A Depressing Virus — The Long View

Summary:

There are not any precedents for how bad this is going to be outside of the Great Depression. There are no modern analogues we can use. This isn’t about the virus anymore. It is about the catastrophe which is unfolding as we shut down economic activity. Regardless of how we contain things, our destiny has been partially set in motion. Millions have already lost their jobs and many more are likely to follow in the coming weeks as our service economy grinds to a halt. However, in the same way that the economic impacts are unprecedented, the monetary and fiscal response will be equally dramatic. Policymakers have already deployed the playbook from the Financial Crisis unleashing trillions in stimulus and are writing a new one now. A short shutdown, massive stimulus, “helicopter money”, loan guarantees and modified loan terms will help save the global economy from what would otherwise be an unmitigated disaster. Expect policymakers to come out guns blazing before they let things collapse. If they do, I think there is a reasonable shot they can succeed, though it seems very likely we come out much different when this is over.

Background

Last month, I used the analogy that China slowing down would be the equivalent of hitting a speed bump while driving full speed. Today’s environment is the equivalent of driving full speed into oncoming traffic.

Canada offered the first taste of how bad this will get.

“Speaking outside his residence in Ottawa, Trudeau said Service Canada has received more than 500,000 applications this week, 20 times the number recorded in the same week a year ago.”

Norway, who is a week ahead, offered even uglier data.

“Norway’s unemployment rate soared five-fold this month to above 10%, its highest level since the 1930s, as companies announced mass layoffs and shutdowns amid efforts to combat the coronavirus outbreak, data showed on Tuesday”

If we translate the much more modest Canadian number (a 2% hit to unemployment) to the US population, that would mean several million US jobs have already been lost. We didn’t even come close to these levels during the GFC. This will not end for at least 3 weeks and that is only if we conduct a Chinese-style shutdown. If we let this drag on it will last for months and leave our very service-oriented economy in tatters.

While this may seem extreme, it’s not. This crisis is unlike anything we have seen. Here is a breakdown of the US labor supply. The job losses from restaurants, bars, hotels and retail will fade quick and fast. The 2m figure is unfortunately just the beginning. These high touch jobs represent a fifth of the labor supply. After this you have another half of the economy at medium risk. Even “safe” sectors like healthcare are already seeing job losses as places like dentists offices close and other services like dry cleaners commercial cleaning and other related industries are negatively impacted. The US is not a high savings society and we are not built to withstand these kinds of shocks. 70% of the economy is services. This will be excruciatingly painful.

Google search results suggest tomorrow will be even worse. If search history scales linearly, it would imply around a 4.7m job loss.

For a more concrete example we can look at some impacted industries. We know many airlines have already shut down 80-90% of capacity. Restaurants and bars are closed except for takeout and hotel occupancy is running around 25%. This makes the GFC look like a walk in the park by comparison. Business models may account for temporary shocks, but no one has prepared enough liquidity to withstand a 1-2m total loss of revenue.

occupancy is estimated to be around 25% today vs 60% at the depths of the financial crisis

As the number of cases has accelerated, so have containment measures on a state by state basis and globally. Italy, China, Spain, India, California, New York, and 10 other states are on lockdown. Global cases are near 400k. This has gotten ugly, very fast. The US is totally infested. Containment has failed and the time we have spent thus far is wasted. I don’t see how we avoid a shutdown at this point. The disease is still spreading rapidly with general precautionary measures and broad awareness in place.

The US is completely infested with cases. Even if we don’t shut down, aversion to public places like restaurants and concerts would take a meaningful hit on GDP.

Estimating the impact:

These numbers may also seem extreme but mainline economists are now acknowledging these figures are sadly realistic. Over the weekend St. Louis Fed President James Bullard argued unemployment could rise to 30% and even Goldman and MS have published data suggesting a 25% hit to GDP. While that may certainly sound alarmist to some, I think the silver lining is that it means policymakers understand what is happening and will try to respond. The Fed just promised unlimited QE and the government is rolling out stimulus that could amount to around 20% of GDP.

With moderate containment measures I was estimating a 30-40% hit to GDP for several weeks during the shutdown given the level of consumer retrenchment across a wide array of industries. This would have led to a ~3-5% hit to GDP (as bad as the GFC) for the full year with scope for this to be partially made up in 2H2020 depending on how quickly people get back to work (though I suspect this will not be as rosy as some expect – the shutdown will cause people to burn through savings, and the wealth effect will leave them poorer).

Tomorrow’s initial claims release will show just how bad things are. The existing slowdown plus a multi-week shutdown would naively translate to a 10-15% hit to GDP for the year given the capacity that will be offline (though likely around a 60% fall for the month). The chart below shows GDP and initial claims. They all hit their lows during the Global Financial Crisis. They give a rough guide of how bad things are likely to be.

Even conservative estimates imply a level of contraction we haven’t seen in our lifetimes.

