Economic Market Update - March 20
Friday, March 20, 2020
Market action continues to be extremely volatile this week, driven by the deterioration of the coronavirus pandemic in Europe and the United States. Governments have recognized the seriousness of the threat posed by the virus and are reacting quickly to implement measures to contain and mitigate the damage. In analyzing the spread of the virus in Asia, where SARS-CoV-2 first appeared, and the varied policy responses pursued by nations where the virus first presented, it is increasingly clear that public leaders must take unprecedented steps to prevent the contagion from growing out of control.
Based on those early outcomes, nations know that preventing the virus from growing exponentially and overwhelming the capacity of the health care system to care for patients with severe symptoms is imperative. The only way to accomplish that is to severely limit person-to-person contact, the means by which the virus is transmitted. And in the quest to limit person-to-person contact, governments around the world are taking the unprecedented step of reducing economic activity on a mass, coordinated scale.
How Did We Get Here?
The outbreak first appeared in the Chinese city of Wuhan, located in the province of Hubei. In this epicenter, the virus grew exponentially out of control, completely overwhelming the capacity of the region’s health care system to provide care for patients who developed severe, life-threatening symptoms. Despite having a population of 1.4 billion, China was able to keep the outbreak relatively contained to Hubei province because a strict quarantine order was instituted.
Factories were shut down, shops were closed, and travel was forbidden. Furthermore, not only was no one permitted to leave the province, but most residents of Hubei were not even permitted to leave their homes. The Chinese government was too late in instituting these policies to save Hubei, which was absolutely devastated by the virus. But history’s largest mass quarantine gave two valuable gifts to the rest of China’s provinces – time, and a warning of what was to come if steps were not taken to prevent the virus’ unchecked spread.
Armed with these gifts, the remaining Chinese provinces were able to prevent the outbreak from overwhelming the capacity of the health care system by taking the steps necessary to inhibit the proliferation of infections. In essence, Chinese leaders issued an order to shut down virtually all economic activity. Normal life ceased to exist. As a result, China will experience negative economic growth for the first time since 1976 – the only question now is how negative. Chinese authorities brought the economy to a virtual standstill because, despite the crushing blow to growth, the alternative was far worse.
The reason why lies in the mathematical nature of contagious epidemics. At their onset, epidemics grow exponentially, a concept that is often difficult for the human mind to grasp. As an example, lets imagine that a loan shark offers to loan $1.00 at 25% daily interest:
- If the loan is paid back the next day, the payoff amount is $1.25.
- If it is paid off in a week, that amount rises to $3.81.
- After a month, it’s $807.79
- After two months, it’s $652,530.45.
- Just a week later, after two months and one week, the payoff would be over $3.1 million dollars.
When faced with a virus that grows in this manner, slowing the growth rate as early as possible is vital because of how quickly an exponentially growing infection can overwhelm the ability of the health care system to care for the seriously ill. This was the situation in Hubei province, and it appears to be the situation in Iran and Italy.
Faced with the prospect of this dire alternative, public officials in nations around the world have issued orders that will essentially grind much of the world’s economic activity to a halt. Leaders in many places have ordered nonessential businesses to close, and even businesses deemed essential (outside of the healthcare sector) are operating with minimal staff and putting new policies and procedures into place to limit interaction that could potentially spread the infection. We are facing an unprecedented decline in global economic activity, and this poses a recession threat unlike any we have seen before.
Since the end of WWII, recessions have largely been the result of overly tight monetary policy, severe systemic fiscal imbalances, or a combination of the two. Neither of those conditions are present today. Modern recessions have emanated from issues in the financial or industrial sector, with those issues then flowing into the other areas of the economy. And given this, the policy tools officials have at their disposal were developed within the context of this framework.
But the possible recession looming ahead would flow in the opposite direction. Other areas of the economy are being forced to close up shop. Economic activity is poised to fall off a cliff in the weeks ahead. And we are now starting to see the potential ramifications of that bleeding into financial markets. Governments are closing down sectors of the economy in order to combat the threat posed by the virus, which will result in negative externalities. They have no choice; the alternative is far worse, with even greater externalities. But the unprecedented nature of this situation means that the traditional policy tools used to combat recessions have far less power. We have never experienced a recession driven by nearly worldwide instruction from policy makers to consumers to stop consuming. New policy tools will need to be devised, and fiscal policy, not monetary policy, will have to do the heavy lifting.
To take a step back, we'll use a simple axiom, borrowed from a recent Neil Irwin column in The New York Times, to demonstrate the truly unprecedented nature of what we are experiencing: one person’s spending is another person’s income.
