Coronavirus panic and a huge shock to oil markets converged on Monday to hand U.S. investors their worst day since the Great Financial Crisis. There were a lot of market-related movements that registered in the stratosphere of the unexpected: the size of the market’s decline; the rapidity of moves in the U.S. 10-year Treasury interest rate, the drop in the price of oil, the rate of change in market volatility.
Such volatility in such systemically important variables will have aftershocks. We continue to watch these unfold. Of course, the response of global policy makers will be critical to developments in markets and the world economy. Below, we will give some of our thoughts on the coronavirus outbreak and panic; on possible outcomes for economies and markets; and on the policy responses that are beginning to appear from the world’s fiscal and monetary authorities. These responses are shaping up to be large, and we will give you rundown of current and proposed actions.
Covid-19: The Current State of Affairs
We have to begin by continuing to evaluate the objective state of affairs beneath nonstop media static. Psychology is of paramount importance, but we want to begin with a sober assessment of what’s happening in the world before we move on to trying to assess the mass response. We believe that the most reliable nation-level data on Covid-19 are the data from South Korea. We give greater weight to the South Korean data than, for example, to the Italian data, because on an anecdotal basis we have somewhat more confidence in the coherence of emergency and data-collection policy execution by South Korean authorities.
As of this writing (March 11), there are 7,407 active Covid-19 cases in South Korea, of which 99% are designated “mild,” and 1% as “severe.” 348 cases are marked as “closed,” of which 288 were recoveries and 60 were deaths. That would give a mortality rate of 0.8%. However, we stress what was stated in the New England Journal of Medicine on February 28:
“If one assumes that the number of asymptomatic or minimally symptomatic cases is several times as high as the number of reported cases, the case fatality rate may be considerably less than 1%. This suggests that the overall clinical consequences of Covid-19 may ultimately be more akin to those of a severe seasonal influenza (which has a case fatality rate of approximately 0.1%) or a pandemic influenza (similar to those in 1957 and 1968)…”
South Korea has a robust testing program, and still has tested only about 0.4% of its population. Many epidemiologists believe that the number of asymptomatic patients is even higher than the authors of the NEJM paper suggest. Therefore we believe that when the dust has settled, it is likely that Covid-19 will prove to have a mortality rate of 0.2–0.4%, or possibly even lower. We believe that commonly repeated figures, which are being used by alarmist media to extrapolate outlandish total mortalities and create panic, will prove to be inaccurate. Further, the progress of the disease is slowing in South Korea, modelling (as we suggested last week) the seasonal pattern of influenza and the common cold. In a call for investors on March 9, Dr. Amesh Adalja of Johns Hopkins University echoed the opinion of many virologists and epidemiologists that Covid-19 will not prove different from illnesses caused by other viruses in its family, such as the common cold, and will fade as weather warms in the northern hemisphere.
Governments do not want to be seen by their people to be sitting on their hands. Their health policy response is not necessarily an accurate indication of the objective severity of the underlying threat. Sometimes their actions are helpful; often, they are not. The dynamics of Covid-19, which is highly contagious, suggest that quarantines have not and will not succeed in arresting or even significantly slowing the disease’s spread. Governments are no more immune than their citizens to fear-driven, counterproductive behavior. Unfortunately such behavior often occurs during crises like this. (We’re grateful that at least the response in most of the world no longer includes scapegoating minorities.) Dr. Adalja actually ranked the risk of disruption caused by government as greater than the risk of disruption caused by Covid-19 itself. We also note that although it will likely be a year or more before a vaccine is available for Covid-19, there are very promising treatments already being tested, and anecdotally quite efficacious.
Where We Go From Here: Two Possible Trajectories
What about the economic and market consequences of the crisis?
