Where we stand today:
The broad and ever-reaching impact of the Coronavirus across the globe is unlike anything that humanity has ever experienced before. While the 1918 Spanish flu pandemic provides some comparison, the interconnectedness of the world today makes this pandemic unique. So, lets get straight to the facts.
As of late April, more than 3.3 MM people have tested positive with more than 200K deaths resulting from the coronavirus globally. These numbers can be expected to be underestimated due to the lack of proper testing capabilities of many nations including the US.
The response globally while uncoordinated, has been to enact policies of self isolation and ‘stay at home’ orders. The result of this has been a sudden shutdown of otherwise normal global business activity. The economy has essentially grind to a halt. As of late April, based on data from the popular site Yelp, there were 176K businesses that had been shut down in the US alone, with the highest impact being in New York and California.
The ramifications of this shutdown are yet to be fully understood. In the immediate aftermath, close to 30 MM unemployment claims have been filed. More jobs were lost in the first 4 weeks after the lockdown measures than were created since the 08-09 crisis. Unemployment levels exceeding what was seen during the Great Depression. We could go on and on with statistics and the numbers are horrific, but most importantly, the gist of it is that the economic carnage is unprecedented by any measure, and there may be more pain to come in the following quarters if there is a second wave of the virus. My biggest worry for the economy is the possible long term structural damages, where we face lower productivity growth and hence lower standards of living over the next decade, further fuelling the economic inequality we experience today.
The Monetary Response:
The response from the FED and global central banks has been unprecedented, both in size and speed. The near simultaneous interest rate cuts across the globe along with an alphabet soup of support facilities by the FED has resulted in an enormous injection of liquidity into financial markets.
Quantitive Easing: The start of QE4 signifies to me the idea of QE forever. We witnessed the original "taper tantrum" in 2013 and more recently the market reaction in late 2018, when Powell said that the balance sheet run off would be on autopilot. Imagine the market reaction to the idea of reducing a balance sheet projected to be multiple times bigger than what it was in 2018. It’s the genie that you can’t put back into the bottle. Furthermore, the FED purchases are more open ended than before.
In terms of the current balance sheet as a % of GDP, compared to the other major central banks, the FED is still at the lower levels and this would suggest that they have the stamina to continue this program and will be in no hurry to slow down anytime soon.
FED - 27% of GDP
BOE - 28% of GDP
ECB - 44% of GDP
BOJ - 105% of GDP
The FED's Lending Facilities: The Fed has enacted a whole alphabet soup of lending facilities aimed to assist in the liquidity challenges that companies face and also to ensure the proper functioning of capital markets.
Primary Dealer Lending Facility (PDLF): The Fed can offer low interest rate (currently 0.25 percent) loans up to 90 days to 24 large financial institutions known as primary dealers.
Money Market Mutual Fund Liquidity Facility (MMLF): The Fed can lend to banks against collateral they purchase from prime money market funds.
Primary Market Corporate Credit Facility (PMCCF): The Fed can lend directly to corporations by buying new bond issuances and providing loans. Borrowers may defer interest and principal payments for at least the first six months so that they have cash to pay employees and suppliers.
Secondary Market Corporate Credit Facility (SMCCF): The Fed can purchase existing corporate bonds as well as exchange-traded funds investing in investment-grade corporate bonds.
Commercial Paper Funding Facility (CPFF): The Fed can buy commercial paper, essentially lending directly to corporations for up to three months at a rate between 1 to 2 percentage points higher than overnight lending rates.
New Loans Facility, Expanded Loans Facility and the Priority Loans Facility: The Fed can fund up to $600 billion in four-year loans.
Term Asset-Backed Securities Loan Facility (TALF): The Fed can support lending to households, consumers, and small businesses by lending to holders of asset-backed securities collateralized by new loans. These loans include student loans, auto loans, credit card loans, and loans guaranteed by the SBA.
Municipal Liquidity Facility: The Fed can lend directly to state and local governments.
The Fiscal Response:
The fiscal response has been just as stunning. We will require more, however the speed at which congress has been able to pass the stimulus bill has to be applauded. Globally, all governments are engaging in various forms of fiscal stimulus. The chart below shows the the breakdown across major nations and the various support that has been introduced. However, the velocity at which this stimulus passes through the financial system and actually into the hands of the folks that need it has been slow and perhaps unsurprisingly so. The financial infrastructure isn’t built to deal with this sort of volume and effectively lending this money to the intended businesses and folks all while staying within existing lending risk parameters is no easy feat for banks.
What lies ahead for the economy:
Much of the economic recovery will depend on the progress made on the healthcare front. While, promising news of a vaccine may rally markets, nothing other than an actual vaccine will bring back the aggregate demand of the economy. The jobs lost has been disproportionately higher in businesses such as restaurants, airlines and other sectors that involve the social gathering of people. Many of the consumers of these services will not feel comfortable returning to these activities even if they were allowed to.
As a result of the slowness of aggregate demand coming back to many industries, companies with excesses on their balance sheets will run into solvency issues. The various FED programs may have put a backstop on the liquidity issues for now, however the FED can not solve the solvency challenges of individual businesses.
As such, we should not expect a V shaped recovery. This recovery will be slow and prolonged and subsequently global rates can be expected to stay anchored at the lower bound. The trillion dollar question on the minds of all investors is whether we see inflation, deflation or disinflation. The view across Wall Street is mixed to say the least.
The inflation camp would point to the massive stimulus being injected into the economy and there may very well be pent up demand, as consumers frustrated by staying home especially in the age of the experience economy, go out and spent, and a sense of FOMO (fear of missing out) sweeps across the nation. A recent Goldman Sachs's report suggests that "disposable income is likely to register slightly positive growth for this year because the unemployment insurance has been so robust". This is predicated on the passage of a Phase 4 bill, none the less it indicates that consumers will have cash to spend.
The deflation camp would point out that, we may well see consumer caution, much like we did after the financial crisis. The double digit unemployment will continue to hamper the economy and consumer confidence will take time to rebuild.
I’m of the view that we are initially met with a deflationary shock due to consumer caution and operating in an ‘essential business’ only world. However, in due time as a possible vaccine arrives and some sense of business normalcy returns, so does inflation. It is very possible that the return of aggregate demand in the economy will be met with a new normal for the supply side. Underlying structural damages to the economy involves a drop in production capacity and productivity. This will largely be due to the permanent loss of certain jobs and the skills of the employees in those jobs, especially in manufacturing. Furthermore, the supply chain disruptions will continue as more and more companies are incentivized both from a contingency front and a political front to bring back supply chains closer to home. These new de-globalized supply chains will take time to reach the pre-COVID 19 levels of efficiency and in the meantime, if the tariff wars continue which they are very likely to do so, we could well be in a position of a lagging supply side unable to meet returning aggregate demand.
What this all means for Investors:
Whether you are an investor in equity or credit, all investors should keep in mind the three following points as they navigate the current landscape.
Expect a long road to recovery. The only “V” shape you will find is in the word ‘very’ to the long road to recovery.
It’s a bottoms up security picker’s market and look for companies with strong balance sheets and that stand to benefit from secular and accelerating trends as a result of the pandemic.
Watch out for the unintended consequences of the necessary actions of monetary and fiscal authorities.
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