Economic Market Update - April 3
Friday, April 3, 2020
With local policy makers issuing shelter-in- place orders and directives shuttering all nonessential businesses indefinitely, it has become increasingly clear over the past week that containment efforts will be in place longer than many initially thought. The Trump administration offered a rough timetable by extending nationwide containment efforts until April 30 during the Sunday evening press conference, but warned that these efforts may need to be extended again if the outbreak continues to spread. The economic impact of the containment efforts has also come more fully into focus, with a sobering record increase in jobless claims last Friday leaving no doubt that economic activity has plunged as efforts to stop the outbreak have been initiated nationwide.
In the face of this uncertainty, many are wondering when the markets and the economy may turn the corner and start to improve. While every crisis is unique, history provides a guidebook on the typical course of a crisis cycle, from onset to recovery. Examining the history of past crises – and in particular, what has driven recoveries in their aftermaths – is informative.
At their onsets, crises are characterized by massive increases in systemic uncertainty and sharp, coincidental sell-offs in risk assets as market and economic conditions rapidly deteriorate. In the early stages of a crisis, the extent of the potential damage is hazy, and the distribution of future outcomes is wide, creating substantial tail risk at the extremes. The potential damage from the crisis – and the downside to markets that comes with it – can seem nearly unlimited. Recoveries begin to occur once the true extent of that tail risk comes into view; in other words, once we gain clarity on the worst-case scenario, a limit on the potential fallout is set. In fact, markets often begin to stabilize before a true recovery from the underlying crisis has started.
Using this historical framework as a guide to help us navigate the current crisis, we believe several prerequisites must be in place for markets to improve and for economic activity to start to normalize.
First, the infection rate curve must begin to stabilize and flatten. Until the virus is under control, economic activity cannot return to normal. As we push to slow the infection rate, however, other areas must begin to stabilize as well, in order to provide a base for the start of the recovery once the virus is under control
Second, the prospect of severely depressed revenue in the weeks and months ahead has sparked a global rush to raise cash to weather the crisis, straining short-term funding markets. Evidence that monetary policy efforts to mitigate the funding and liquidity stresses that have cropped up in the financial system are working and likely to be successful is the first step on the path to normalization in investment markets.
Third, markets will need to see evidence that the massive fiscal policy response is working as intended, providing the financial bridge businesses and individuals need to make it through the crisis.
Fourth, the recovery in risk assets will also require clarity on both the depth and expected duration of the economic disruption that has resulted from global efforts to contain the outbreak to fully take root.
The duration of containment efforts is the most important unknown variable because economic activity will remain suppressed so long as they are in place. The ultimate duration of containment efforts will be determined by how quickly we are able to slow the growth rate of the infection and feel confident that the outbreak has been contained. Stabilization and/or reduction in the rate of infection is the single most important milestone to be achieved on the way to normalization, and the longer it takes the country to contain the virus, the greater the economic damage will be.
FFA has been closely monitoring data on the scale and geographic reach of the virus, and while the US is still in the relatively early stages of the fight against the outbreak, we are swiftly implementing the necessary measures to slow and stop the spread. Across the nation, leaders are implementing social distancing directives, ramping up diagnostic capabilities, and working to ensure that medical professionals have the personal protective equipment they desperately need to stay safe while treating the ill. As these efforts continue, the country may see an initial increase in the number of infections as tests are more widely administered, but over the next month, the hope is that these efforts will be effective and the growth rate of new infections will decline.
To gauge progress on this front, FFA will be closely monitoring the difference between the daily change in recoveries and the daily change in the number of new cases (recoveries - new cases). This number is negative and growing currently, but stabilization in this metric will signal that we are turning the corner. Eventually, the negative figures will begin to increase and ultimately turn positive, but stabilization will provide a signal that the nation is stemming the tide and reducing the rate of new infections.
While the battle against the virus is the primary concern, minor victories can be achieved in other areas along the way that will hasten a return to normalcy once the viral outbreak is under control. The most crucial is the stabilization of short-term funding markets, which would signal that monetary policy tools are working. Firms around the world began to recognize that they would be facing significant declines in revenue while containment measures were in place, which set off a rush to stockpile cash, severely straining short-term funding markets. Simplistically, these markets make up the “plumbing” of our financial system; when they become clogged and cash stops flowing, problems can quickly spill over into every other market.
