Art Micheletti, Economic Consultant
March 31, 2020
Economics has historically been a rough, but fascinating, tool to gauge prospects for the equity markets. In our current COVID-world, realities change faster than almost all economic data can measure, reducing their value as short-term drivers of markets. Likewise, data points that are generally considered longer-term indicators give little information since the breadth and length of the current shutdown is so uncertain. Even shocking data can be easily discounted. To wit, prior to the end of the first quarter, the weekly initial jobless claims number had never breached 700,000 (it came close in 1982 and again in 2009). The combined tally for the final two weeks of March was a pip below ten million. But does that mean much? As part of the $2 trillion CARES Act, unemployment benefits have expanded dramatically, giving some employers more incentive to lay off workers. From a longer-term view, once COVID-induced shutdowns are reversed, we can expect many of these workers to get their jobs back. So, while economic data is noisier than ever, it contains kernels of reality. Although the weatherman is only occasionally right, if he calls for rain the next day, we’re likely to have our umbrellas at the ready. And so it is with economics.
In the last edition of the 9:05, we again projected continued slow growth on the back of stable consumption, while noting some green shoots emerging from the housing sector. We also reiterated concern about growing deficits, debt accumulation, and liquidity shortfalls that were beginning to appear in financial markets. These imbalances were already showing up in the Treasury repurchase (repo) market, which is used by the Fed to boost liquidity. The Fed’s balance sheet had expanded by $1 trillion in the fourth quarter of 2019, and this was before the most recent monetary actions.
That was then…
The coronavirus is the pin that popped the stock market balloon and further exposed additional cracks in the financial system.
If you fell asleep after Thanksgiving and woke up this March, you found an almost unrecognizable alternative landscape. Late last year it would have seemed unfathomable to see major cities quarantined, the global economy ground to a halt, businesses shuttered, global travel restricted, borders closed, and citizens confined to their homes. It’s not surprising that stocks dropped 30% in just over a month (from 2/19 to 3/20/2020, as measured by the S&P 500 Index), the fastest decrease of that magnitude ever witnessed.
The coronavirus is the pin that popped the stock market balloon and further exposed additional cracks in the financial system. Credit spreads widened dramatically in the first quarter, as the economy shut down and the outstanding amount of distressed debt spiked higher. Slowing economic activity and an oil price war pushed oil down to nearly $20 per barrel as of quarter-end. Combined with evaporating margins, energy sector debt has fallen to distressed levels. In addition, leveraged loan pricing is tanking, corporate bond ratings are being downgraded, and corporate cash flow is likely to contract. Some of the biggest risks to the financial system are if collateral values behind loans, margin debt, and leveraged loans continue to deteriorate.
The conventional wisdom is that the economy will be fine once we get through the coronavirus shutdown, with many calling for a V-shaped recovery. We cannot predict how steep or long the economic slide will be, let alone what kind of recovery will follow. James Bullard, President of the Federal Reserve Bank of St. Louis, stated that second quarter GDP could decline as much as 50%, sending the unemployment rate to 30%. Goldman Sachs has projected a 30% decline. Whatever the number, it will probably be the biggest decline ever.
With interest rates now at zero, the Fed is running out of monetary policy measures and is resorting to its most extreme tool: printing money.
In March, the Fed took unprecedented and staggering steps to help support the economy and markets. It cut the Fed Funds rate to zero, announced a $750 billion quantitative easing (QE) program, and expanded dollar swap lines with other central banks to boost liquidity. Just prior to the end of the first quarter, the Fed called for unlimited QE, taking a page from former ECB President Draghi’s “whatever it takes” playbook. With interest rates now at zero, the Fed is running out of monetary policy measures and is resorting to its most extreme tool: printing money.
While the Fed has been increasing liquidity, support by way of fiscal policy is also on the way. Congress passed a $2 trillion stimulus package that includes $500 billion to back loans/assistance for large corporations, $350 billion for small business loans, $150 billion to state and local governments, and $117 billion for hospitals. This is in addition to $300 billion of direct payments to households in the form of $1,200 per individual and $500 per child. There will also be increases in unemployment benefits, as well as support for the domestic airline industry. These stopgap measures are crucial but they will leave a longer-term legacy: a budget deficit (already back over a trillion dollars) now primed to explode higher.
As in 2008 and 2009, the Treasury Department is enacting an alphabet soup of new programs to support the economy, while hopefully avoiding large negative externalities. These programs include:
• CPFF (Commercial Paper Funding Facility): buying commercial paper from the issuer • PMCCF (Primary Market Corporate Credit Facility): buying corporate bonds from the issuer • PDCF (Primary Dealer Credit Facility): provides funding to primary dealers of government securities • MMLF (Money Market Mutual Fund Liquidity Facility): a lending and asset purchase facility for money market funds to help meet redemptions and avoid cash equivalency deposit asset sales that would cause funds “to break the buck” • TALF (Term Asset-Backed Securities Loan Facility): funding backstop for asset-backed securities • SMCCF (Secondary Market Corporate Credit Facility): buying corporate bonds and bond ETFs in the secondary market and • MSBLP (Main Street Business Lending Program): Details are to come, but it will lend to eligible small and medium-size businesses, complementing efforts by the Small Business Association.
