There’s an old saying, “Don’t fight the Fed,” but in the current environment, it’s “Don’t fight the Fed and the Feds.”
There’s a battle going on between the extent of the damage being done to the economy by the coronavirus and the massive response. We have to be open-minded and acknowledge that there are still many unknowns and uncertainties. Market liquidity has improved, but there is ongoing volatility as we saw in recent sessions in the equity markets.
It cannot be denied, particularly by those of us with a bearish bias, that we have seen a double-barrelled move by monetary and fiscal authorities, which are working together to prevent the deep vertical down in economic activity in the second quarter from carrying over to the third and beyond.
The second-round pernicious effects from a financial meltdown, and the wave of defaults and bankruptcies, have been averted or minimized. I was concerned about this becoming a depression and not just a deep recession, but the response has been so quick and dramatic that it has lessened the odds of a sustained negative trajectory in the pace of economic activity.
The second quarter is indeed a writeoff, given the economic free fall that started in March. Nothing the Fed or U.S. federal government have done, or will do, will stop the steep slide in the coming months in output and spending. The government is replacing lost income to the personal sector and lost revenue to the business sector because up to 70 per cent of production has been idled in both the goods-producing and services parts of the economy. We are just left with the essentials segment operating at any capacity. Until people are either allowed, or feel comfortable, going to work or spending again, this situation will be with us.
The U.S. government seems to believe that the economic shutdown will last three months. If GDP was going to expand US$5 trillion per quarter, it looks like as much as 40 per cent or 50 per cent of that has been stalled. The US$2-trillion worth of fiscal help fills that void. It limits the blow in the second quarter and then paves the way for a recovery in the next quarter.
Chair Jay Powell has been more aggressive in one month than Ben Bernanke was in the first 15 months of the Great Financial Crisis of 2007-09
How strong a recovery will depend on a lot of things, mainly the extent to which households feel cautious about spending as they did before the shock and how much of the fiscal proceeds will go into savings or balance-sheet repair.
The business sector gets loans to be forgiven as long as companies maintain their staffing, pay rent and service debts. Expenses get looked after by Uncle Sam, but companies lose cash flow. They sacrifice their net profits while the economy is in shutdown mode. Much of this cash flow, given how much of it is concentrated in the service sector, will not be fully recouped, so the equity market has to deal with this blow — at least one quarter of no profits. Some of that loss, but not all, will be made up over time and the stock market theoretically discounts earnings over a long time-horizon.
But these losses may be just a bump nonetheless, and were likely priced in already at, or near, the recent lows. That’s only a premise. It’s plausible. There is another hurdle, mind you, that may come from a depressed fair-value market multiple, given the heightened uncertain economic and financial climate and because share buybacks will no longer be a compelling feature of the marketplace.
Indeed, there are many crosscurrents, but even if one can make the claim that the lows have been put in since the government acted swiftly and aggressively (and simply won’t allow a recession to morph into a depression), we are not going back to the highs anytime soon. A retesting process back to the recent lows in the S&P 500 wouldn’t surprise me, though it is very clear that tradable opportunities will appear from oversold conditions, which was the case in the bounce we saw in the midweek bear market rally.
If the economy rolls over again, I assume that we will see yet another blockbuster fiscal program. There seems to be no limit, since bipartisan support for massive stimulus is intact and likely to stay that way. The battle against the coronavirus downturn is being treated as a war, and justifiably so. Nobody in Washington has any appetite for a recession, especially in an election year. The willingness and ability to pursue such aggressive easing in fiscal policy is without precedent and we should stand on guard that more stimulus will come if need be.
As for the Fed, Chair Jay Powell has been more aggressive in one month than Ben Bernanke was in the first 15 months of the Great Financial Crisis of 2007-09. The Treasury bond, municipal bond and investment-grade bond markets have been made money-good. The same goes for general business loans through the Small Business Administration. The Fed has backstopped wide swaths of the financial market and critically helped restore liquidity to the high-quality segments.
That backstopping is a key point. The markets can function again because the fear of a wave of delinquencies and defaults has been alleviated. The Fed has moved in as the lender of first and last resort and the fiscal authorities have ensured that negatively affected private-sector incomes will be replenished, in part or in full.
A recession has not been averted, but a potential disaster has been. Counterparties now know there is an entity with deep pockets that will ensure payment to lenders, landlords and suppliers. Most businesses will be allowed to stay alive, which means there will be jobs waiting for workers who have been forced to stay at home because of the coronavirus. This policy response is just about as good and well-thought out as can be under the circumstances.
Not everyone will be fully bailed out, so there will be some failures, at least three months of profits will be lost and it is reasonable to assume that consumer behaviour could become more cautious. Plus, those companies with lost net income will likely be curtailing some of their capital spending plans.
I’m not backing away from my downbeat call on the macro outlook at all, but I have to factor in the stimulus, which is huge, far-reaching and likely induces a post-Q2 bounce, even if for a short while. That we get a third-quarter economic rebound can be viewed as a subtle shift in view. But the risk is the lack of any follow-through thereafter in terms of economic rebound.
What the savings rate does will be key. How firms respond with respect to expansion plans will be as well, since they will likely have a preference for liquidity. The high-yield market is surely not getting bailed out, which limits improvement in corporate credit, and the lack of buybacks will impede the stock market. In any case, investors should refrain from buying indexes and concentrate on specific names with quality balance sheets and a safe and strong dividend.
In essence, a bad tail risk has been taken away by vigorous policy actions. That, at least, is something, even if a V-shaped recovery is probably going to look more like a series of small-capital Ws.
David Rosenberg is founder of independent research firm Rosenberg Research and Associates Inc.