From the Archives
A contemporary look at how the Spanish Influenza became such a global reckoning, and the medical field struggled to control it.
Well, well, well… another relaxing week, eh? In only five trading days, we saw some of the following developments:
- Federal Reserve cut rates by 50 bps, the first “between-meeting” cut since the financial crisis.
- The 10-Year Treasury yield dropped to its lowest point ever.
- The S&P 500’s dividend yield is now the highest versus 10-year Treasury yield on record.
When 2019 came to a close, there would have been very few investors (if any) that included a global pandemic in their 2020 investment outlooks. All commentary on how asset classes would fare in 2020 were blindsided by the coronavirus outbreak. Time will tell if we look back at this period as a prime example of behavioral biases and overreaction in the markets, or this was the event that set off a true financial crisis. Crises almost always have a catalyst, and they usually take the form of an unexpected event. One of my favorite examples comes in the first article of this week’s Sunday Reads, which covers the San Francisco earthquake, and it’s implications for the 1907 panic. Like the coronavirus, this was an event that investors could not have predicted beforehand, but had a significant impact on markets.
So, without further ado, while we looked at the historical relationship between Pandemics & Markets last week, we’ll now dive into the topics that dominated markets this week:
- Exogenous Shocks (Coronavirus)
- Monetary Policy
- Corporate Bonds
Although they are different in many ways, the coronavirus pandemic in 2020 and the San Francisco Earthquake of 1906 share some commonalities. Specifically, they are both examples of exogenous shocks that had substantial impacts on financial markets.
“The San Francisco earthquake, on the other hand, is an identifiable exogenous real shock with a traceable impact. We follow the impact of this disaster and its effects on the American economy and world financial markets. We show how the payment of insurance claims resulting from the disaster prompted changes in money and financial markets worldwide; the Bank of England raised interest rates and discriminated against American finance bills for the next year. These actions helped push the U.S. economy into recession by May 1907 and the financial sector crashed with the collapse of the Knickerbocker Trust Company in October.”
In fact, the ensuing 1907 panic was so severe that the San Francisco earthquake can really be credited as the impetus behind creating the Federal Reserve.
“Economists have long studied the relationship between the real and monetary sectors. We trace out the effects of an exogenous real shock, the 1906 San Francisco earthquake. The quake’s impact manifested itself in international gold flows, as British insurance companies paid their San Francisco claims out of home funds in the fall of 1906. The capital outflow threatened the fixed sterling-dollar exchange rate, leading the Bank of England to raise interest rates and discriminate against American finance bills. The resulting contraction pushed the United States into recession, setting the stage for the 1907 Panic and the founding of the Fed.“
To give you an idea of the severity of this earthquake, Britain ended up shipping the equivalent of 14% of its gold stockpile to pay insurance claims stemming from the disaster. Nuts!!
The effects of this earthquake stretched beyond San Francisco, leading to changes in interest rate policy in both the US and UK:
The last two weeks have been filled with market swings, to say the least. On Monday of this week, it seemed as if markets were on there way back from the previous week’s rout, but these hopes were short lived as Tuesday brought back another drop.
So with the return of increased volatility, now is a good time to reflect on the long-term role of volatility in financial crises. One of the more interesting aspects of the paper is their dive into volatility in different regimes:
According to Bloomberg News, this week marked the largest weekly outflow from U.S. corporate bond funds in at least a decade. As investors become increasingly pessimistic as markets plummet and coronavirus cases grow, the yields on corporate bonds are ratcheting higher and higher. Companies within the travel space have been particularly hard-hit:
“American Airlines and Viking Cruises Ltd. are among the worst travel industry performers in the high-yield market Friday, with some of their bonds yielding more than 12%“
As the impact of coronavirus fears spreads from equities to bonds, it is worth looking at the 150-year history of corporate bond default risk.
