The silver bullets
Did Congress find a silver bullet last night?
Our Top Market Takeaways for March 25, 2020.
The silver bullets
On Monday, we discussed three problems that the economy and markets would have to work through before they could find a bottom.
- The spread of COVID-19
- The issues in credit markets that are inhibiting borrowing in the real economy
- The government’s ability to bridge the private sector’s gap while social distancing halts revenues
What makes this crisis different is that there are silver bullets for each problem that could drastically change the outlook for the better.
- A vaccine or antiviral medication that mitigates the threat of COVID-19
- The Federal Reserve and other central banks alleviate issues in debt markets
- The government bridges private sector revenues and worker’s wages until the disruption has passed
Now, this isn’t a folk tale. Silver bullets don’t come easily in the real world, and when they do, they often present externalities of their own. Vaccines take time. Central bank balance sheet expansion has been controversial for a decade. Congress and the Administration had to go through several rounds of negotiations before finally reaching a deal for a fiscal package late last night. But in today’s note, we wanted to explore the likelihood of the silver bullets saving the day.
A vaccine or antiviral medication
First, let’s state the obvious. We aren’t experts in medical treatments or scientific research. However, our Chairman of Market and Investment Strategy, Michael Cembalest, has been at the forefront of translating the latest scientific findings to investors, so please visit his dedicated page for details. According to Michael, there are no less than 32 vaccines, antiviral medications, antibodies, or immunomodulators currently in development. Needless to say, the medical research community is working tirelessly to find a medical solution to this problem. While the idea of a vaccine is exciting, the problem is that an expedited process to get a vaccine to patients could be 12–18 months. There will likely be a vaccine developed at some point (given the advances in technology over the last 10 years), but it will still take time for the proper testing and the manufacturing buildout to take place.
Our verdict is that there is likely to be a medical solution to COVID-19 at some point in the future, but it does not seem imminent. In the short term, it seems like social distancing is the best way to reduce the threat of the virus.
The Federal Reserve and other central banks alleviate issues in debt markets
We touched on this on Monday, but one of the most troubling features of markets over the last few weeks has been the scramble for cash, and its adverse impact on monetary policy. This is a complex topic, so we will try to simplify it. The Federal Reserve uses interest rates to influence economic activity. The effectiveness of that policy is constrained by the degree to which debt market pricing cooperates with the Fed’s policies. Lowering the federal funds rate does not help if banks don’t actually end up lending to each other at those lower rates (shown in the chart below comparing LIBOR to OIS). Said differently, pushing borrowing costs down does not help if the rates that businesses and consumers actually transact at, such as mortgage rates, are more expensive than usual relative to Treasury bonds (chart shown in our note from Monday).
The line chart shows the spread between LIBOR and OIS from 2005 through March 22, 2020. It shows that this spread is currently at its highest level since the Global Financial Crisis.
That is why the Fed has dusted off so many of its Global Financial Crisis era facilities and created some new ones (the Fed can buy corporate bonds now, for example). It is trying to lower borrowing costs across loan tenors and borrower types. In general, the Fed is creating new reserves to support demand for debt. More demand leads to higher prices, which leads to lower interest rates (that’s the idea at least). We have already started to see the Treasury market react to these new measures, and we are confident that other segments (like money markets, mortgages and corporate bonds) will follow suit.
Could the Fed’s silver bullet have costs down the line? Perhaps. Since 2010, there have been arguments that quantitative easing would lead to a “debasement” of the U.S. dollar and spiraling inflation. However, the problems in fixed income markets and the real economy are immediate, and the Fed needs to fix them before worrying about side effects. Second, if there is anything that the post–Global Financial Crisis period suggested, it is that central bank balance sheet expansion has not caused inflation to rise. For investors, the best solution is probably to not fight the Fed and look for opportunity in dislocated fixed income markets. At the same time, it could make sense to hold gold in case the negative externality of inflation does happen this time.
The verdict on the Fed is that it is the closest of the three to finding a true silver bullet for their problems.
The government replaces private sector revenues and workers’ wages until the disruption has passed
The stock market is fixated on Congress. On Sunday, S&P 500 futures lost -5% after a procedural vote failed in the Senate. Yesterday, the S&P 500 gained almost +10% (which would be a good year, let alone single day) on headlines proclaiming the Republicans and Democrats were close to an agreement on a massive bill to respond to the COVID-19 crisis. Overnight, the press reported that lawmakers had come to an agreement on a roughly $2 trillion stimulus package. The size of the bill isn’t going to be the problem. Now, we are focused on the design.
A silver bullet in the bill would have been a mechanism through which the government could replace business revenues while the COVID-19 shutdown lasts, contingent upon the businesses retaining and paying their workers. Of course, there would be bureaucratic and logistical hurdles to that solution (this is the government we are talking about), but, in theory, it would allow small and medium-sized businesses to maintain all of their human and physical capital so that they can ramp up quickly when the threat from the virus has passed. This is critical, because small and medium-sized businesses make up 83% of employment in the United States. Over 30 million workers are in the industries most exposed to social distancing. Right now, it seems more likely that the thrust of the fiscal response will be a combination of small and medium-sized business loans and a massive expansion of unemployment benefits. That is better than no response, but it isn’t quite as optimal as the “silver bullet.”
The stacked bar chart shows the millions of employees who have been impacted by COVID-19 as of February 28, 2020. It shows the breakdown between retail, leisure & hospitality, and air transportation employees.
Let’s take a nail salon for example. It is closed because of social distancing measures. And demand is being destroyed (you aren’t going to get double the amount of manicures in the second half of the year because you missed the first half). It employs 30 manicurists. It isn’t sure how long this shutdown will be in place, but the salon knows it has to start cutting costs to survive. It has probably started laying off manicurists already, but maybe not all. If the government’s response was to replace the salon’s revenue as long as it maintained its payroll, it would probably not lay off any more workers and wait out the virus. Once the virus passes, it would be up to speed fairly quickly.
Now, since the response seems to be a scheme of loans and expanded unemployment benefits, the salon is more likely to lay off the manicurists (because they are receiving a good portion of their incomes through unemployment benefits anyway), and taking the loan would be a hard decision. Further, there is a chance the salon can’t make the rent and it loses its location before it can make a decision. In this sense, it would be much harder for the salon to get up to speed once the virus passes. When you aggregate this scenario up to the whole economy, it suggests that the more workers are laid off, the longer the economic recovery will take.
There have been reports that the loans could be entirely forgiven if the businesses who take them maintain their payrolls. That would be a positive development and would make the loan scheme very close to the silver bullet that we outlined. If that is the stipulation, then the rise in the unemployment rate would be lower than it otherwise would have been, but the details are still scarce.
The verdict here is that the bill as designed isn’t [quite] a silver bullet for the economy, but looks robust enough to cushion the economic fallout. We will give it a bronze.
In the end, we can’t make investment decisions based on hoping for silver bullets. That is why the portfolios we manage are the most defensive they have been since the Global Financial Crisis. However, markets are beginning to present targeted opportunities in high-quality assets that we think can generate outsized returns. While it is nearly impossible to call a bottom in broad markets, we believe it is time to focus on adding those specific exposures.
All market and economic data as of March 2020 and sourced from Bloomberg, FactSet and Gavekal unless otherwise stated.
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