"If you can't handle these 21 days, this country and your family will go back 21 years. The only option is social distancing, to remain away from each other. There is no way out to escape from coronavirus besides this." —Indian prime minister Narendra Modi, announcing a complete three-week lockdown for his nation's 1.3 billion citizens
Amazing how quickly the world can change in such a short amount of time. Just five weeks ago, the market made a new high (Feb 19th) of 3392. As of Friday's close, the S&P500 was at 2541, down 25%, and staring down what's likely to be some of the most difficult economic reports ever witnessed. Has the market bottomed? The answer is nobody knows. Indeed, a significant amount of policy has been implemented in a very short time. How quickly and efficiently these measures are implemented and make their way through different channels will go a long way in determining the duration and depth of the recession. Below are some general thoughts on key segments of the market and our response to questions received during calls last week.
Will monetary and fiscal policy be enough to reduce the damage caused by the recession?
The objective of government policy has been to stabilize the economy by underwriting businesses requiring a backstop while the virus is active, and business remain closed. The Federal Reserve's balance sheet has ballooned to $5.25 trillion from $4.13 trillion on February 19th. And this is before the additional $4.5 trillion in lending facilities made available by the Fed since the crisis began.
Given the relatively high level of leverage in the US economy and various industries, the decline in cash flows over the past 3-4 weeks has jeopardized the survival of many businesses. The total debt of U.S. nonfinancial businesses has increased by about $6 trillion since 2007, while cash on hand has increased by only $1.7 trillion. The added debt levels have made servicing the interest expense on this debt a major challenge during business closures. As a result, the Federal government introduced a sizeable stimulus package, that if nothing else, ushers in a level of spending never seen in the US.
The U.S. budget deficit in 2019 was 4.6% of GDP, larger than any period outside a war or recession. The bill passed by Congress last week adds an additional 9.5% of GDP to the budget deficit (see chart below). The basic outline of the bill is as follows:
With so many balance sheets stressed and at risk of failure, the government has been forced to step-in as the lender of last resort. By ramping up the printing press, the Fed hopes to provide enough liquidity to offset the collapse in the velocity of money. The risks to this massive increase in liquidity are two-fold. On the one hand, if the government fails to respond quickly enough, the price of assets used as collateral for bank loans can deteriorate rapidly. On the other hand, in the event the government over-extends credit, then the likelihood that inflation makes its long-anticipated comeback increases significantly. At this stage in the crisis, we’re assuming most small business owners would willingly opt for the risk of inflation over the risk of business closer. The quote below from Guggenheim’s CIO Scott Minerd, however, is a stark reminder of where we find ourselves.
“In Goethe’s 1831 drama Faust, the devil persuades a bankrupt emperor to print and spend vast quantities of paper money as a short-term fix for his country’s fiscal problems. As a consequence, the empire ultimately unravels and descends into chaos. Today, governments that have relied upon quantitative easing (QE) instead of undertaking necessary structural reforms have arguably entered into the grandest Faustian bargain in financial history."
What is the Bond market telling us?
Do Equities have more upside or downside?
Last week's 10% spike in the market showed how quickly sentiment can change. Even after the rebound, however, the S&P500 is still down 24.4% from its highs on Feb 19th. As corporate balance sheets are repaired, losses will be recovered. This will take some time, however, as forward earnings will need to adjust to the pace of the pending recovery. Fiscal and monetary authorities have delivered what they believe is necessary to address increased illiquidity. Many of these measures are unprecedented and leave the door open to a range of possible paths to recovery.