In the past week, I have had several discussions with investors about my recession call (see OK, I’m calling it). Since the publication of that note, Bloomberg Economics’ US recession probability estimate spiked recently up to 55%.
The odds of a 2020 recession at betting sites are even higher.
To reiterate, I would like to clarify the reasoning behind my recession call, which is based on a triple threat:
- The emergence of COVID-19 in China has created a supply shock that disrupted supply chains all over the world.
- The Saudi-Russia oil price war, which has devastated the oil patch in the US.
- The COVID-19 pandemic, which is expected to result in both a supply shock and demand shock in the US.
China’s supply chain shock
I covered most of the effects of the COVID-19 epidemic in China in a previous publication (see Don’t count on a V-shaped recovery), so I will not repeat myself. The Chinese leadership was faced with a painful trade-off between the health of their population, and economic growth. Once the bureaucracy got over the denial phase of the epidemic, Beijing chose to focus on the health of their people with a containment strategy of quarantine, mass-testing and contact tracing. These measures effectively shut down their own economy for Q1, and likely part of Q2. Once the infection rate stabilized, they pivoted to economic growth as a priority.
Nevertheless, the slowdown created supply chain bottlenecks all over the world, and threatened the global growth outlook. Axios reported that the coronavirus disrupted supply chains for nearly 75% of US companies. Bloomberg reported that the effects of the slowdown is worldwide:
U.S. seaports could see slowdowns of as much as 20% continue into March and much of April, according to the American Association of Port Authorities. The same trend is seen in more distant places, with Rotterdam — Europe’s economic gateway to Asia and beyond — seeing a similar cut of about 20%.
China is recovering from the virus. Even if you are dubious about China’s official statistics, consider this NY Times interview with Dr. Bruce Aylward, who led World Health Organization (WHO) team that visited China and found no apparent evidence of fudged numbers.
During a two-week visit in early February, Dr. Aylward saw how China rapidly suppressed the coronavirus outbreak that had engulfed Wuhan, and was threatening the rest of the country.
New cases in China have dropped to about 200 a day, from more than 3,000 in early February. The numbers may rise again as China’s economy begins to revive. But for now, far more new cases are appearing elsewhere in the world.
China’s counterattack can be replicated, Dr. Aylward said, but it will require speed, money, imagination and political courage.
Indirect market and anecdotal evidence does show that the worse of China’s downturn is over. Hong Kong has the epidemic well under control. Neighboring Macau announced last week that they were discharging their last COVID-19 patient.
The Baltic Dry Index, which measures shipping costs, is recovering after a deep slide.
As well, Bloomberg reported that American exports of chicken is starting to return to normal:
U.S. chicken exports to China are flowing freely again as logistical bottlenecks caused by a deadly virus dissipate and the Asian nation issues tariff waivers to buyers, according to Sanderson Farms Inc.
The U.S.’s third-largest chicken producer has shipped 522 loads to China of mostly dark meat and paws, Chief Executive Officer Joe Sanderson Jr. said in a presentation Wednesday.
That’s up from 420 at the end of February, when the company reported earnings for the first quarter
The coronavirus outbreak, which has claimed more than 4,000 lives globally, disrupted transport operations in China and left thousands of meat containers piling up at ports. While retaliatory tariffs were until recently a hurdle for U.S. shipments, China is now giving duty waivers to buyers, Sanderson said.
China is returning to work, albeit slowly.
The Saudi-Russia oil price war
If the Chinese COVID-19 epidemic wasn’t enough, the global economy was unexpectedly hit with a oil price war when Russia could not come to terms with OPEC on oil price cuts in the face of falling global demand. Saudi Arabia responded by not only pumping at capacity, but selling above their production capacity with sales of their reserves.
This sparked a different sort of supply shock. The market saw the effects of an oil shock in late 2014 when the price skidded from over $100 to about $40 in short order. The US economy experienced a shallow industrial recession, which was especially evident in the oil patch. Earnings estimates fell, and stock prices weakened in the latter half of 2015.
Forward 12-month consensus EPS estimates have been flat, and they have just begun to decline as a result of the Chinese supply chain disruption, indicating negative fundamental momentum. What will happen once the full effects of the oil price shock work their way through earnings expectations?
Can America flatten the curve?
