By Justin Pawl, CFA, CAIA
In this week’s edition:
- Last Week Today.
- Economic Coma. Out of options, the government is putting the economy in a regulatory-induced coma to curtail the virus.
- Imagine. How will the response to the virus change society?
Last Week Today. Risk assets rallied forcefully, though equity market performance comparisons to the largest three-day gain since 1931 are unsettling. The amplitude of the rally was not all that surprising as the biggest daily gains in equity markets occur during bear markets. Predicting the beginning points of market rallies and selloffs is a different story, which is why market-timing tends to be a money-losing strategy in the long-run. From here about the only thing that can be said with great certainty is that markets will remain volatile, characterized by face-ripping rallies and disheartening selloffs. For context, Goldman Sachs published research showing that during the Financial Crisis between September and December 2008, the S&P 500 experienced six periods (ranging in length from 1-6 days) in which the index bounced 9% or more. The largest sustained rally was 19%. However, in between and around those periods of investor ebullience, the market declined, and it did not ultimately bottom until March 2009. Such is the nature of financial markets during periods of economic dislocation.
During the Financial Crisis, investors reacted to news of bank closures, government-brokered mergers, and stimulus packages to counteract massive deleveraging from the real estate bubble. In the current dislocation, investors are responding to news about virus infection rates and government programs to ward off the effects of shuttering large sectors of the economy. History never repeats, but it often rhymes.
For detailed weekly, month-to-date, and year-to-date asset class performance, please click on the table below.
Economic Coma. In response to the COVID-19 virus, government agencies are putting the economy into a regulatory-induced coma. Medically induced coma, though widely known, is not commonly used by doctors. It’s the last resort when other treatment options have failed. A rolling economic coma on a global scale is a novel idea, borne out a lack of effective treatments for COVID-19. China started the process, shutting down the epicenter of the outbreak, which also happens to be the manufacturing heart of the country. Policymakers around the world reached a similar conclusion – temporarily shutting down all but essential economic activities is a price worth paying to contain the virus.
In the U.S., the Federal Reserve and Congress are attempting to mitigate the effects of the coma with the most powerful “vaccine” in their arsenal, money. The Federal Reserve committed to “Quantitative Extreme” (aka, unlimited Quantitative Easing), expanding their purchases beyond US Treasuries and mortgages to include investment-grade corporate bonds and short-term municipal bonds. Congress passed a bill providing $2+ trillion in loans, grants, and tax forgiveness programs. Though a historically sharp decline in economic activity is a foregone conclusion (indeed, it is the goal), the government’s actions are intended to keep the economic patient alive. The hope is that when the virus threat passes, the economy can be brought out of a coma and quickly recover. I’ve written a lot about the great central bank monetary policy experiment coming out of the Financial Crisis, but this is next-level stuff.
The hoped-for recovery won’t begin for months, but in the meantime, economic “vital signs” indicate the economy is slipping out of consciousness and into a coma. Purchasing manager indexes, especially in the services sectors, are plummeting in response to social distancing measures adopted across the country. Consumer confidence is understandably weak. The University of Michigan’s consumer sentiment index fell from 101.0 to 89.1 in the final March survey – the most significant drop since October 2008. The labor report released last week showed 3.3 million workers filed for unemployment insurance. The labor market EKG looks like it’s malfunctioning as the spike in jobless claims (on the right of the chart) is unprecedented.
It’s heartbreaking, but the unemployment number understates the actual number of people out of work as unemployment insurance systems were overrun with applications and crashed. Moreover, since the March 21st filing date, at least 16 states have issued social-distancing restrictions, so next week’s claims numbers will climb relentlessly higher. Estimates on where unemployment will top out vary, but an unemployment rate higher than 10% is extremely likely. Only one month ago, the official unemployment rate was at a cycle low of 3.5%. The swiftness with which the economy is shutting down is tragically remarkable.
Some estimates indicated GDP will drop by 14.2% in the second quarter alone, equating to a $3.1 trillion reduction in output. Suddenly the $2 trillion government CARES Act doesn’t look so generous. The government will have to do more and do it quickly if they hope to pull this economy out of a coma and avoid permanent impairment.
In terms of recovery, its anyone’s guess at this point. We are still dealing with imperfect information about the spread of the virus, and until we have a better handle on the rate of infection, specific forecasts for recovery are mostly moot. The lack of reliable data hasn’t prevented educated guesses, and now mainstream media is introducing the general populace to economists’ descriptions of potential recovery shapes in the form of letters (V, U, and L).