“We study corporate bond default rates using an extensive new data set spanning the 1866–2008 period. We find that the corporate bond market has repeatedly suffered clustered default events much worse than those experienced during the Great Depression. For example, during the railroad crisis of 1873–1875, total defaults amounted to 36 percent of the par value of the entire corporate bond market. We examine whether corporate default rates are best forecast by structural, reduced-form, or macroeconomic credit models and find that variables suggested by structural models outperform the others. Default events are only weakly correlated with business downturns. We find that over the long term, credit spreads are roughly twice as large as default losses, resulting in an average credit risk premium of about 80 basis points. We also find that credit spreads do not adjust in response to realized default rates.”
In this article, there is a section on the Panic of 1873 that offers interesting parallels with markets today. The 1870s were highlighted by the exciting and rapid growth of new technology: railroads. With this exciting technology came booming debt markets:
“The growth in economic activity was accompanied by a rapid expansion in the corporate bond market. For example, the number of bond issuers listed in the Commercial and Financial Chronicle was 158 in 1866, but quickly reached 421 by 1872. The Commercial and Financial Chronicle from this period is often filled with enthusiastic accounts about the promise of new technology:
‘Every well-built railroad if suitably located becomes a productive machine which adds to the wealth of the whole country… Our new railroads increase the value of farms and open new markets for their products. They lessen the time and cost of travel. They give a value to commodities otherwise almost worthless. They concentrate population, stimulate production and raise wages by making labor more efficient. Our existing railroads are computed to create more wealth every year than is absorbed for the construction of new railroads.” (January 11, 1873).’
Yet, eventually, this exuberance must face reality.
“However, later in the same year there was a major panic which led to a default rate of 14.3 percent in 1873. Contrast the buoyant spirit reflected in the previous quote with that evidenced by the following quote from the Commercial and Financial Chronicle exactly one year later.
‘After such a panic as has, the past year, swept over the country, it becomes a kind of melancholy pleasure to look over the field and find that there are not quite so many dead and wounded lying about as was anticipated. It was a fearful storm while it lasted, and although every one of course can say now that he knew it was coming, yet the real truth is, its breaking was terribly sudden and unexpected… There are few people who allow themselves to remember long the lessons experience would teach them. If this were not so, there would be many less failures in the world… Almost all felt they were carrying too much debt; they would henceforth be out of it. There are now, however, very evident signs that these resolutions have been mostly forgotten. Over-trading, as it is called, is an evil that has ever existed, and pretty much the same epitaph can be written above each business prostration—here lies the result of an attempt to do too much with too little capital. Must history necessarily repeat itself?” (January 10, 1874).'”
The biggest headline this week was that the Fed cut rates by 50 bps, and did so between meetings for the first time since the 2008 crisis. The major stock market indices dropped on the news. Since the Fed’s decision, however, many investors have been left curious about the historical role of monetary policy and stock market booms/busts. Thankfully, you have come to the right place. This article is particularly relevant as it looks at US monetary policy through a global lens:
“We examine the role of U.S. monetary policy in global financial stability by using a cross-country database spanning the period from 1870-2010 across 69 countries. U.S. monetary policy tightening increases the probability of banking crises for those countries with direct linkages to the U.S., either in the form of trade links or significant share of USD-denominated liabilities. Conversely, if a country is integrated globally, rather than having a direct exposure, the effect is ambiguous. One possible channel we identify is capital flows: If the correction in capital flows is disorderly (e.g., sudden stops), the probability of banking crises increases. These findings suggest that the effect of U.S. monetary policy in global banking crises is not uniform and largely dependent on the nature of linkages with the U.S.”
If you want historical context on financial crises, you will be hard pressed to find one more in-depth than this paper covering eight centuries of crises.
“This paper offers a “panoramic” analysis of the history of financial crises dating from England’s fourteenth-century default to the current United States sub-prime financial crisis. Our study is based on a new dataset that spans all regions. It incorporates a number of important credit episodes seldom covered in the literature, including for example, defaults and restructurings in India and China. As the first paper employing this data, our aim is to illustrate some of the broad insights that can be gleaned from such a sweeping historical database. We find that serial default is a nearly universal phenomenon as countries struggle to transform themselves from emerging markets to advanced economies. Major default episodes are typically spaced some years (or decades) apart, creating an illusion that “this time is different” among policymakers and investors. A recent example of the “this time is different” syndrome is the false belief that domestic debt is a novel feature of the modern financial landscape. We also confirm that crises frequently emanate from the financial centers with transmission through interest rate shocks and commodity price collapses. Thus, the recent US sub-prime financial crisis is hardly unique. Our data also documents other crises that often accompany default: including inflation, exchange rate crashes, banking crises, and currency debasements.”
