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Bridge to the Future

Words are woefully inadequate to describe the coronavirus earthquake which has tilted the earth on its axis. Coronavirus has created a rare demand and supply side shock, and the widespread shutdown efforts globally have created the first recession by government decree in an effort to prevent an even greater humanitarian crisis.

Once the damaging effects of the shutdown became clear, the natural question that leaped to mind was whether the “cure was worse than the disease.” But the question of whether we should prioritize saving the economy over saving lives is a false choice. It is painfully clear that the highly infectious coronavirus, had it been left unchecked, would have washed over the economy in an even more chaotic way than it has. Nobody would have gone to work, restaurants, or concerts once the deadliness of the contagion was known. The economy would have shut down anyway, and at the probable cost of even more sick and dead. We are not organized, but at least we’ve prioritized. Controlling the virus has to precede any return to normal, whatever that may look like, or we may not have anything normal to return to.

Economists are working overtime to try to quantify the economic damage in dollars, but the greatest damage may be to confidence. Economic growth is a matter of confidence as much as it is of technology and interest rates. Without it, neither households or business will make long-term plans, and will tend to hoard cash.To understand what a recovery looks like, we should look to indicators that show consumers’ conviction about the future. Right now, confidence is as low as it was in previous major recessions, and it’s early in the decline. If widespread testing boosts confidence, people will venture out to group events and begin traveling again. But a second wave of coronavirus would surely send Americans scurrying back into their homes, starting the cycle over again.

Amidst the daily toll of grim news there are also daily examples of compassion and sacrifice. In this age of schism and polarization, we are witnessing ordinary people fulfilling extraordinary calls to pull together for a common purpose. From the nurses and doctors literally risking their lives on the front lines, to grocery store workers keeping food and household goods well-supplied, the rise of a common threat to society has brought out the best in Americans as we try to build our bridge to the future.

But social fissures are already beginning to open, as the need to isolate to prevent contagion is facing massive pressure to reopen business to stem the impoverishment of America. Policymakers have been desperately trying to build that bridge under conditions of extreme uncertainty and time constraints. Fortunately, the response from the Federal government and the Federal Reserve has been quick and substantial. Congress passed the $2.3 trillion dollar Coronavirus Aid, Relief and Economic Security (CARES) Act in only ten days, an astounding feat given that CARES is the single largest piece of legislation ever passed. The Act provides for direct payments to individuals and families, small business loans, support for state unemployment benefits, and aid to hospitals and industries shuttered by the social isolation decrees, such as airlines. The amount of the rescue package is equal to fully 50% of the total federal budget for 2019. The Act is an attempt to replace income for a vast proportion of U.S. workers who’ve had their incomes shut off without warning, as if it were a light switch. Given the vast scale of the shutdown and the complete cessation of cash flows, the question is whether it will be enough to effectively bridge us to the point of the reopening of businesses.

The Federal Reserve jumped into the fray with even more speed, reviving its “quantitative easing” (QE) policy with unimaginable size. Their balance sheet, shown below, has expanded by nearly $2 trillion in a matter of 60 days, and now sits at just over $6 trillion. The Fed’s massive QE response is designed to backstop financial assets and stop a cascading series of defaults. The widespread stoppage in the economy, though, has meant that the Fed has had to backstop virtually all financial assets, from bond ETFs to municipal securities to, unthinkably until now, the junk bond market. The need to raise cash was so intense in March that even blue-chip corporate and Treasury bonds fell for several days when overleveraged investors faced a tsunami of margin calls and sold whatever they could. Having opened the Pandora’s box of QE after Lehman Brothers’ collapse in 2008, the central bank has had difficulty weaning the financial markets off this monetary drug. Now, they have pledge “unlimited” QE to put a floor of support under the markets, so we should expect their balance sheet to climb even higher. The Fed, traditionally the lender of last resort to banks, is now effectively the lender of last resort to the entire economy.

The chasm over which the Fed and Congress are trying to build a bridge is not just wide; nobody knows where the end is.  Economic reports are just now coming in that reflect March’s monthlong shutdown, and they are staggering. Retail sales dropped about 9% in March (record decline), industrial production dropped 5.4% (most since 1930s), and confidence measures among businesses and consumers plunged.  With initial unemployment claims surging by 22 million in just four weeks, we have wiped out nearly all the jobs created since 2009. It is naïve to call this a mere “recession.”

