Highlights:

· The global economy is on pause as governments across the globe attempt to slow down the spread of the coronavirus.

· Governments and central banks responded with aggressive measures to provide liquidity and keep select industries, small businesses and millions of unemployed workers afloat.

· It is impossible to say at this point when normal economic activities will resume, but when that happens there is likely to be pent-up consumer demand and a highly stimulative environment.

Commentary:

“You never want a serious crisis to go to waste. This crisis provides the opportunity for us to do things that you could not do before.”

-Rahm Emanuel, Then-President Obama’s chief of staff

Soon after making this statement to a conference of chief executives in the wake of the 2008 global financial meltdown, the Obama administration convinced a once-reluctant Congress to pass the then-president’s $787 billion stimulus plan.  Policy makers swore after the global financial crisis that they would never do it again.  “There will be no more tax-funded bailouts—period,” then-President Obama declared in 2010. Only a decade later, Congress hardly needed any convincing at all to pass a $2 trillion coronavirus aid bill that is the largest economic stimulus in U.S. history and dwarfs the previous stimulus package.  What is different this time around is that the prior bailouts went to banks, who were blamed for helping cause the crisis, but who needed saving because they were essential to providing credit to the mainstream economy.  By contrast, the current bailouts are aimed at the mainstream economy itself, much of which has halted as governments have ordered non-essential businesses to close and asked people to stay in their homes.

Their hope is to press pause on the economy, save lives, and then press play again.  The problem is that the economy has no pause button.  Social distancing measures, such as stay-at-home orders and non-essential businesses closures, has suspended the buying and selling of many goods and services and has created some massive supply chain disruptions.  Nevertheless, many costs keep on running. Households have rent or mortgages to pay, as well as bills for food and other necessities.  Businesses have payrolls, debts and other fixed overheads.  Banks are owed money and so must collect it.  People and businesses could live off their savings until the restrictions end.  However, many do not have adequate reserves and, as the health emergency continues, liquidity will become even more restricted.   

The Federal Reserve has taken unprecedented steps to try to calm markets and restore order, and has pledged to do more if necessary.  Reopening its playbook from the financial crisis of 2008-2009, the Fed has lowered interest rates, indicated it would return to buying bonds in “unlimited quantities” for its balance sheet, eased some regulatory requirements for banks, and created new vehicles to target the areas that are most stressed, including the corporate and municipal bond markets.  The combination of these moves—interest rate policy, forward guidance, large-scale asset purchases and regulatory relief—is designed to free up money that has become clogged in the financial system and make it easier for businesses, households and communities to access the funds needed to last through the crisis.  In the process, the Fed’s balance sheet has risen to over $5 trillion for the first time ever.

Governments and central banks around the world have stepped up in unison with the United States to fight the virus pandemic.  China eased monetary and fiscal policy to counterbalance the negative impact of the coronavirus and pledged to connect factories with technology companies to identify weak links in their supply chains.  Britain’s government and central bank announced a rare joint stimulus plan to combat the debilitating effects of the coronavirus on the economy and encourage banks to lend to small businesses.  European Union finance ministers agreed on a €500 billion rescue package for European countries hit hardest by the coronavirus pandemic.  This followed European Central Bank (ECB) President Christine Lagarde’s pledge that the ECB is “…fully prepared to increase the size of our asset-purchase programs and adjust their composition, by as much as necessary and for as long as needed. We will explore all options and all contingencies to support the economy through this shock.”  Japanese Governor Haruhiko Kuroda echoed these sentiments, saying that the Bank of Japan would “strive to provide ample liquidity and ensure stability in the financial markets.”

Monetary and fiscal stimulus can serve as triage, but they are not the cure.  What makes this situation so unique is that most small- and medium-sized business, millions of under- or unemployed workers and select industries, such as airlines and hotels, do not need a traditional bailout; they need a bridge to get from this side (quarantine) to the other side (post-quarantine).  We know a lot more about COVID-19 than we did a few weeks ago, but many questions remain unanswered at this stage.  We do not know how much worse this gets before it starts to get better.  We do not know how severe the economic impact will be because of the containment effort, or how long we will stay in this level of containment.  Finally, we do not know when markets will find their footing, especially given that traditional technical, sentiment and valuation metrics are less relevant in a pandemic-driven bear market.  The resilience of the consumer was a common theme during the most recent eleven-year bull market, but it is certain that near term consumer demand has been severely reduced.  The extent of pent up, post-virus demand is also uncertain as the consumer’s willingness and capacity to spend is impossible to gauge at this point. 

In a typical recession, the global economy tends to have large imbalances that take a long time to unwind, such as a housing bubble or over-investment by businesses.  This time, the global economy is experiencing a shock, rather than the natural end result of a slow build-up of excess.  In just a few months, this virus has spread across the world and caused governments to take extreme measures, including closing schools and businesses to limit human interaction, protect us, and combat the disease’s spread.  While this implies that the recession and bear market could deepen, the duration may also be shorter. The length of this recession will greatly depend on when people are allowed to leave their homes and when they feel comfortable resuming their normal activities.  It will also depend on how many of the struggling businesses are able to survive this lock down period, and how many people who have lost their jobs as a result of this pandemic will find gainful employment when the economy reopens.

Job losses have been widespread, from restaurants to manufacturing plants to airlines and hotels, inflicting damage to the labor market, which dwarfs the most significant economic downturns of the post-World War II era, according to many economists.  Millions of U.S. businesses have announced layoffs or furloughs, as their cash flows dry up.  Until March, U.S. employers added jobs for a record 113 straight months, causing payrolls to grow by 22 million. In the process, millions of people found work.  The unemployment rate, which was 3.5% in February, had been at levels not seen since the 1960’s.  Wages even started to accelerate in the last two years after lagging during the early stages of the expansion that followed the 2008-09 recession.  The strong labor market kept the U.S. economy humming for a decade, straight through a European debt crisis, a Chinese economic slowdown, a domestic manufacturing slump, volatile energy prices and a global trade war.  In a matter of days, it came to a sudden halt.

The aggressive fiscal and monetary response is a positive sign that there is a clear societal interest in preserving small businesses and jobs from this unprecedented economic shock.  Although most countries lacked a sense of urgency in responding to this pandemic, nations will inevitably be better prepared to deal with future pandemics because of our collective experience with the coronavirus, from both a humanitarian and economic perspective.

The economy was in reasonably good shape when it went into this pandemic and, when we eventually return to some semblance of normal, there is a good chance it will recover with a combination of pent-up consumer demand and a highly stimulative environment characterized by low interest rates and high global stimulus.  In his annual shareholder letter, Warren Buffet wrote that stocks will likely outperform bonds long-term, especially if interest rates and corporate taxes remain low, which seems even more likely on the heels of this pandemic. “What we can say is that if something close to current rates should prevail over the coming decades and if corporate tax rates also remain near the low level businesses now enjoy, it is almost certain that equities will over time perform far better than long-term, fixed-rate debt instruments. That rosy prediction comes with a warning: Anything can happened to stock prices tomorrow. Occasionally, there will be major drops in the market, perhaps of 50% magnitude or even greater.” Buffett added that equities “are the much better long-term choice for the individual who does not use borrowed money and who can control his or her emotions. Others? Beware!”

We share Buffet’s long-term conviction in equities and believe investors with the confidence and patience to ride out periodic economic shocks like the one we are currently experiencing will ultimately be rewarded for doing so. 

Urban Financial Advisory Corporation – April 2020