Even worse, COVID-19 has landed upon American soil and it is expanding its beachheads and spreading all over the country. Since there is no cure or working vaccine, health authorities use two types of strategies to combat the virus in order to “flatten the curve”, containment and mitigation. As shown by the stylized diagram, the infection can either run rampant in an uncontrolled fashion (yellow curve) or in a slower way (violet curve). Each country has a limit on healthcare resources, and an uncontrolled epidemic will quickly reach and overwhelm care capacity, in hospital beds, healthcare providers, and so on. Strategies to slow down the outbreak buy time so that care capacity does not become constrained.
Anecdotes from northern Italy, which has a first-rate healthcare system, indicate a society that is in a desperate fight against COVID-19, as reported by Bloomberg:
More than 80% of the region’s 1,123 acute care beds are dedicated to coronavirus, after many other patients have been moved elsewhere and 223 extra places have been opened to cope with the emergency. About half of those are occupied, Gallera said.
Newspapers and WhatsApp groups are rife with personal accounts from doctors on the front lines of the epidemic. When new patients come in with pneumonia, a symptom of advanced coronavirus infections, doctors have little time to decide whether to assign them intensive-care beds, ventilation machines or respirators that could make the difference between life and death.
Some doctors have said that they sometimes make the call on who gets treatment based on the age of the patient. In some areas, hospitals are suspending other treatments to focus personnel on the contagion.
A doctor who asked not to be named because of potential repercussions painted a dire picture of the situation in a hospital in Milan. While the coronavirus is best known for causing severe disease in elderly patients, even some young people are affected, the doctor said, and without sufficient beds and ventilators, some can’t be treated.
The hundreds of patients needing treatment for pneumonia have swamped the supply of available specialists, the Milan doctor said. Physicians such as gastroenterologists, who normally focus on the digestive system, have been conscripted to help out with lung patients, and they’re still not enough, the doctor said.
This NY Times account of a Seattle area hospital provides a glimpse of what will probably be common scenes all over the US in the very near future:
While much of the country is just starting to see clusters of cases emerge, the hospital east of Seattle offers a window into the challenges set to cascade through the nation’s health care system, testing the resilience of workers, the readiness of institutions and the flexibility of supply chains.
The past few weeks have seen medical workers operating at the very edges of their capabilities, facing a virus so virulent that some patients were dying within hours of coming down with their first symptoms.
Caregivers who had been sent home into quarantine had to be called back to work to face the overwhelming task at hand. Engineers spent late nights scrambling to overhaul rooms so that contaminated air could not escape. Sanitation and janitorial crews struggled to swab down rooms where even a trace of the virus could infect the next patient. Supplies were so strained that nurses turned to menstrual pads to buttress the padding in their helmets.
If an outbreak is caught in its initial stages, health care authorities can utilize the containment, or quarantine, strategy to prevent the virus from spreading to other patients. This approach can be useful if patients from infected regions, e.g. China, can be identified and isolated. Once the infection spreads into the community, a combination of isolation and mitigation strategies have to be employed. Mitigation include personal hygiene practices such as frequent hand washing, and wearing a mask in order not to infect others. Social distancing is another mitigation technique, which includes closing down public events where crowds gather, such as schools, arts and sports events, and any other large gatherings. The downside of social isolation strategies is an economic shock that significantly reduces the demand for goods and services.
China has been relatively successful with draconian isolation and mitigation strategies, and so did Singapore. South Korea managed to contain its outbreak with a combination of mass testing to identify patients so that they could be isolated, and social distancing strategies that made most of the country virtual ghost towns. For some perspective, read this American ex-pat’s account of living in Seoul in the Dallas Morning News, which she described as “living in end-times”.
One way of measures the success of COVID-19 countermeasures is the time it takes for confirmed cases to double, as shown at Our World in Data. Outperforming countries include China (doubled in the last 32 days), South Korea (12), and Singapore (15). By contrast, the same metric for Italy is 4, Iran is 6, France 3, and the US is 3, which is probably affected by an under-counting of cases due to a shortage of testing capacity.
While the American healthcare system is generally thought of as first rate, access is uneven. In particular, many rural counties lack primary care doctors, or even hospitals. Notwithstanding the problems of insurance coverage, and lack of sick days, which can be an obstacle to a patient seeking care, the lack of proper facilities in these under-served rural areas highlight a key US vulnerability.