It will take many months to recoup these losses, and those expecting a V-shaped recovery will be sadly disappointed. The abrupt drop in cash flow has introduced the risk of a domino-like payments problem for mortgage lenders, credit card issuers, and auto lenders.

Wall Street seems to be oblivious to the plight of Main Street, as it has rallied some 25% off the lows reached March 23rd. Like Pavlov’s dogs, institutional investors have been conditioned over the last decade to buy the dips, knowing that the Fed would prevent any bear market from spiraling out of control. Deluding themselves into believing they can model this depression based on past history, and flush with free money from the Fed’s QE fire hose, stocks have rallied strongly, making up about half the decline from the all-time highs of February. Using the QE-biased decade as a guide, these investors have bought into the almost religious belief that central banks can paper over any of Wall Street’s problems.

But intellectually honest students of market history, like Isaiah Berlin’s hedgehog, know “one big thing.” In our case, it’s three big things.

First, major bear markets don’t end until stock values become truly cheap. Commonly, analysts use the “price to earnings” (p/e) ratio to measure value. Today, the “e” is falling a lot faster than the “p.” On this basis, especially after the recent rally, stocks have hardly become a bargain at all. Moreover, earnings estimates are just starting to be revised lower. As the fallout from the shutdown drags on, earnings are set to fall dramatically. Prices should follow, and ultimately p/e ratios will find themselves in the single digits, from about 28 currently. Investors would be well advised to use a less volatile measure, such as price-to-book value or price-to-sales as an adjunct to the popular price-to-earnings ratio to judge when stocks have finally reached the bargain bin.

Second, major bear markets have the potential to drop some 50% from the highs to the ultimate bottom. Today’s quick-buck traders seem to have forgotten that the S&P 500 dropped 45% in 2000-03, and 50% in 2008-09. Those bears were driven by excesses in particular sectors (technology/internet in the former, banks/mortgage lending in the latter), whereas today we face a widespread, but temporary, global cash flow crunch whose effects are being felt in every industry. Can we realistically expect the Fed’s QE programs to replace this cash flow? While the Fed’s efforts can mitigate a wave of defaults, it may not do much to create jobs, at least in the near term. We should expect stock prices to grind lower as the sales and earnings expectations are deflated, and with them the consensus as to what price level constitutes “fair value.”

A corollary point is that investors are still too bullish. The quick rally has certainly removed some of the sting of this bear market, but the rapid rise in bullish commentary indicates we are far from the ultimate bottom. Major bear market lows are marked by a revulsion for stocks. Headlines at that time will bear grim warnings that buying stocks is a fool’s game, as the relentless bear claims the majority of bulls under its claws. When we reach that point, though it will take nerves of steel to invest, we will be close to the bottom.

Finally, leverage of households and (especially) large corporations and government entities will have to be reduced before a new bull market can be launched. Companies, municipalities, and the federal government have spent the last ten years gorging at the debt trough. Now that cash flows have dried up, these entities are paying the price and begging for bailouts. Corporations, rather than acting as stewards of shareholder assets (not to mention employees and customers) have left the debt binge and stock buyback orgy with little cash to survive the depression. The Fed has been the chief dope peddler, artificially suppressing interest rates in the hope that we could borrow our way to prosperity. Having reduced rates to near zero percent, they have no choice now but to expand QE even more, encouraging even more borrowing to bridge the gap to recovery. But debt doesn’t simply disappear-it is subject to the three Rs: repayment, refinancing, or repudiation (i.e. default). We will have to see some combination of these take place before sustainable growth can lay the groundwork for a new bull market.

Our bridge to the future is obscured with uncertainty. The pandemic has rendered standard theories of economics and finance obsolete, and monetary and fiscal policy are venturing where no one has gone before. With any luck, and by embracing facts and not fear, we can complete this bridge without creating major social dislocations and trauma, and be better prepared to meet this invisible foe when the next viral outbreak occurs.

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