The current disruption has two components or stages — a supply shock and a demand shock. The supply shock, which consists essentially of supply chain disruptions from manufacturing and logistics, is already beginning to recover as China and other Asian manufacturing exporters go back to work. Of course there are many ramifications which will take longer to play out; for example, with airline flights cancelled, cargo rates are skyrocketing (cargo is usually shipped in passenger flights). But in the big picture, the economic damage on the supply side is already turning around. On the other hand, the demand shock may just be getting started. The chorus of voices from national governments, local governments, big companies, and educational institutions, and from the cancellation of large public events, is telling consumers, employees, and students to just “stay home.” That puts a drag on consumption, and for that drag to dissipate will require a shift in psychology and the lifting of an attitude of fear among the population and the authorities.
The U.S. economy is primarily consumer-driven. It is not impossible that the demand shock will precipitate an earnings recession in the U.S., followed by a decline in business confidence. If that occurs, we would anticipate a sharp but relatively brief contraction in economic activity, followed by a robust snapback.
Add In the Oil Fight
Layered on top of the ongoing Covid-19 crisis is now a shock to world energy markets. Russia is one of the world’s largest oil producers. It is not a part of the OPEC cartel, and for many years has cooperated with the cartel in an uneasy relationship to coordinate production policy and try to stabilize and support the price of oil, especially in the face of U.S. shale production and in the face of Saudi’s struggle with Iran for regional hegemony.
Last Friday, a rift emerged between Saudi and Russia, which deepened on Sunday as the Saudis cut prices to many customers, leading to a sudden drop of 25% in the price of crude on Monday. The rift may be real, or it may be show, as both Saudi and Russia have adversaries to punish by lowering oil prices. The move will be catastrophic for Iran, which was already facing sanctions, economic collapse, and one of the world’s worst Covid-19 outbreaks. It will be tough for American shale producers as well. The stress it is placing on many highly indebted companies has sent shockwaves through the whole high-yield debt market, and through there, into the stocks of all high dividend yielders. At the same time, as investors have fled to safety, U.S. long-term Treasury rates have declined dramatically. That disconnect could lead to more stresses in certain areas of the U.S. financial system. Of course, lower oil prices are not all bad — it is good for the U.S. consumer and for many U.S. industries. After the dust settles, barring systemic issues created in high-yield debt, the lower prices will be a boon.
The First Big Gun: Monetary Stimulus
Therefore, around the world, central banks and governments are announcing and planning major actions to support their economies and markets. We believe that these policy actions will lead to periodic rallies, which for some time will be subsumed in the ongoing volatility until fears resolve and the overall direction of the global economy becomes clearer.
There is monetary stimulus coming from everywhere, and more on the way. Since mid-January, 15 central banks have cut rates. The U.S. Federal Reserve cut its benchmark rate by 0.5% and is very likely to cut rates by another 0.5% at the March meeting of the FOMC. Bond markets are pricing in further action by the Fed. The Fed, which had gradually ratcheted back support to the overnight repo markets, indicated that it would make liquidity abundantly available so as to forestall stress in interbank lending. The Bank of England has cut rates. The European Central Bank is expected to take its benchmark rate even deeper into negative territory at its meeting this week. The Bank of Japan is expected to follow suit. Of course, in a post-2008 world, there is a lot more on the menu from central banks than interest- rate cuts. The Federal Reserve will likely give strong forward guidance, and if conditions deteriorate, will likely re-start its asset purchase program, otherwise know as QE. Even hawkish Boston Fed president Eric Rosengren commented recently that in a crisis, the Federal Reserve should be permitted to buy stocks (which has been the policy of the Bank of Japan for years). The law governing the Federal Reserve does not currently permit this, so it would have to be amended. Even before then, of course, the Fed could again begin buying Federal government debt, Federal agency debt, state and local government debt, commercial paper, and some asset- backed securities. Should stresses increase, it is likely that they will.
