Note: Current events are very fast-moving. The following note was composed last week and sent to our clients and paid subscribers last Thursday.
Our first thoughts for our clients, friends, and readers are for your health and resilience, both physical and psychological, as the current crisis unfolds. We trust and hope that all of you will take the measures that seem right to you to keep yourselves and your loved ones safe.
While we are not experts on physical and mental health, we have spent decades developing expertise on financial markets, and our experience comes from rigorous study, observation, and investment, sometimes under conditions of great stress like those the world is currently experiencing. We can likely be of the greatest service to you by emphasizing this lesson: it pays to take prudent defensive action, but it does not pay to panic out of markets at a point when prices do not reflect a functional pricing mechanism. A further lesson is that crises pass, and this crisis will pass as well. If we can help you remain calm in this situation, we will consider it a job well done. Remaining calm when the world is panicked is the best way not to destroy your savings. In fact, being prudent and not panicking can bring benefits at this stage.
In January, we started taking some prudent actions to reduce exposure. Doing some hedging and looking for more defensive positioning in the early stages of the crisis helped, but during these past three weeks in the markets there were few safe havens. This type of market action is usually short lived.
Coronavirus Progression Since Last Week
Our model for the progression of the coronavirus outbreak had been the experience of South Korea, and we believed that the more difficult experience of countries in Europe, particularly Italy, would be atypical, due to local conditions there (such as a much older demographic and less efficient data collection).
It became clear to us that besides collecting data aggressively, South Korea also used those data well in the earliest stages of the outbreak to contain it by tracking and isolating infected persons. (It did not follow China’s draconian route of wholescale quarantines.) Some countries did not collect the data and did not make the same interventions as South Korea did. Consequently, the progression of the outbreak has been more severe elsewhere.
In other countries such as the United States, the virus may not yet have gained a strong foothold. We hope that intelligent and timely action from local, state, and Federal authorities will allow for a more gradual spread and the achievement of better outcomes. The coming weeks will begin to give us an idea of how that effort is progressing.
Economic disruptions are occurring, but we do not believe that the basic social and economic fabric of the United States is at risk. Our logistics system is not set up to deal with the overnight emptying of store shelves, but it is robust, and those shelves will again be full. It will help public and market psychology as that becomes apparent.
The Policy Response
In the face of uncertainty about the outbreak’s progression, global markets have of course reacted with high volatility. This crisis is a classic, unexpected “Black Swan” event. Even so, the world’s monetary authorities have long warned that when the next economic downturn occurred, whatever its cause, it would have to be countered not just by monetary policy, but by fiscal policy. Last week, we ran down some of the monetary policies that had been taken, and said that the fiscal response would also be awe-inspiring. Here is some more news on both fronts.
From the monetary side, the Federal Reserve has opened the toolbox and has begun to implement virtually all of the tools it used in the 2008 crisis to avert a seize-up in the financial system that is the monetary life-blood of the global economy. You could call it the “Lehman toolbox.” Sunday’s rate cut to zero and the announcement of $700 billion in QE was only the beginning. Additionally, the Fed has re-opened facilities to buy commercial paper — the short-term corporate debt instruments that permit the smooth functioning of day-to-day corporate finance. This is a direct support to the corporate sector. It has re-opened its Primary Dealer Credit Facility, to provide overnight funding to the Fed’s trading counterparties (very large systemically important banks), collateralized by a very wide variety of assets, including many equities. The Fed is providing essentially unlimited support to the repo market.
Overall, the Fed is doing everything within its power to make sure that a Black Swan event for the global economy does not morph into a Black Swan event for the global financial system. The actions taken so far have been strong, and we believe that they will be successful at reassuring markets that the essential plumbing of the financial system is not at risk of collapse.
Of course, the Fed is not acting alone, but in concert with the world’s other central banks, although it bears a unique burden in its importance to global finance.
From the fiscal side, the details are still emerging but it is apparent that the theme here will be “shock and awe” as well. The final fiscal support bill that makes it to the President’s desk may well exceed $1 trillion (the administration is proposing $1.3 trillion) including tax deferments, direct payments to small businesses, subsidies to affected industries (such as airlines), and “helicopter money” — direct cash payments to American citizens.
Therefore after some unedifying bickering, U.S. lawmakers seem to be on track to offer a package that is convincing in its scope. As Senator Marco Rubio observed, their urgency is being enhanced by the realization that any restrictions on internal travel in the United States could make it hard for them to convene for further negotiations. The momentum is for them to act immediately, and to act very strongly.
The U.K. is poised to enact a very large fiscal stimulus as well, some $400 billion, including loans to support British businesses, equal to 15% of the country’s GDP.
Even Europe is beginning to move. Back in 2012, during the European sovereign debt crisis, Germany’s Angela Merkel reportedly told member of her party that there would be “No shared European debt liabilities as long as I live.” Yesterday we read that she is discussing “joint debt options” with other European leaders. Never say never.
Economic Scenarios
Our base case is for the global economy to experience a flat first quarter, a sharp contraction in the second quarter, and to begin to recover in the third quarter. Of course, this scenario depends on how the outbreak progresses and on the measures taken by the world’s economies to combat it — and how long it proves necessary for those measures to remain in place. Of course, financial markets will bottom before the economy.
The health and medical emergency the world is experiencing is serious, and it will have lasting effects. Despite how things may look now, not all the lasting effects are bad. We are seeing a wave of global cooperation and creativity from the scientific community that could bring both positive health outcomes and positive investment outcomes. We expect that once the health situation normalizes and improves, and the powerful stimulus measures that are now being put in place begin to bear fruit, the turn up from the bottom will be strong; and rewarding to those who do not panic.
Again, please be safe, and be patient while the world deals with this most unpleasant development. The coming weeks will likely bring waves of relief and of further anxiety. Those who can act with both compassion and clear deliberation will weather this crisis well.
Thanks for listening; we welcome your calls and questions.
