By Wagner Azevedo, CFA, Partner of the A dministrative Division of G5 Partners
Can past financial market crises be used as a mirror for the current one caused by the new Coronavirus (Covid-19)? Where actions taken in previous crises that minimized impacts and that can serve as a legacy to be copied now? Will the actions taken now leave a positive legacy for future generations?
Until now, the three historic crises that brought the most impact to financial markets began in the United States. They were, in chronological order: The Great Depression (1929 to 1933), the 1987 Crisis and the Global Financial Crisis in 2008.
In 1929, the sharp fall of the stock markets gave rise to the beginning of the Great Depression. At its worst moment, on October 28, 1929, the Dow Jones index fell 12.3% on what became known as Black Monday. This crisis was caused by an extremely deficient banking system, dominated by a huge number of small banks with low diversification, a housing bubble and the sharp increase in debt levels during the prosperous 1920s.
The disasters caused between the years of 1929 and 1933 in the USA included a 29% decline in GDP, a 25% drop in stock prices and a 25% unemployment rate and the government did not take active measures. A comment made by Mellon, the Treasury Secretary at the time, leaves no doubt: “Liquidate labor, liquidate stocks, liquidate the farmers, liquidate real estate. It will purge the rottenness out of the system”. There is no single fact that confirms what led to the end of the Depression. A few stimulus programs helped, but government resources were not large enough to end the crisis, thus many believe the economic recovery came from the Second World War and investments towards the production of weapons.
The second largest market crisis, in October 1987, made the US stock exchanges collapsed once again, with the S&P500 index plummeting 20% on a single day. This event was very significant, not only because of the size of the drop, but also because it demonstrated the weakness of the trading systems since, in times of stress and rapidly declining prices, damage is potentialized. In summary, there were three problems with these systems 1) inability to process a huge number of orders during a chaotic period, 2) automated order execution programs, and 3) volumes and maturity of margin calls. In order to calm the markets and avoid that it contaminated the real economy, the Federal Reserve (North American’s Central Bank), took public actions to provide market liquidity and restore investor confidence. Through open market transactions, the FED injected liquidity into the system and reduced interest rates.
The 2008 Global Financial Crisis originated after a long period of unusually low interest rates, flaws in regulatory enforcements and an overheated housing market. The default of a significant number of subprime mortgages (with low risk ratings) spilled across the market through derivative instruments associated with these mortgages, thus freezing the interbank loan market and leading to a crisis for commercial and investment banks. Bear Stearns almost broke but was saved by the FED and incorporated by JP Morgan, in an episode where the motto Too Big to Fail, or too big to break, was once again applied.
When Henry Paulson, the US Treasury Secretary at the time, announced that he would allow the financial giant Lehmann Brothers to crash, markets plummeted, credit froze and contaminated the global markets, resulting in a huge global crisis. Once again, recovery came through the injection of resources into the economy, with public spending sent to saving banks, insurance companies and car manufacturers, as well as support to consumers and small and medium-sized companies through tax cuts and financial aid checks. According to Ben Bernanke, the CEO of the FED from 2006 and 2014, the Global Financial Crisis had potential to be more destructive than the Great Depression but didn’t happen due to the different responses from government agencies between both crises. The government made minimal interferences during the Great Depression but responded quickly and profoundly this time.
Now, the crisis generated by Covid-19 is completely different from previous ones. From an economic viewpoint, this is the first time a simultaneous disruption occurred in both supply and demand. Industries and service providers froze and reduced the supply of many products and services, while consumer experienced sudden loss in purchase power and, due to the expected deterioration in future economic projections, reduced spending and are purchasing only essential products. From a broader perspective, this pandemic affected almost two hundred countries, causing unprecedented impacts on the commercial relationship between them and undermined the supply of essential hospital equipment to treat infected victims in seriously conditions.
Lessons from previous crises are extremely useful. Governments around the world, particularly in the USA and Brazil (not so much the EU), are looking back to 2008 and understanding that it is necessary to put money in the hands of people and to help businesses as quickly as possible. In 2008, the USA Congress took 4 months to approve a US$ 800 billion financial plan, but this time around, a US$ 1 trillion plan was approved in just one week. Brazil is also taking all possible measures to respond to the crisis. The Central Bank of Brazil has been taking extremely quick measures to maintain the banking system’s liquidity and stability and to ensure that credit can serve as a channel for boosting growth. In addition, the executive and legislative powers have taken several daily measures to help tackle the crisis, in what can already be considered as the largest injections of resources into the economy in the country’s history. It is also important that the private sector, especially banks, also make their contributions to the problem.
However, lessons from previous crises have a key limitation this time. There is a new element in the equation, a virus, that literally affects people’s lives. This virus was confirmed to have reached western countries just a few weeks ago and thus the medical and scientific knowledge on it is still very limited. No proven cure, vaccine or treatment currently exists to treat the virus. The only measures to prevent its spreading are the social distancing, isolation and quarantine of the infected individuals. For this reason, we are living days that are more similar with the 1917 Spanish Flu than the 2018 global crisis.
In summary – crises happen and, when they are over, recovery tends to be very strong. But there is still a huge challenge ahead of us until this actually occurs. This virus will remain circulating for a long time. Therefore, in addition to the measures already taken, at some point we will have to make crucial decisions as to how and when to leave isolation, either vertically or partially, to avoid the risk of a second wave of contamination, which would be catastrophic. The monetary and fiscal economic measures taken are expected to increase and last for a much longer period. Heavy investments in the public health system should be taken, but without forgetting that other sectors lack investment in Brazil, such as security, education and infrastructure. We must prepare to redesign our personal interactions at work, social events, school, sports and leisure gatherings in such a way that society will need to adopt a new behavior model for the days, weeks and months to come.