The European Central Bank and the Bank of Japan are both also likely to resume and/or increase asset purchases, as may the Bank of England. We note that the world’s most important central banks, facing a potential crisis, will want to avoid market disappointment at their efforts and are therefore likely to be more aggressive than expected. Of course, besides the U.S., the other key policy response will be from China. President Xi Jinping is very eager to see that China reaches the target of doubling the size of its economy in the 2010–2020 period, which would require achieving a 5.7% growth rate this year. The Bank of China will act aggressively to encourage credit growth by cutting rates and reserve requirements, and seems likely to take measures to expand lending to the worst-hit sectors of its economy.
The Second Big Gun: Fiscal Stimulus
In early January, just as coronavirus was identified and before the crisis was underway, four emeritus policymakers appeared at a conference in San Francisco: Mario Draghi, Larry Summers, Janet Yellen, and Adam Posen — all influential participants in the events of the Great Financial Crisis. All concurred that in the next crisis, it would need to be fiscal policy that would do the heavy lifting. Besides some specific virus-related spending appropriations, the coming fiscal stimulus is just beginning to take shape, but we believe that it will be robust.
In the U.S., the administration is negotiating for a payroll tax holiday that would put some $300 billion into the pockets of workers and business owners by the end of the year. The April 15 tax payment deadline may be extended. Loan support may be offered to challenged companies in the energy sector. Support for paid sick leave has become cautiously bipartisan. And of course, there is the prospect of a big infrastructure bill finally being able to garner sufficient support to pass.
The Eurozone is mooting tax cuts, as well as cuts to social security contributions and its value-added tax. Even stalwart deficit-phobic Germany is considering scrapping its anti-deficit law and joining the rest of the world in the spending party. Japan may also cut consumption taxes, though this is thought to be a higher hurdle. China could also make a broad-based VAT cut, as well as spending measures targeted to support consumption, particularly on cars and home appliances. Tax cuts targeted at the economy’s most troubled sectors are likely.
Another Positive: Trade
Trade war rhetoric has now died down between the U.S. and China, and the U.S. has been quietly lowering tariffs on Chinese medical products and other Chinese imports. This will likely continue even after the crisis resolves itself.
What Does It All Mean?
A positive scenario for stocks hinges on two things: first, that we’re correct in evaluating the coronavirus threat as being relatively modest; and second, that the emerging response to that threat from the world’s financial authorities is effective. If those two things proved true, then as fears were subsiding, stimulus would be taking effect — first monetary, and then fiscal. By the second half of the year, the global growth inflection that coronavirus interrupted would resume; interest rates would be lower; central banks would be back on the liquidity warpath; and consumers and small businesses would begin to enjoy the benefits of fiscal support, both from government spending and from tax cuts and other targeted measures. Some analysts have observed that the various shocks experienced by global markets in the post-crisis period — the European sovereign debt crisis, and the dollar and oil shock, for example — have actually served to inoculate and extend the bull market, by preventing it from overheating in a way that would call for central bank tightening and put an end to the party. Coronavirus may prove to be another of these.
If we are incorrect, and the virus turns out to be more disruptive than we believe, it is very likely that the policy response will be even more robust. Under the most severe conditions, central bank authorities — even the most hawkish — have voiced their support for measures outside their currently permissible playbook, as we noted above. Just remember, QE is now normal, and the goalposts have shifted for “extraordinary” and “creative” policy. Are there limits? Certainly, but we are not yet close to them.
The key will be to watch financial conditions and credit stress. In the U.S. the formal banking system is strong, but in the post crisis period, a great deal of debt has built up outside that system, in the world of corporate debt, leveraged loans, and the like. Should disaster befall there, and begin to make its way into the larger financial system, we would move to become still more defensive than we already have.
Investment implications: Covid-19 is likely not as bad as feared, and massive stimulus is coming, both monetary and fiscal. The demand shock may precipitate an earnings recession and provoke a sharp economic deceleration in the U.S. The key will be spillover into deteriorating conditions of financial stress. Fast and concerted easing and fiscal expansion may forestall that deterioration — so we are watching conditions closely, to see what stimulus measures are enacted, and how the markets respond. Fear needs to subside, and when it does, the underlying economic positives and the effects of stimulus should lead to a strong rebound.
