Comment

A Covid financial crisis is surely only a matter of time

An economic crisis is always followed by a financial collapse somewhere

Rising unemployment? Check. Soaring government deficits? Check. Corporate collapses? Check. So far the Covid-19 recession, one of the worst on record, has followed the script for a major economic downturn in every respect.

Except this one: a financial crash. So far, the banks seem to be doing fine, so do the hedge funds, and the bond markets and the asset managers. Even the insurers seem OK.

There are two potential explanations for that. It is possible the regulators and central banks have done such a fantastic job of managing the crisis that they have been able to steer us through the downturn without a collapse. Or else it is just a matter of time.

Sure, it could be the former but somehow the second explanation is more convincing. In truth, there has never been an economic crisis that wasn’t followed by a financial collapse somewhere. From the private equity markets, to property, to banking and the currency markets there are plenty of candidates – it is just a question of which one goes down first.

Ever since records began, a major recession has always been the trigger for, if not a full-blown financial crash, at least some stress in the system somewhere. In the downturn of the Eighties, there was the Savings & Loans crisis. In the collapse of the Seventies, a fringe banking crisis. In the Great Recession of the Thirties banks closed on an epic scale.

It is not hard to figure out why. When money is lost, and businesses go broke, the losses are going to show up on a balance sheet somewhere, and that is going to create pain for one kind of financial institution or another. We've already seen UK GDP plunge almost 20pc in the second quarter.

True, it is possible that we have got slightly better at managing that. Central banks are quicker to pump liquidity into the market and regulators stress test the system for catastrophes. Both might mean we can muddle our way through a recession better than in the past.

Even so, a 10pc annualised drop in GDP without any financial pain? That is surely stretching credibility. In truth, there is going to be some turbulence in the financial sector before this is over.

Where exactly? Here are four places to start looking.

First, private equity. The big funds all piled into industries that generated plenty of free cash and were resilient to a downturn. The trouble is, they weren’t resilient to a pandemic. Pubs and restaurants were a favourite sector. So was retailing.

But those are precisely the industries where the worst losses are being suffered. When a chain closes, it takes the shareholders down with it, and all the debt secured on the asset as well. In total, there are $4.1 trillion (£3.1 trillion) of assets in the private equity funds. If just 20pc of that is lost, $800bn disappears into thin air. Not good.

Second, property. Again, restaurant chains and retailers were the key tenants for many malls and out-of-town shopping centres. It is increasingly clear that many of them are not going to open again. Likewise, the shift to working from home looks permanent.

That means it won’t be long before companies decide to halve the amount of floor space they are leasing (with staff hot-desking a couple of days and at home the rest of the time, no one needs the same office). All of those buildings are owned by big property or pension funds. And all of them have liabilities, and with income plunging they will struggle to meet them.

Next, look at the insurance industry. Does Covid-19 count as a “business interruption” and if so can companies claim for any losses they have suffered? Are contracts still valid and does rent have to be paid if you can’t operate? The lawyers will have different opinions, depending on who is paying them. Sooner or later a judge will have to decide. If so, there could be a tidal wave of claims against the insurers – and probably far more than even the gloomiest actuary ever allowed for.

Fourthly, the banks and bond markets. Lots of money was borrowed to tide companies through a closure that was meant to be temporary, but as lockdowns drag on until Christmas and potentially next year those loans will go sour.

So will bonds issued to get through the crisis - after a staggering amount of inflows experienced in August.

There are already worrying signs of that starting. AMC Entertainment, the world’s largest cinema operator and owner of the Odeon chain in this country, has seen the value of the bonds it issued in the spring plunge.

The National Audit Office last week estimated £26bn of losses on fraudulent bounce back loans.

The Treasury will be on the hook for most of that, but not all of it. Even worse, if we find ourselves with negative interest rates, as we might soon, the banks won’t even be able to make any money on deposits to compensate for losses elsewhere.

Bank shares are already close to 10-year lows, but it could get a lot worse.

Finally, nobody has been worrying about trade balances for a long time. But this might be the moment to start.

When you lock down huge swathes of the productive economy, then print money to keep everyone on their existing income, you have to import more and export less.

The result? Trade deficits start to soar.

We are already starting to see that. France recorded a trade deficit of €7.7bn (£7bn) last month as exports plunged, one of the largest deficits on record.

The US saw an unexpected increase in its deficit. At some point, spiralling deficits are likely to rock the currency markets. All that printed money just might not turn out to be free after all.

In truth, everywhere and always economic turmoil has created financial turmoil. That has been true of every other recession and it is very unlikely that this one will prove to the single exception. We have been lucky so far. But it is on its way – it is just a question of where and when.