EC The Biggest Downside Risk To Markets

Investing across the cycle requires a firm grasp of the fundamentals, and perhaps nothing is more fundamental than the flow of money and credit.

Indeed, the current economic shock facing the world can be boiled down to a simple one-liner: we are currently in the middle of a liquidity crisis, and the biggest downside risk is that it transitions from a liquidity crisis to a solvency crisis.

As the charts and analysis below show, disruptions in the flow of money and credit can trigger and signal a self-reinforcing downdraft to markets.

That said, I remain constructive on the medium-term outlook for risk assets... but that view rests on a few key underlying assumptions - and requires close monitoring of a number of key indicators. 

The following charts and commentary addresses the dynamics at play, what to watch for, and the resultant implications for the risk/return outlook across corporate credit and equities.

1. Lending Standards vs Policy Rates:  This is quite a powerful chart - in a way it shows the disconnect between monetary policy easing versus banks tightening up lending standards.  In other words, benchmark interest rates may be lower, but it's harder to actually get a loan.  In fairness, it is completely understandable that banks would take this stance given the impairment of credit quality, servicing ability, and balance sheets as a direct result of the economic shutdown shock of the pandemic. But it highlights or leads into a couple of other themes and trends worth noting...

(Click on image to enlarge)

  What to watch for: In my view, the pandemic is essentially a liquidity crisis in that the vital interlinked system and chain of cash flows has been disrupted for a large part of the economy.  The biggest risk is that a more prolonged shutdown turns the liquidity crisis into a solvency crisis (i.e. the shortfalls go from income statement to balance sheet).

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