that their fractional share and crypto apps have brought the world of ‘investing’ to everyone. Maybe. But they have also delivered a powerful weapon of mass speculation into the hands of first time traders, with no interest in learning – they simply trade on gut and many will make money on momentum, meaning this will probably not end soon.

Welfare may now be supporting the equities market.

But with a stalled economic engine, chances are that earnings for this quarter and the next will not align with the extraordinary valuations being created.

And if that wasn’t confusing enough, what does it say to you when Elon Musk complains that the Tesla share price is too high? The last time I remember something similar was in 2018, when Ethereum’s founder said that the value of Ether was way too high. Since then, Ether has lost almost all of its value.

That said, no one knows which way this will go because never before have we had so much balance sheet (or shock absorber) support from world centrals to businesses and households. And that accommodation has got to go somewhere, rationally or not.

Not my job.

Last Wednesday, Jerome Powell said that he felt the economy was in a good place before COVID-19.

Now he says that with 20-25 million displaced in the labour market, there is a massive need for fiscal support. But he stops there.

As a result of the stalled engine, he insists that bond buying and lending programs are required in large and immediate doses, regardless of whether one of the effects is a raging equities market.

In fact, he has said that the idea of withdrawing accommodation for the “fear of creating a bubble” is a notion that’s not even being considered.

It may not be Powell’s job, but the engine team checked out decades ago and he knows it. He also knows that Donald Trump expects a high equities market.

And the more he pumps up the shocks, the bigger the bubble.

Whether it’s enough to kick start the engine without flipping out in the process is yet to be seen. But with 20% to 30% of the world’s GDP sprayed around the racetrack, it’s a bit of a worry that it hasn’t happened yet.

For the moment, let’s see what he said last Wednesday that fired up volatility.

Powell’s press conference mirrored Lagarde’s warnings.

Here is what came out of Powell’s address and Q&A session on Wednesday:

1. The decline in GDP this quarter is expected to be the most severe on record.

2. Unemployment has gone from its lowest level in 50 years to its highest level in 90 years, in 2 months.

3. The recent unemployment print of 13.3% understates reality because of the amount of employed but absent workers, and adding them in would add an additional 3 pips (making it 16.3%).

4. The Fed will do whatever it takes for as long as it takes to limit lasting damage to the economy.

5. The Fed will use forward guidance, asset purchases (which won't go lower than the current reduced pace) and a potential targeting of interest rates across the yield curve, to tweak monetary policy as needed and create a robust recovery.

6. No interest rate increases until at least 2022. Any changes will be ‘economy-reopening’ data driven.

7. The Main Street lending program is getting its act together (with an improved two year delay on repayments and a one year delay on interest payments) and once doled out the loan book will probably be managed outside the Fed (that’s also code for ‘not my job’ and it is worrying because the Fed has pledged to buy almost anything).

No wonder the market cratered on Wednesday.

And the message is not much different in Europe. Last week ECB president Christine Lagarde said:

“Our baseline projection sees GDP falling by 8.7% this year, but this is surrounded by a wide range of potential scenarios. In our mild scenario, the drop in GDP would be 5.9% this year, and in our severe scenario it would be 12.6%. In this latter case, output would still be well below its pre-crisis level at the end of 2022.

Faced with such an outlook, it is understandable that households are anxious about their future incomes and firms are hesitant about making irreversible decisions. In particular, many citizens fear that, in a slow recovery, some jobs will be lost once government support schemes are phased out.

This underlines why it is so important that the recovery is properly managed and that the economy is adequately stimulated. Confidence in government policies is critical to reducing uncertainty, which is itself a form of stimulus.”

So far, the ECB package includes a €1.35 trillion pandemic emergency purchase programme and €3 trillion for banks to lend out.

Lagarde went on to say:

“But monetary policy cannot address the more profound questions about how the economy will look in the future. Historical experience suggests that major economic shifts like the one we are going through today require government action to foster change and smooth the transition to the new normal.

In particular, governments need to foster innovation by providing the right framework to encourage experimentation and risk-taking in new and growing sectors, and to support the transition to new jobs for people working in 'sunset' sectors.