By law, these actions are outside of the Fed’s traditional mandate. Its core responsibility is simply to purchase and lend against government-guaranteed securities. To pursue the suite of acronyms described above, the Fed will finance a special purpose vehicle (SPV) for each program. The Treasury will make equity investments in each SPV using the Exchange Stabilization Fund and take a “first loss” position. The Treasury, not the Fed, will be buying securities and backstopping loans.
However, with this bear market arriving so quickly and painfully, many believe the bounce off the bottom will be just as sharp. In our opinion, investors should continue to be cautious here: bear markets typically don’t just start and immediately stop. Based on Bloomberg data, evaluating the eleven bear market periods since 1926 reveals an average length of 1.3 years and an average cumulative loss of 38%.
The coronavirus has yet to run its course and we don’t know how long “normal” life will be disrupted. Nor do we know the full extent of damage or the size of bailouts needed for financial markets or, most importantly, how investors will react. We have historically had powerful bounces off market bottoms, which are normal after a sharp decline. However, in 2000 and 2008, initial rallies faded and became bear market traps for investors. The biggest bear market trap was in 1929 as the Dow Jones Industrial Average dropped 48% in the first two months and then rallied for four months. The Dow rose 50% off that low before renewing its downward slide, eventually falling 89% before bottoming in July, 1932. Hopefully, like in previous episodes, forward-looking markets will turn long before the economic data.
Regardless, we believe Bailard should pay close attention to what markets are telling us, not be wedded to any position or outlook, and keep focused on investors’ risk tolerances. Portfolio diversity and flexible allocation should help us navigate this unprecedented environment.
Like the U.S., control of the pandemic is at the top of most countries’ agendas, with central bank credit support and balance sheet expansion pledged to contain the financial impact of the coronavirus. Fiscal packages to support households and business are getting bigger and bigger.
The People’s Bank of China (PBOC) and Chinese regulators are trying to boost bank lending to companies impacted by the coronavirus outbreak and also lower financing costs, particularly for smaller, private companies and agriculture. Measures include ensuring that banks have sufficient liquidity by increasing the PBOC’s relending quota (that is, money lent to other banks). Regulators have lowered bank reserve requirements in an effort to boost private lending, which has collapsed. Other measures being discussed include medium-term lending facilities (akin to the U.S.) to support the financial system. China could also use its existing supplementary lending facility to fund loan extensions, tax cuts, rent cuts, and interest payments. Given China’s massive debt and inflation rising to 5%, financial risk remains high.
European economic data leaves little doubt that Germany and the eurozone are already in recession. The question is, how deep and that is unknowable until the pandemic is reversed. The former head of the ECB is urging a “war-like” expansion in debt and liquidity to banks.
In March, the ECB announced the creation of a 750 billion euro Pandemic Emergency Purchase Programme. This is a bailout fund available to euro-area members to fund public finances. The ECB is also discussing activating the Outright Monetary Transactions (OMT) program, which was designed in the summer of 2012 during Draghi’s “whatever it takes” monetary response to the region’s debt crisis. Effectively, this could provide unlimited liquidity to sovereign debt.
OMT received pushback from Germany, where it was challenged in German courts and never utilized. The German Bundesbank’s long memory of hyperinflation and EU law against monetary financing of governments will need to be overcome to move to OMT.
Over the last decade, Japan has shrunk the universe of Japanese bonds as the Bank of Japan (BOJ) effectively nationalized the financial markets. The BOJ now owns government bonds totaling 100% of the country's GDP. Something unusual is happening: while the BOJ is buying everything in sight, currency dealer demand for dollars is preventing them from selling. Currency dealers are using their Japanese Government Bonds as collateral. Just because there are willing buyers does not mean there are willing sellers on the other side.
The BOJ also created a new loan program to provide one-year, zero interest rate loans to financial institutions in order to boost lending to firms that were hit by the coronavirus. They are pledging to buy risky/failing assets, including ETFs. The BOJ said it will double its ETF purchases, aggressively increasing the program to purchases of $112 billion annually.
Like the U.S., the BOJ is keeping the overnight rate for lending to banks at 0% and a facility to purchase commercial paper and corporate debt. BOJ President Kuroda, in an emergency statement, said that the BOJ will make every effort to provide ample liquidity and try to ensure stability of financial markets.
Going into the crisis, Japan’s economy was already slowing rapidly, with October-December quarterly GDP falling an annualized real rate of 7.1% due to an increase in sales taxes. The pandemic has only made things worse.
Broadly, this may be just the start of extraordinary measures by global central banks and fiscal authorities.