Hopes for a “V” shaped recovery, in which economic growth quickly rebounds to the pre-crisis trend, are waning. Once government agencies adopted economic comas as policy, a V-shaped recovery relies on a miracle vaccine discovery in the next couple of months. On the other extreme is an L-shaped recovery, which is not much of an economic recovery at all. In an L-recovery, economic activity declines rapidly and may never recover to P.V. (pre-virus) levels – in other words, permanent economic impairment. In between these extremes, lies the U-shaped recovery. The U-recovery can be thought of as an elongated “V” in which recovery to P.V. output levels is eventually reached after a period of sluggish growth. Similar to a patient coming out of a coma, our expectation is the economy will struggle to find its footing adjusting to the new normal of the P.V. world, but that it will eventually recover.
Imagine. I’ve been thinking a lot about the P.V. future. Global events that force what is believed at the time to be a temporary change in social behavior, often lead to permanent changes. These behavioral shifts will be lauded by some, criticized by others, and there will be unintended consequences, good and bad, from all of this. There will also be winners and losers in terms of economic sectors and businesses. But change will happen because the human race is adaptive, curious, and ambitious. Here are a few changes I’m thinking about:
- Education. With elementary, high school, and college students forced to learn remotely, academic institutions across the country are quickly adapting curriculum and adopting technology to educate students. Will this event usher in a new era requiring fewer physical schools, and studying from home becomes a viable and common option? The impact on colleges could be profound. Aside from currently enrolled college students learning from home, a whole generation of future college students are now training in the art of remote learning. Might traditional colleges begin to compete for students by expanding their degree programs such that physical attendance on campus is not required, or is severely reduced? For example, can students earn general education requirements at home and complete their degrees with two years of physically attending college? What will that mean for college tuition prices and colleges as a business? How about the impact on dormitory and off-campus housing rents? What would the long-term social implications be for college graduates and society, since some of the most enduring relationships (personal and business) form in colleges and graduate schools?
- Commercial Real Estate. Home officing is required for many businesses now to comply with local government ordinances designed to prevent the spread of Covid-19. Office buildings have emptied “temporarily” as workers across numerous corporate sectors grabbed their laptops and set-up shop at home. How many companies will figure out that employees can be equally productive at home as they are in “the office”? Or, even if the employee isn’t quite as productive, do the savings from eliminating expensive triple-net lease payments, office furniture, and operating a physical office offset the decline in productivity? Will this event lead to an increase in home offices that negatively impacts demand for office commercial real estate?
- Environment. Reduced commuting in cars and airplanes is leading to decreased air pollution and improved air quality already. Will encouraging people to work from home and conduct interstate and international meetings via the web become a category in the Environmental portion of the ESG investing movement? Moreover, will employees and employers come to realize that commuting to work every day is a waste of productive hours, especially in crowded cities where commute times can easily exceed an hour each way? Would a reduction in commuting time lead to richer lives in which laborers reclaim 2+ hours a day of their lives that can be dedicated to family, art, music, innovation, etc.?
- Auto industry. Will this event accelerate the demand for autonomous vehicles? If fewer people are required to drive to work every day, the economic benefit of owning a car will decline for a large swath of the population. This will be especially true as autonomous vehicles come online, and competition between robotic taxi service companies makes the cost per mile fee competitive with, if not cheaper than, owning a vehicle. Is this the next step in transitioning from an “owning” society to a “sharing” society?
- Family structure. All over this country, indeed, all over the world, family schedules have been upended. Parents are no longer hurrying kids off to school or rushing to get on the road for work to avoid traffic. College students are at home. In many respects, families are returning to the days of the American West settlement. Due to social distancing and shelter-in-place measures, there is less physical interaction with the outside world and a greater reliance on each other for entertainment, personal conversations, learning, and advice. Though not without its challenges, might this event lead to closer family relationships? If an increasing portion of a college education is earned online, will it delay the point at which children permanently leave home and parents achieve “empty nester” status?
This virus and efforts to combat it are already changing our lives. At first glance, many of these changes, including restrictions, seem like a burden. Some changes truly are a burden. But what if, in the aggregate, these changes create a tectonic societal shift for the better? Quoting John Lennon, “Reality leaves a lot to the imagination.”
Let me know what big changes you see coming (email@example.com). I’ll put together a list and share it in a future 5-Minute Huddle. We can then vote on the most likely (or out there) changes, and collectively track how good we are at predicting the future. Consider it a social experiment in the wisdom of crowds.
Keep your chin up, hands clean, and, to do your part in curtailing the length of this economic coma, please stay home.