The Virus Analysis

Caveat

Before I start off, this piece was written on 15 March 2020 and is based on what has happened till date and some related likely scenarios.

At the blindingly fast rate at which the virus and markets are moving, I won’t be surprised if some of my assumptions and analysis turns out to be very obsolete very quickly.

For example, till recently most of the analysis assumed that the biggest impact on the U.S. economy would come from disruptions to global supply lines from China, leaving U.S. manufacturers and retailers without the goods they need. In other words, it would hit only the supply side of the economy, but not the demand side. But that assumption is so last week.

With that critical health warning (pun intended) in mind, I will kick off.

Great but Obsolete

Yes, the numbers look great.

The US labor market added 273,000 jobs. The unemployment rate fell from 3.6% to 3.5%, matching a 50-year low. Job gains for December and January were revised up by a total 85,000.

But sadly, this is news from another planet, mostly irrelevant (except for the fact that the very low unemployment rate gives some sort of cushion) thanks to COVID-19.

Breaking Records

We are now being deluged almost daily with some mind-boggling numbers, some of which should go straight to the record books.

The US stock market has now lost the entire $11.5 trillion it gained since Trump's 2016 election victory.
The S&P 500’s tumble from a record to a bear market would be the fastest since World War II.
Oil saw its worst day since 1991 on Monday when the global commodity battle drove a 32% price drop.

The Known Unknowns

The terrible thing about this pandemic is that there are a disturbingly large number of unknowns as of now. Let’s talk about a few.

What we do know is the Americans have stopped talking about containment (too late) and are talking about mitigation. What we do NOT know is the extent of the outbreak in the US. Testing will be coming into place soon and we get a better idea of its spread throughout the US.
IF social distancing and quarantines are in effect for longer, the more damage they’ll inflict on corporate balance sheets, hiring and consumer spending. It may kill the pandemic but it will halt the economy. Like in China which, if the mendacious dictatorship can be believed, appears to be slowly recovering.
Can countries stem COVID-19 without resorting to China's drastic measures? The Chinese appear to have contained COVID-19, but at a HUGE cost. Schools & factories went on hiatus. Tourism halted. Auto sales plunged 80%. Beijing shut down and rebooted its economy. 6.4% may become an 8.5% contraction. China's factories and stores are slowly opening, but activity remains far below normal. That’s exactly why Trump's ban on travel from Europe sent the stock market correction plunging to new lows. The U.S. is rapidly intensifying its approach to containing COVID-19 at the cost of economic activity.
IF policymakers can ward off contagion and recession, there is scope for a “very sharp rebound in economic growth and in risk assets given the benefits of loose monetary policy and a low oil price.”
The heat and humidity of the summer is supposed to dramatically reduce the spread. IF the world doesn't catch a break on the China pickup and the seasonal fronts, expect a longer coronavirus pandemic and global recession.

I am not even covering the Unknown Unknowns (what we don’t know we don’t know)!

The REAL Danger

But my biggest worry right now is not the banks or the leveraged corporations. It is the American consumer. It’s critical to track whether the American consumer, the reliable engine of U.S. growth for the last decade, is pulling back.

Why?? US consumer spending, also known as personal consumption expenditures (PCE) , was at $14.799 trillion as of the fourth quarter of 2019, according to the Bureau of Economic Analysis (BEA). US GDP was at $21.542 trillion for the same quarter. That is a massive 68%!!

COVID-19 means that people will be forced to work from home, but this number may be as low as 25% of the workforce. Most of the workforce cannot work from home, mainly due to the nature of the work. If you are in manufacturing, retail, F & B or health care you can’t work from home. So they may be put on paid leave and then laid off.

About 10% to 15% of U.S. gross domestic product consists of consumption of services that could be curtailed. Another 16% of GDP consists of non-food goods consumption that could be at risk if consumers don’t want to go out shopping.

More than 16 million people work in the US leisure and hospitality industries. About 5 million work in education and child care. About 1.2 million work in US transportation industries that could be affected. Let’s not forget the large gig economy where most workers have no medical benefits or unemployment insurance.

