For some time, I have outlined the growing softness in the U.S. and world economies. Most of the recent data is pre-virus, and are generally meaningless. The numbers we will get for March will be awful, but the worst is yet to come. An example of March’s data is from the Philly Fed. The print of their Manufacturing Index was -12.7 for March, down a record amount from the +36.7 in February. Q2 GDP growth will be more negative than any of us have ever seen in our lifetimes. You already know the reasons: most small businesses dealing with the public are shut-down, and larger (essential) businesses are working with reduced staff or staff working from home. The hardest hit industries are in the travel and leisure space (airlines, hotels, restaurants, casinos, movie theaters, convention and meeting space… The list goes on and on).
Recession with a Capital “R”
The Recession started this month, March. Note that I capitalized the “R” word, as this one is going to be faster and deeper than any since the Depression. And, it may rival that. Q2 GDP growth is going to be negative double digits, like -15% or -20%. As outlined above, small businesses are directly impacted, and one can only hope that the fiscal plans being discussed in D.C. adequately include this business segment, else the recovery will be slower than anyone has yet discussed.
The Attack on American Oil
In addition to the issues surrounding business, the virus, and “social distancing,” there is an ongoing attack on America’s shale oil industry by Saudi Arabia (SA) and the Russians. The price/bbl. of oil was less than $20 (West Texas Intermediate (WTI)) on March 18th (it was $52+ on February 23). It has since risen, closing at $23.64 on March 20 due to some remarks by the President about intervention. The price has fallen out of bed because along with the rapid falloff in demand caused by the virus, SA decided not only to release its OPEC partners from the 2.1 million bbl. per day reduction that had been in place, but to actually produce more. The $20/bbl. price is significantly under the cost of production in America’s shale industry, whereas the cost of production in SA is only about $9/bbl. While this is not a prime Recession mover, it will add to America’s pain, as production workers in America’s shale areas are laid off.
The depth and duration of this Recession is going to depend on infection control. In China, the original cases began in December (they didn’t tell the world until late January), and, from the time they quarantined in January, it was about 45 days till their daily infection rate (new cases) declined. In the U.S., once we get enough test kits and get a handle on how many existing cases there are, the key to the length and depth of the Recession will be determined when the daily count of new cases falls on a consistent day to day basis. (Hopefully, if we repeat what China did (or better yet, Korea), the case counts will begin falling in late April.)
Liquidity, Liquidity, Liquidity
Meanwhile, the financial markets remain in a chaotic state, with liquidity a huge issue. In a Recession, equity prices always fall. And the contraction is between 20% and 50% depending on the recession’s perceived length and depth. Since no one currently has a handle on either of those two parameters, we get 1000+ point swings in the DJIA on a daily basis (down, then up, but more downs).
One big difference in this bear market is that bond prices, which should be going up (and yields down) have also been falling, at least until today, Friday, March 20, when Treasuries rallied and Corporates stabilized. In the 10 days to March 18, the yield on 10-Year T-Notes rose at an unprecedented rate (0.34% to 1.25%). Consumer rates, which are often tied to the 10-Year have risen .6 pct. points on auto loans and mortgage backed securities, .6 to .9 pct. points on home equity loans, 1.0 pct. point on muni bonds, and 1.2 pct. points on credit cards.
In the corporate bond space, the spreads between investment grade corporates and the same maturity Treasury widened from 1.06 pct. points on February 19 to 3.08 pct. points on March 18. High yield corporate spreads went from 3.45 pct. points to 8.88 over the same period.
The Panic of 2020
In a recession, interest rates always fall. The Fed cut the Fed Funds rate essentially to 0% in an emergency FOMC meeting on Sunday, March 15. Given these, why are rates rising?
Here are some reasons:
- The most rapid fall in equity prices in history caused margin calls for those who had borrowed to partake in the market uptrend that ended on February 19. These are mainly hedge funds. When this occurs, there is a need to sell, and, with no one buying (at least not anywhere near an acceptable price), fund managers and other shorts are forced to sell their most liquid assets, i.e., Treasury Notes and Bonds.
- Panic selling of mutual funds and ETFs had a similar impact. Here are some data: Investment grade bond funds saw $35.6 billion in redemptions this past week, handily beating the $7.3 billion previous record set the prior week. The outflows from high yield funds, another record, were $11.9 billion. And emerging market funds lost $18.8 billion (you guessed right – another record).
- As a result, safe havens, like Treasuries, had to be sold to meet the record redemptions (that no one was prepared for).
- Markets are also worried as there is no clarity as to revenues, costs, etc. at the corporate level; thus better to shoot now and ask questions later (i.e., sell, sell, sell).
Such behavior is highly unusual, but not unprecedented. It happens during times of panic selling. Economist David Rosenberg recently outlined four instances over the last 22 years of similar behavior (but not to this extent). The table below uses the 30-Year Treasury Bond (the “Long” Bond) behavior to show initial levels, panic levels, and the ultimate level after the panic has passed.
Behavior of the Long Bond Yield
|Event||Initial Yield||Peak Yield||Ultimate Yield|
|Bear Stearns ‘08||4.17%||4.79%||4.20%|
It’s Up To The Fed To Calm The Markets
The Recession will only get worse if interest rates rise! It’s up to the Fed to calm the markets, and they initially tried to do that by moving the Fed Funds rate to 0%. While many commentators now say they are “out of bullets” because they are at the 0% bound, that simply isn’t true. The Fed has a balance sheet that can grow to unlimited size (via QE). There are other methods too, like buying corporate paper or munis. Technically, Congress must approve these, but on Friday, March 20, the Fed found a way around this and purchased assets in the muni market (they must have an attorney with the ability to loosely interpret the Federal Reserve Act).
During World War II and in the post-WWII period (1942-1951) the Fed targeted yields. The yield on the Long Bond was targeted at 2.50%; and the Fed hardly had to intervene to purchase or sell, as the credit markets enforced the Fed’s dictum (now that’s called “credibility”). The Fed still has this tool in its toolbox to control the yield curve, and, it is my guess that they will employ it.
One last issue remains: how much fiscal stimulus will there be, will it be sufficient, will it be properly targeted, and will it arrive on time. The answer is likely “no” initially, but, eventually, they will get it right. Right now, they are talking $1.3 trillion. Likely, that isn’t going to be enough.
Conclusions (i.e., Questions Still to be Answered)
- Uncertainty regarding the length and depth of the Recession, except we know it will be awful;
- The added issue of the attack on America’s shale oil producers;
- The panic in the equity markets;
- The seemingly contradictory rise in bond yields;
- Does the Fed have the tools to combat the liquidity issues?
- What is going to happen to corporations with high debt levels; what about small businesses; will the fiscal package(s) be effective?
There are more questions than answers, and, at this writing, there is little clear vision into the future. Likely still rocky times ahead. But, at least you have an accurate picture of what happened this week. Stay Tuned!
Robert Barone, Ph.D.
March 20, 2020