‘Just in time’ is bad risk management, or just plain greed, in an interconnected and China-dependent world

COVID-19 is a smart coronavirus because it can spread quickly among humans. The speed of that spread has been helped by the interconnectedness of humanity through international air travel.

The speed and dramatic impact on the global supply chain and responses by financial markets, governments and central banks have also been due to the world’s increased interconnectedness, both physically and virtually.

That same interconnectedness also means that the whole world can learn of COVOD-19’s spread and score as they happen, provided there is a free and honest flow of information.

The supply chain effects have been complicated by China’s ascension as a major global player in manufacturing, a global dependence on single sources of ingredients and components and so-called efficient inventory management, i.e. ‘just in time’. The latter is proving to be a short-sighted cost saving that works very well in good times but fails in bad times. Poor risk management or greed, depending on your viewpoint.

China is now the world’s biggest manufacturer of steel, active pharmaceutical ingredients, medical supplies and motor vehicles, as well as industrial and consumer electronics. People can live comfortably if they delay the purchase of that new phone, car or TV for a few weeks but most pharmaceutical and medical supplies wholesalers and suppliers have only a limited supply of these essentials.

The hopes are that China’s manufacturing will resume soon and supply chains will move again. Now though, we are seeing forced isolations in other countries that could result in the same supply chain blockages that China is trying to clear up; forced isolations and supply chain blockages that will have drastic implications for the earnings and spending of the average business and household in countries that do not have the draconian ability to impose the same sort of control over and co-ordination of businesses and people as China.

For the rest of us, the threat remains for further restrictions on the supply to health professionals and individuals of vital items of medical and sanitary products – all because of someone’s poor risk management, or greed.

Time for reasoned assessing and planning – not for panicking

The COVID-19 outbreak has hit the world just as governments, central banks and financial markets in many industrialised nations were seeing hopes of a recovery in economic growth after a slow down in response to the effects of major geopolitical events last year – the US/China trade war, Brexit and escalating tensions in the Middle East.

Those hopes promised governments and central banks some latitude to ease fiscal policy (i.e. spend) and to hold steady on monetary policy (i.e. not to worry about having to further cut interest rates that are already at record lows, or in many cases negative). But, COVID-19 has dashed those hopes, for now.

Governments are having to loosen purse strings through unplanned public sector expenditure (e.g. at borders and hospitals) while witnessing a slow down (or, in some cases, a complete halt) in household spending and business production, which will translate into governments spending more and earning less.

Central banks are scrambling to identify the problems so that they can take action, just as they did when the GFC hit.

Financial markets are keenly waiting for central banks’ responses, confident that central banks can again come to the rescue of markets and economies. This time though, the problems are very different and so the required responses most likely will be very different, and central banks have less ammunition to call upon. The central banks’ interest rate quiver, at best, has one, maybe two, arrows left and the bow string is frayed. So, they must look at other targets and take other measures.

The dramatic falls in sharemarkets have rocked investor confidence with such force that bond and credit markets have also reacted forcefully. Cash exiting sharemarkets has gone into the safety of government bonds but there has been collateral damage by way of a sharp spike in market volatility, wider credit spreads and, more significantly, stymied primary and secondary market activity in the corporate bond markets. In the case of the US, the CBOE Volatility Index closed Friday at its highest since August 2015 and the US corporate bond market has all but ground to a halt.

Indications are that central banks are very worried about the impacts of this latest disruption on the liquidity and stability of banking systems, which carry higher priorities for central banks than managing inflation, unemployment and growth through monetary policy.

On Friday, the Chair of the Federal Reserve (Fed) Board, Jerome Powell, reassured markets that “the coronavirus poses evolving risks to economic activity” and that the Fed “is closely monitoring developments and their implications for the economic outlook. We will use our tools and act as appropriate to support the economy.”

Powell’s statement on Friday came a day after the Bank of Korea assured that “it will judge whether to adjust the degree of monetary policy accommodation, while thoroughly assessing the severity of the COVID-19 outbreak, its impact on the domestic economy, and changes in financial stability including household debt growth.” No mention of interest rates, rather a generic reference to “monetary policy accommodation” and a focus on “financial stability.”

Governments, central banks and (bank) economists are universally assuming that this will be a short to medium term event while planning for the worst over a longer period. Now is a time for governments and individuals to undertake reasoned and disciplined risk management planning, not to panic.

Have we really escaped the GFC?

The slowdown in global economic growth over the more than 10 years since the Global Financial Crisis (GFC) seems to have bottomed out. Sharemarkets (by definition, an indicator of future company cash flows and profits) have had a stellar 2019 and started 2020 in the same vein, much to the delight of investors. Given that most of us are (or should be) KiwiSaver investors, that is good news.

Yet, other key forward indicators are proclaiming the opposite. Prices for industrialised commodities (e.g. oil, iron ore, aluminium and copper), global bond yields and official (central bank) interest rates not only are below 2019’s peaks but also are well below their respective peaks since the GFC.

Many (including the writer) attribute rising sharemarkets to historically low funding costs as a result of low benchmark interest rates and credit spreads.

Low benchmark interest rates are the legacy of central banks’ vigorous monetary easing since the GFC, to avoid a repeat of the economic and geopolitical devastation after the 1929 sharemarkets’ crash, and the interest rate markets’ response to still sluggish economic growth and inflation.

Low credit spreads are the result of investors chasing yield in a low interest rate environment but, in doing so, they are lowering their risk tolerance. That, in itself, is another worrying sign that the financial community has leveraged its investments. Leverage is a useful business tool but too much leverage reeks of greed. And, unlike a Gordon Gekko, I believe that greed is anything but good.

I really hope that the messages from sharemarkets and credit spreads presage the future. But I am not hopeful, although I want to be for the sake of my family, especially future generations.

Over-enthusiastic sharemarkets and credit spreads were signs of greed that preceded the GFC and the crashes of 1987 and 1929, among others. Furthermore, bond yields have been a more consistent forward indicator than sharemarkets and, historically, the longer that bond yields and sharemarkets have proclaimed divergent outcomes, the more reliable has been the message from bond yields.

I do not know the future. No-one does! A prudent risk manager assesses all the risks in the context of risk preferences, objectives and the intimate relationship between risk and reward.

To find out more, email me at
cavanaugh@theeconomicbutterflyeffect.com or
ital@cavanaugh.co.nz