This concept is the foundation of our modern, global economy. Money is the perpetual motion machine that drives the world economy. And we are about to see it stop moving across the economy. The upshot will be a shortfall in demand, delays in payments, and widespread production disruptions. Each has the potential to result in a cash flow deficit on its own, and all invariably will, when combined, as in the situation we are facing today. Certain sectors of the economy such as travel and lodging, are projected to see activity decline by 80% due to the containment efforts. This cash crunch is already beginning to cause ripples in the market.
Monetary policy is necessary to keep the system functioning properly, but it is not sufficient to confront the unprecedented situation we are facing. Demand shortfalls and production disruptions won’t be solved by lowering interest rates. They can’t be; governments are ordering that the activity that would correct those issues can’t occur. And the issues will arise in the first place because governments are saying that economic activity can’t occur.
Confused? That’s the conundrum of what we are experiencing. The economic activity - the cash in motion that drives the economy - is coming to a near stop. Businesses that are solvent but reliant on cash in motion will be severely stressed. The recession will end when the virus is contained, life returns to normal and money is in motion again. We are not facing serious underlying structural issues; we are facing a historically unprecedented, globally coordinated policy that brings economic activity to a standstill. This will be a recession purposely created by policy makers. And only those policy makers will be able to limit the fallout.
While there remains a great deal of medical uncertainty given the novel nature of the virus and the fact that we are still in its early stages, evidence from countries hit first suggests that it will take approximately two months to contain the virus. At that point, we can begin to return to normal life, with activity hopefully returning to pre-containment levels, as the policy-induced recession ends (or is avoided altogether). Given our base case of a two-month containment period, we will avoid a technical recession, which is defined as two consecutive quarters of negative GDP growth.
For this outcome to be realized however, most of the previously solvent businesses will need to have weathered a period of steep declines in revenue – or no revenue at all – due to the government mandates. While some businesses will certainly be able to weather the storm, others will not.
Fortunately, policy makers have recognized the unprecedented nature of the challenges facing the economy in the weeks ahead as we hope to contain the virus - and the appetite for fiscal response appears to be increasing. The total package may exceed $1 trillion, and it is aimed at large as well as small businesses, and also at consumers. This aligns closely with estimates of the value of the economic activity that will be lost during the containment period, and in theory should mitigate much of the pain and prevent the situation from growing into something far more serious.
Two plans have already been passed and are listed below:
- An immediate health-focused spending package of $8.3bn.
A package consisting of paid sick leave for workers, state fiscal aid, and expanded unemployment benefits, among other provisions estimated to cost around $300bn
- Current policies under consideration are:
- Payments to individuals – the Trump Administration is proposing as much as $500bn in such payments.
- Programs to stabilize small and medium-sized businesses – expanded lending through the Small Business Administration (SBA) and a program to provide credit through the Treasury and/or Federal Reserve.
- Further expansion of safety net benefits – unemployment benefits to compensate workers whose hours have been reduced or who have been furloughed.
- Employee-retention subsidies – direct payments to firms to keep employees on the books.
While we face a unique challenge over the next few months, bright spots are emerging. Policy makers in Washington have made it clear that they understand that novel forms of fiscal policy will need to be enacted to combat the negative externalities of the containment efforts. Years of partisan rancor have melted away in the past few days. The Fed and Treasury Department are headed by former bankers who truly understand the financial system. They have acted quickly to address concerns over liquidity, and they appear willing to do whatever it takes to prevent a liquidity crisis. With these measures in place, we expect that the negative economic growth that will occur in the second quarter will be short-lived, with growth eventually reverting to previous levels once economic activity resumes in full.
A key risk to this outlook is the duration of containment efforts and widespread social distancing. If these remain in place for months on end, the political unity we are seeing from our policy makers in Washington will begin to evaporate. Currently expected funding levels should help offset the reduction in economic activity for about two months. We have received promising news on that front: China reported no new cases yesterday. Life appears to be returning to normal and business activity appears to be moving toward normalized levels. While data is still limited, the virus has the potential to be seasonal in nature, following a pattern similar to that of the seasonal flu. Most cases are concentrated between 30 and 50 degrees latitude in the northern hemisphere. So, while nothing can be known with certainty at this point, cases may substantially decrease in May, and peter out by June.
Given this framework, we expect to be able to weather the period of decreased economic activity and emerge on the other side with little permanent economic damage, but risk remains elevated due to the unprecedented nature of the slowdown. 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.