Fortunately, the Fed recognized the strains on the system early and has responded swiftly by announcing an unprecedented level of intervention to stabilize these systemically important markets. Over the past three weeks, the Fed has taken more action to shore up short-term funding markets than they did during the entirety of the Great Financial Crisis (GFC) in 2008-2009. The Fed is now supporting credit and commercial paper markets in an unprecedented way, announcing a number of new facilities to serve as a backstop, with the Federal Reserve functioning as the buyer of last resort. These measures have begun to stabilize these markets, but yields in these markets are still trading at abnormal levels, and we are not out of the woods yet.
FFA will continue to monitor these markets in the weeks ahead, and expect that a return to normal in short-term markets will be required before other markets start to normalize. Historically, investment-grade credit markets have been the next to stabilize after coming through a crisis period, followed by high yield credit markets. Once fixed income markets have stabilized, equity markets finally begin to fully recover. Credit spreads have increased significantly as the crisis has unfolded, and we will be looking for compression in these elevated spreads to signal a potential recovery in equity markets.
Stabilization in short-term funding markets will indicate that monetary policy has been successful, but the unprecedented nature of the current crisis means that fiscal policy plays a pivotal role. Globally, governments in developed markets have been quick to implement novel fiscal policy measures to limit the economic damage from containment efforts. The success – or lack thereof – of these programs will likely be visible in labor market data, mortgage and credit delinquencies, bankruptcy filings, and business closures.
In the US, relief programs for businesses provide incentives for firms to maintain payroll levels and to continue to make mortgage or rent payments during the period in which policy makers have mandated that nonessential businesses remain shuttered. The business programs will benefit individuals and families to the extent that they allow employers to keep them on the payroll, but direct cash transfers to individuals are part of the relief package as well. The US government has never attempted a fiscal relief package of this breadth and magnitude before, and administrative issues have the potential to delay or blunt the impact of these fiscal policy efforts. Large upticks in jobless claims and delinquencies may indicate that relief dollars are not flowing smoothly to the businesses and individuals that need them, and that these programs are not working as well as had been hoped.
Progress on slowing the rate of infection will also provide us insight into the duration of the economic disruption, since it is directly tied to containment efforts that have mandated the closures of nonessential businesses. We expect markets will respond positively to promising news on the fight to stop the outbreak and the impact of these new government programs. On average, six of these “mini” rallies occur during crisis bear markets before the bottom is truly reached, and we likely experienced the first one of this cycle last week.
For a sustained rebound, however, a reduction in the infection rate and evidence of the success of public policy will need to be confirmed in the macroeconomic data. Incoming economic data can provide clues about the depth of the economic damage and the success of policy measures. The methodology behind the measurement and reporting of GDP is initially based on assumptions and models; the collection of hard data leads to monthly revisions of these initial estimates, with the official number being confirmed only three months after the end of the quarter being measured. Because of this, GDP is unlikely to provide an accurate picture of the economic environment in real time, especially in the early reports. Given this deficiency, creativity is required in order to gauge how the economy is responding in real time. Given the tools at our disposal, the labor market is likely to provide the most accurate picture of the economy during the crisis.
In order to roughly estimate the impact of containment efforts on economic growth in as close to real time as possible, FFA can employ Okun’s Law to determine an estimate of the hit to economic growth implied by the labor market. Okun’s Law is the empirically observed relationship between the unemployment rate and economic growth, which suggests that for every 1% increase in the unemployment rate, economic growth falls 2% below trend. Given the substantial fiscal policy measures the government has enacted in an attempt to limit some of the economic fallout from containment efforts, Goldman Sachs estimates that this relationship will be closer to 1:1 in the months ahead. Jobless claims, which are released weekly, and the household survey data, which is released monthly, will enable us to estimate the hit to growth, and may also provide a signal that the economic activity is normalizing.
The onset of the current bear market has been truly exceptional in speed. The infamous crash of 1929, which sparked more than a decade of economic malaise, held the record for the swiftest drop into bear market territory (defined as 20% off the highs), at 44 trading days. The current market decline shattered that record, dropping 20% from an all-time high in just 16 trading days. Volatility has also been near record levels. In mid-March, the S&P 500 posted moves greater than +/- 9% three days in a row for the first time since 1929 as well, and moves well in excess of 1% have become the norm in recent weeks.
We expect market volatility to continue in the near term, but believe we have developed a framework that will allow us to recognize when we turn the corner and start the recovery process. Please reach out to your relationship manager or portfolio manager to discuss the ongoing events in further detail, and stay safe as we all work to get our nation through this pandemic safely, and emerge stronger on the other side.