We are talking of massive layoffs because companies globally don’t have clients or goods to sell and their employees can’t work! And if they lay off enough numbers the consumer demand will plunge, leading to yet more layoffs and the vicious spiral goes on. The economic engines around the world may come to a grinding halt.

Monetary Policy

So, what can Governments do? Well for one there is the ever-popular Central Banks who have been continually bailing out countries, markets and companies for the last 25 years.

But COVID-19 is giving the Fed a policy headache like never. How to judge the potential impact on the economy in the absence of reliable data on how fast the illness is spreading across the U.S? Most data the Fed usually relies on are too backward-looking to be of any use, like the rosy employment numbers I mentioned at the outset.

Unfortunately, aside from calming stock markets, there’s not much that monetary policy can do to restore global supply chains. It’s ability to stimulate demand is hampered by the fact that fighting the outbreak requires a temporary economic slowdown as people quarantine themselves.

The Fed rate cut is not totally useless. Lower interest rates on mortgage loans, credit cards and other consumer loans should lead to increased consumer spending and borrowing. It may make it easier for small and medium businesses to service existing debt and take loans and hence survive.

The BoE recently took the drastic step of slashing its key interest rate by 50 basis points. The ECB decided to buy up 120 billion euros more in bonds. But the ECB must be more cautious than the Fed or the BoE: Its key rate has been negative for more than five years, reducing its capacity to act now

Powell jumped the gun and cut too early, just like he hiked too soon and too much in December 2018. He should have waited and watched the progress of the pandemic.

One reason is that central banks need to keep rates at their current level. They can’t afford to fire all their bullets now; there are too many other risks that existed well before COVID-19, risks like the trade war and Brexit.

Fiscal Policy

The other thing Governments can do is fiscal policy.

Trump floated a payroll tax cut. That may not work- the effect on the average salary is too little plus the benefits will be very unequal. What may work better is massive fiscal support to support consumers and businesses. Not just what’s been announced like bigger and wider unemployment benefits and paid leave but interest and principal moratoriums on loans, handouts to the needy etc.

The Eurozone is in a more fragile state. Because not only do negative interest rates crimp the ability of the ECB, but what the Eurozone lacks is the ability to initiate a major, coordinated fiscal push by governments acting together.

But even fiscal stimulus will NOT work that much. Because the financial markets are not the problem. Efforts to limit the spread of COVID-19 are more likely to have a bigger impact on the market than fiscal stimulus.

Corporate Earnings

American Airlines, Ralph Lauren and Hilton Worldwide are among the S & P 500 companies that have warned investors their finances will take a hit because of the outbreak.

Companies with global supply chains like Apple are already facing severe supply shortages and must shut down plants, shops temporarily. They will also be hit with demand shocks as people stay at home and lose their savings.

Goldman Sachs predicts that earnings growth for S&P 500 companies will collapse in Q-2 and Q-3 2020, but recover by the end of the year and into 2021. But don’t bet on it.

Stock Market Now

The market sell-off like this typically implies a 65% to 75% chance of recession in the next 12 months, based on history. That is unlikely with a 50% chance of recession as of now.

The market has priced in too severe of an adverse scenario, assuming we get timely and strong counter-policy response and a COVID-19 outbreak that peaks in the coming weeks

Stock Market Outlook

I think it will get worse before it gets better, because the virus is spreading in Europe (Germany, UK, France) and the US. The US has been incredibly incompetent in its response.

Hence the financial markets may see ”peak virus” 4-8 weeks from now.

The good news? Nothing lasts forever, not even bad news. Things will pass and companies and economies will get back on their feet, but it may take a few quarters for that to happen.

Plus, equal or worse single-day sell-offs historically were followed by forward returns of +4% and +17% over the subsequent 1-week and 12-month periods, respectively. Global equities could fall 25% from peaks, before rallying to slightly down for the year.

Summary

It’s a very fluid situation and the virus is still spreading within countries. And it seems the only cure is an economic slowdown.

Hence its early days. Until the results from the first round of widespread testing for the coronavirus infection are tallied in the U.S., don’t buy or sell. I’d wait for a minimum 30% drop from the peak before nibbling.

Trust me, if you are a long term investor, I expect some amazing deals on the back end of this.

2020
THE REAL FINANCE MENTOR
by Binod Shankar

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