In parallel, they need to ensure that the conditions are in place to direct investment towards the technologies and sectors of the future.

This requires sufficient financing. The European Commission estimates that the investment needs for delivering the digital transformation as well as the green transition will be at least €1.2 trillion over the next two years.”

With negative rates in the German monster jam and the more serious problems in demolition derby Italy to contend with, there’s no doubt Christine Lagarde and the ECB PR team will be thinking about the same issues as Powell, although they have 27 countries to think about, not just one.

27 governments are required to foster innovation and experimentation, in order to get 27 engines started, otherwise, it’s all down to the ECB to keep those shock absorbers primed.

Back to Jerome Powell. He did not give the market what it was looking for on Wednesday.

Maybe the market was secretly waiting for some commentary on an eventual move to negative rates. This did not happen. Rates were left at a 0% lower bound. And there was a lot of language about rates staying that way at least until 2022 and bond buying continuing, at least at the current pace.

So, whilst we know rates will stay low (already baked into markets) there was no direction on Powell’s pet hate – negative rates. And, if we do move to deflation, the only way to avoid real rates going up is to go to further into the negative with nominal rates.

On the other hand, there is a view that a ‘reopening’ might create a growth and inflation slingshot (i.e., flation going the other way) and this might explain why yields are still above zero further out along the yield curve. Although that could also be the bond market expectations for a deluge of deficit financing bonds where trillions in new issuance would create an over supply, causing prices to fall and yields to rise.

No one knows for sure which way it will go from here. But if you’re expecting Powell to say “hold on guys, this market is way too high, let’s pull back,” you may be waiting a very long time.

Meanwhile, tickets to see the cancelled Monster Jam appear to be the hottest asset in town, for the time being.

Now what for Corporate Australia?

Much activity in WA is dependent on offshore involvement, and as long as the travel lock-down is on and workers are paid to sit at home, business levels are unlikely to return to past levels.

China and South Korea (both large trading partners) have not yet seen the last of the virus.

We have not yet seen the China/Australia dependency play out in full, but we are seeing some early trade war maneuvering and the iron ore price has gone sub-$100 again.

The RBA has refused to go to negative rates and this plus a generally high iron ore price has provided some strength for the dollar, although it has had many moments of weakness before recovering a little today.

But now is not the time for a strong AUD because exports are a lot more important than imports at the minute, particularly as domestic consumption slows. Whilst importers see a little benefit on the buy-side when the AUD strengthens, today they would be selling those goods in a low demand and low price environment.

The real question is whether or not we are at the end of a technical recovery and heading into a major correction, or whether central banks and treasuries have done (or will do) enough to kick start consumption and investment in order to bleed the monster truck off its shocks and get that engine firing again.

We don’t know, but for all of the above reasons, it makes sense for many companies in challenged industries to move to a net cash position now if possible, no matter how cheap debt might look at present.

Other reasons include:

• Government welfare may run out in September/October (if not extended) and businesses will go back to relying on cash flows from operations.

• Due to the complexity of global supply channels, you cannot just switch the economy back on over a few months, so cash flow will be slow in many industries.

• There’s not much of a bond market here in Australia and accessing the U.S. bond market is difficult and unless you have a natural hedge it is far too dangerous to contemplate if debt deflation sets in.

• The IPO market is pretty much shut other than for exceptional candidates.

• The secondary issuance market has been open and some decent fundraising has already occurred, however if a second wave of the virus hits, shareholders are unlikely to be as forthcoming with funding as they appear to have been the first time around.

• Cash is an attractive form of takeover consideration, particularly now.

• A paper for paper merger with no cash in either company is not as good as a merger where one party is bringing a significant cash holding.

• With cash, you can sit on the sidelines and move in when opportunities come up.

This is easy in some industries and some companies have already done this. However, where operating cash flow will not allow, the key alternatives are equity for debt refinancings, asset sales, discontinuing zombie divisions, outright business sales and/or mergers to create strength.

Mike.

NextLevelCorporate is a leading independent strategic corporate advisory firm with a multi-decade track record of delivering transformative corporate finance solutions, in and out of Australia.