The Silver Lining

The sheer magnitude of the hit to growth has finally nudged the US towards coordinated monetary and fiscal policy. To offset this contraction, government spending in the range of $5T will be needed (around $15,000 per American and should be directed towards the lower and middle class given low savings and higher propensity to save). Anything less than this is only going to soften the impact. Right now total spending is around $3T, though much of this is not traditional spending and is only loan support to help prop up the financial system. Yesterday the Fed announced “unlimited” QE after cutting rates to zero and $700B in QE last weekend. The upcoming stimulus bill looks set to line people’s pockets and go a long way towards making sure a public health crisis does not also become a financial crisis. In addition to normal monetary policy, the Fed has also rolled out the GFC 2008 playbook. Their goals seem pretty clear. The first is to ensure the Treasury market is operational (QE/Repo). Next is to stop forced deleveraging by allowing banks and others to sell assets to them for cash. Next is to stem defaults and this will come via commercial paper operations and by directly lending to businesses (fulfilling its role as the “lender of last resort”). The problem also exists globally. There are trillions in dollar-denominated debt and the contraction in activity means that they are likely to come up short. Outside of central banks handing over their fx reserves there wasn’t a lot countries could do to help. To help soften the blow, the Fed set up swap lines with more central banks to help them pass along dollars to their banks so they can lend to impacted companies. This will also help, but not solve their problems. Low rates will help consumers refinance their properties and low fuel prices will provide a little extra stimulus, but this will be little consolation to the millions without work.

Separately, it also looks like China is returning to some sense of normalcy after their nearly two month slowdown. Korea and Japan also appear to be having some success getting things under control. While Asia is unlikely to come roaring back, it does offer some hope that an end is in sight.

Asset Implications

OPEC started the distress when they shocked oil markets and their decisions spilled over into Treasuries (massive rallies) and credit (significantly wider spreads). However, oil is cheap but likely to get cheaper in the short term without extraordinary measures by OPEC. Shale is hedged for several months and will keep producing. OPEC could likely cut to zero in the short term and the market would still be oversupplied. Positioning is lopsided though so be careful if you have any trades here.

You can see the impact on the Treasury market here. When oil fell, bonds rallied, but in an unorderly manner. For a few days, TIPS offered extraordinary value. Fixed Income RV trades also became incredibly stressed (Futures vs cash bonds were dislocated at levels not seen since 2008). TIPS are still a good bet, but not the screaming buy they were. Breakeven inflation is low, which is reasonable given the deflationary shock, but I would prefer to look elsewhere for value.

Oil wrecked the bond market. As oil rallied many market relationships broke down.

Credit was a total disaster as liquidity dried up and leverage was punished. In some ways this was just a lagged effect as they didn’t really participate in the February pain. A lot of the biggest opportunities have also faded here, but there is still upside (with risk). The chart shows various IG fixed income funds relative to Treasuries. They are not perfectly duration matched, but you get an idea of how bad things were dislocated. Select preferred securities are also interesting. It appears many were liquidated in a retail focused panic. At one point, IG corporate bonds were down as much as equities for the month of March. Munis are the most interesting, but will also be the most impacted by a weaker consumer and higher unemployment rates. That said, I am happy to take A-AAA government credit risk at 4% in a world where t-bills are now negative. Cash is finally trash.

It’s also probably worth noting the same issues were present in emerging market debt, high yield and the leveraged loan markets but these are less interesting given the weak covenants, poor quality earnings ("addbacks”) and higher leverage. More importantly they don’t have the support of the Fed at this time. If that changes, they could be a little more interesting. I would rather take longer duration high grade credit risk than shorter duration junk credit with a higher level of yield. The returns are the same if things normalize but you’re much safer in investment grade paper.

For a few days, everything but Treasuries were sold. A few opportunities remain.

Despite the selloff, equities are still not all that interesting to me right now given the wide range of uncertainty and attractive opportunities in safe assets. When A rated paper is yielding 4% and high yield near 10%, what’s the appropriate discount rate for stocks? That said, we have a very large month/quarter end rebalancing (roughly ~$200B in pension flows) which could create the opportunity for a nice swing trade. There are a few cases of the baby getting thrown out with the bath water. Utilities are one such example. They should remain relatively economically stable and are typically an alternative to fixed income instruments. On a relative basis, I like the trade, though it’s not much different than the higher quality credits I outlined above.

Energy was also universally shellacked. There are some interesting, natural gas focused midstream assets like Williams that should prove resilient if financing issues are off the table. They have little sensitivity to oil prices.

Conclusion

This is going to be very painful and scary for millions of Americans. Recent policy actions will help soften the blow but the next two months are likely to be worse than many people expect. The economy is literally grinding to a halt and there are no periods we can point to that are helpful analogues. The Fed helped reduce volatility in the financial system, but there is not much they can do to help the actual economy. If we are able to shut down for a few weeks and restart, the effects are likely to be manageable as the checks and unemployment benefits from DC will help blunt the short-term impacts of any shutdown. However, if the outbreak runs on for months as it did in Wuhan, this has the potential to be very, very ugly. Many will be out of work, defaults will rise (both corporate and household) and savings will fade away. This means no V shaped recovery as people do not have the means to go back to their old lifestyles.

If this happens, we will need to see unprecedented levels of spending on par with WWII to get us out of the funk. I wouldn’t be surprised to see a lot of infrastructure spending and “New Deal” programs in place to help us get back to work.

I would recommend a higher quality asset allocation (high grade credits and safe equities) given the attractive relative valuations. A short term dabble in equities could be interesting for the next week, but tread carefully. I would use it more as an exit than an entry point. Wait for cases to peak and some sign of a return to normalcy before leaning in hard. Valuations are reasonable but only if you’re looking backwards. Earnings estimates are still a joke and not reflective of the pain we are facing. If you pencil in a shock the size of the GFC, there isn’t much value in the broader US equity market at the moment.

Earnings estimates are still a joke and have a long way to go before they reflect the economic reality we are facing this year.