Who defaults first?

The coronavirus panic is now bad enough to knock over a domino somewhere. And the rest of the dominos are nicely lined up. The only question is which one tips over first, beginning the chain reaction.

You might think the stockmarket plunge is bad enough. But what I’m referring to is the debt markets. Financial crises truly kick off with debt defaults, not the profit warnings and dividend cuts we’ve seen so far.

The Asian financial crisis began with a small Thai property developer’s default. 2008 got bad with Lehman Brothers. The European sovereign debt crisis featured Greece and Cypriot banks.

Defaults are so powerful because they involve the loss of principal, not just a change in price. It’s a binary outcome – you lose the lot.

So it’s not the stockmarket you should be worried about. Stock prices are a reaction to what’s going on elsewhere.

On days where stocks have recovered, or just bounced briefly, debt markets still haven’t looked so healthy. That was the big hint the carnage would continue. And that’s where your eyes and ears should be tuned to.

My eyes are focused on Italy’s debts in particular. Its economy, banks and government debt were all heading for a crisis before coronavirus hit. And the Italian government has made all those problems worse with its response to Covid-19.

Mortgage payments are suspended. Some taxes need not be paid. And there’s a stimulus package. In other words, precisely those parts of the Italian economy and financial system that were already overburdened are bearing the brunt of the response to coronavirus. That won’t work out well.

Ambrose Evans-Pritchard is also focused on Italy in The Telegraph. He describes what’ll happen next:

Italy needs a precautionary rescue of up to $700bn from the US and the major powers to head off the danger of a global crisis, a bail-out veteran from the International Monetary Fund has warned.

Ashoka Mody, the IMF’s former deputy director in Europe, said economic fall-out from the coronavirus is pushing Italy to the brink of “vicious negative feedback loop”, raising the risk of a financial chain-reaction through the international system.

A fully credible firewall would require funding of €500bn to €700bn, orders of magnitude greater than any previous package in history. “The Europeans can’t do it themselves. They’re hopelessly divided and financially much weaker than they were ten years ago.  Their instinct will be to punt,” he said.

We’re already discussing bailouts…

Then there’s the oil sector. A lower oil price may be good for the economy – a much-needed boost during the coronavirus shutdowns – but this just shifts risk to the oil companies instead.

This may be the whole point of the oil smackdown engineered by Russia and Saudi Arabia. They can survive lower oil prices better than marginal producers in the US. Large swathes of the US oil industry are unprofitable at these prices. And Iran’s government is struggling for cash too.

Oil companies borrow heavily to fund their capital-intensive operations. These debts must also be refinanced frequently. But at what rates? Or will they be refinanced at all when the oil price leaves companies unprofitable?

So far, oil explorers are hardest hit. And the banks which lend heavily to the energy sector. ING Group’s share price is down almost 40% in three weeks, for example.

Airlines should be top of the list for benefiting from lower oil prices. But coronavirus has other ideas. Poor Cathay Pacific can’t get a break between Hong Kong riots and the virus.

The cruise industry isn’t small fry either. It holds plenty of debt and a lot of infected.

In fact, the virus couldn’t have hit at a worse time generally. The world’s corporates have loaded up on debt thanks to low interest rates. Bloomberg reports US business debt exceeds that of households for the first time since 1991. They bought back huge chunks of their own stocks to goose performance.

Now that revenue is tumbling, all that debt will suddenly look dangerous.

A major corporate default is on the horizon. The only question is, who will it be? Who is the next Lehman Brothers?

But is it all bad news?

For the first time ever, I’ve considered opening an ISA account. Some stocks are looking mighty enticing at these prices…

Gold stocks are primed to outperform. Companies without debt aren’t at risk of default, making them a comparatively safe way to bet on the eventual recovery. And some UK companies will benefit from divergence from the EU in coming years too – they’re an opportunity.

My colleague Kit Winder is pointing out that renewable stocks are not crashing alongside the energy sector like usual. Is this the beginning of the real green boom as even a lower oil price can’t undermine renewables?

I think it’s clear that, at some point, the market plunge becomes a buying opportunity. Even with the FTSE 100 going nowhere for more than two decades, there have been plenty of bull markets during that time.

Why the optimism now? Not just because stocks are cheap.

Governments have begun to fight back. Incompetently, so far. Central bankers are cutting rates and governments are launching fiscal stimulus. It hasn’t worked, yet. But between the two, you’ve got limitless spending potential. And somebody will be getting that money. I’m thinking it should be me. And you, of course…

If you’re already wondering which stocks to buy, and when, you need to see this. It’s a tool designed to help investors make key decisions that we don’t usually focus on. But which are actually the key to long-term investing success.

When to buy, how much and in what combination, for example. It’s a tool I’ll be using if I take the ISA plunge. To analyse the companies I buy, and the overall ISA portfolio.

Will your decisions be as informed as mine? Will you have an in-depth understanding of how your portfolio is performing like I do? Will it be nice and clear how much of each stock you should buy?

If you’d like to find out what I’ll be using to do all this, click here.

Until next time,

Nick Hubble
Editor, Southbank Investment Research

Category: Commodities

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