The paper is filled with interesting insights and facts. For example, “the median duration of default spells in the post–World War II period is one-half the length of what it was during 1800–1945 (3 years versus 6 years)”.
As far as commodities go:
“The upper panel of Figure 7 is an illustration of the commodity price cycle, which we split into two periods, the pre– and post–World War II periods. As the figure broadly suggests for the period 1800 through 1940, (and as econometric testing corroborates), spikes in commodity prices are almost invariably followed by waves of new sovereign defaults. The lower panel of Figure 7 calibrates the same phenomenon for the 1990s and 2000s. We note that while the association does show through in the pre–World War II period, it is less compelling subsequently.”
“Did the Black Death have any effects on the medieval economy beyond what would be expected from the population losses? I test this by constructing measures of real wages, real land rents, and rates of return on capital from 1210 to 1500. These reveal first that there is no sign the Black Death had any effect on the efficiency of agriculture. Indeed efficiency changes little all the way from 1210 to 1500. Second the return on capital did fall from 10% around 1300 to about 5% by 1400, the biggest change in English history. But this decline seemingly began around 1300, long before the Black Death, and so was probably unconnected. Third the measured efficiency of the agricultural sector in 1210 is little below the efficiency measured in the same way in 1600-49. Only after 1650 is there sign of growth in the efficiency of agriculture. The growth of the medieval economy in the thirteenth century, by implication, must have come from demographic factors and not technological advance.”
There were already concerns from some investors over the strength of China’s credit system, and the outbreak of coronavirus has only exacerbated these concerns. This article takes a look at the integration of China into world financial markets from 1870 – 1930. It’s a very informative paper for how to view China’s relationship with the West today.
“This paper focuses more narrowly on the process of securitization of the assets of Chinese firms and government debt that began to occur in the late 19th Century, both inside and outside of China. Over the period 1870 to 1930, the Chinese financial system underwent extraordinary change. Chinese enterprise in major port cities developed from family-based, private equity ventures and quasi-public firms, to publicly-held corporations which could tap both domestic and foreign savings through both international and domestic stock and bond markets.”
For a while, this system was great. Just take a look at how relatively stable the yields on China’s debt was at the time:
However, as you probably guessed, things eventually turned.
“Foreign investment over the period 1870 to 1930 financed remarkable growth in the Chinese economy, however it came at a price – the most visible of being preferential government concessions to foreign investors, and partial foreign control over government finances. From the foreign perspective, these concessions were simply investor protections.
From the Chinese perspective, however, these terms were viewed as an affront to Chinese sovereignty and an impediment to the development of a domestic corporate sector. As a consequence, the terms of Chinese external investments contributed to a backlash against foreign ownership of Chinese capital and foreign encroachment on Chinese sovereignty.
Although a vigorous capitalist system grew in cities like Shanghai in the late 1920’s and 1930’s, the seeds of resentment towards foreign capital became a popular catalyst for the Leninist revolution in 1949, an event that shifted China away from widespread economic and financial relationships with large sectors of the developed world. Only in the last two decades has China returned to the global financial community and in the last decade China has begun to rebuild her own domestic capital market.”
Bloomberg’s Tracy Alloway wrote about how Trump’s New Trade War Tool Might Just Be Antique China Debt. In her article, she notes:
“The U.S. once referred to the money that flowed into China at the turn of the 20th century as “dollar diplomacy”—a way of building relations with the country (and its massive untapped market) by helping it industrialize. The Chinese have another term for it: For them it fits squarely into China’s “Hundred Years of Humiliation,” when the Middle Kingdom was forced to agree to unfair foreign control.”
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