The policy response
In the face of this triple threat, what can American policy makers do?
Former New York Fed President Bill Dudley laid out what the Fed can do under these circumstances in a Bloomberg op-ed. Dudley believes that lower rates is a no-brainer.
At this point, more short-term rate cuts seem certain. After all, the outlook has deteriorated since the Fed’s 50 basis point cut on March 3. Moreover, historical experience indicates that rate cuts between Federal Open Market Committee meetings have typically been followed by rate cuts at the subsequent FOMC meeting. Finally, the language accompanying the last rate cut — that the FOMC would “act as appropriate” — also has been a reliable predictor of future rate adjustments. Thus, it would be very surprising if the FOMC didn’t cut its federal funds rate target by 50 basis points, or possibly more, at next week’s meeting.
QE would be the next tool once rates have reached the zero lower bound.
The decision to use the monetary policy tools such as forward guidance and quantitative easing will be straightforward. If the Fed has pushed short-term rates to zero and the economic outlook suggests the need for greater monetary stimulus, these tools will be used. They are now part of the Fed’s standard tool kit.
Like other central bankers, Dudley called for fiscal policy support in addition to monetary policy. Monetary policy is of limited utility under the current conditions.
The stresses that emerge as a result of the coronavirus are likely to be very different from those that occurred during the financial crisis. This time we are likely to see considerable stress on small businesses that encounter cash-flow problems and on households, especially if unemployment spikes.
These types of problems probably are better addressed through fiscal policy than monetary policy. Payroll tax cuts, sick-leave pay, extended unemployment benefits, and block grants to state and local governments to forestall layoffs should all be considered.
Governments face policy trade-offs between the health of their population and economic growth, but much of the US focus has been on growth (Wall Street) over public health policy (Main Street). A coronavirus bill is working its way through Congress. as the Democrats and Republicans bargain over its many provisions. A WaPo article outlined the policy choices that lawmakers face:
The first is spending aimed directly at stopping the spread of the virus: buying masks, producing a vaccine, paying for testing and so on. Everyone, Republicans and Democrats, agrees that’s necessary.
The second set of actions is focused on the people most directly affected by the economic fallout. Some of that can be done by extending existing programs such as unemployment insurance and food stamps and paying for sick leave, but it can also include simply giving people money.
Up until Friday’s dramatic declaration of a national emergency, it appeared that the Trump administration was prioritizing economic growth (Wall Street) over public health (Main Street). It remains to be seen how quickly the federal government can make the Main Street pivot.
What’s next for Main Street?
How bad can things get for Main Street? As a reminder, I previously highlighted the results of a CBO pandemic study (see A Lehman Crisis of a different sort).
The Congressional Budget Office conducted a study in 2005-06 that modeled the effects of a 1918-like Spanish Flu outbreak on the economy. The CBO assumed that 90 million people in the U.S. would become sick, and 2 million would die. Those assumptions are not out of line with current conditions. The population of the US is about 330 million, so an infection rate of 27% (90 million infected) and a fatality rate of 2% (1.8 million dead) are reasonable assumptions.
The CBO study concluded that a pandemic of this magnitude “could produce a short-run impact on the worldwide economy similar in depth and duration to that of an average postwar recession in the United States.” A severe pandemic could reduce GDP by about 4.5%, followed by a V-shaped rebound. Demand shocks would also be evident, with an 80% decline in the arts and entertainment industries and a 67% decline in transportation. Retail and manufacturing would drop 10%.
In all likelihood, somewhere between one-third and two-thirds of the population will be exposed to the coronavirus. Using the Chinese experience as a guide, 81% of the cases will be mild, 14% severe, 5% critical, and 2.5% will die. As it is set up, the healthcare system will be overwhelmed.
Add to that the recent hit to the US energy sector, which became a net exporter as fracking techniques took hold in the oil patch. We saw in 2014-15 that plunging oil could cause further weakness in business investment. In addition, China’s decision to shut down its economy to battle the COVID-19 pandemic has caused supply chain disruptions that rippled throughout the global economy. It is difficult to see how the US can avoid a recession under these conditions.
Investors should brace for an equity bear market. Ryan Detrick of LPL Financial pointed out while not all bear mean recession, bear markets that accompany recessions tended to last longer and the drawdowns are more severe.
Please stay tuned tomorrow for our tactical trading commentary.