What Now?

We have learned that China, the world’s second-largest economy contracted by nearly 10% in Q1.  The US has lost in less than two months all the jobs gained in the record expansion.  The central bank of Canada, the 10th largest economy, warned that its output could fall by 30% in the first half.  Europe’s automakers’ association estimates that sales imploded by 55% in March, twice the pace at the worst of the Great Financial Crisis.

Investors know that the shutdowns mean those claiming welfare benefits, unemployment insurance are surging.   Benefits have generally been increased and extended. Some countries offer to subsidize wages of employees whose employer reduces their hours rather than letting them go.  The US has offered loans that turn into grants to businesses that retain or rehire employees.  The early April manufacturing surveys conducted by the New York and Philadelphia Federal Reserve Banks (-78.2 and -56.6) provide more color of the depth of the economic contraction that is underway.    

It is hardly surprising that activity slows down dramatically when broad parts of the major economies have shut down.  A coin is dropped from the top of a 50-story building.  Snapshots of what it looks like at the 35th floor and again at the 10th floor may be interesting for a photographer, or physicist but it makes little difference.   And so it is with the economic data, except in slow motion.  It is going to get worse.  More important for investors and businesses is when the turn comes.  That is, of course, predicated in part by the easing of restrictions on movement, but it is not as simple as that due to complex and opaque supply chains.

Nevertheless,  like the rubbernecks on the highway, investors will take note of the preliminary April PMIs that are due in the days ahead.  The economic entrails will be combed and teased, but the reports are unlikely to influence investor or business decisions.  That said, Europe’s report will be released as the heads of state meet virtually to ostensibly approve the compromise struck by the finance ministers last week.  The no-doubt dreadful preliminary PMI may further embolden those seeking a more significant response.  

The 540 bln euro deal pales in comparison to the economic catastrophe.  Europe is shaped by its reaction to crises.  A milquetoast response will set into motion forces that will exacerbate and deepen the fissure between creditors and debtors in Europe. Northern Europe entered the crisis with a better balance sheet than the South.  This will allow greater resources to be devoted to the reconstruction and rebound.  As a consequence, those centrifugal forces that threatened the European project a decade ago would likely re-emerge.   

Many attempts to chronicle recent events and official reactions cannot help but draw parallels with the Great Financial Crisis.   The debate over a common bond is one reiteration, and no progress has been made. The cart is often put before the horse. There has been too much focus on the liability and none on the asset.  Find compelling joint projects.  The Common Agriculture Policy ensures that Europe can be food self-sufficient.  It needs a Common Public Health Policy, and it needs to be tailored for every country.  From education and research, the capacity to manufacture essential drugs and medicines, as well as the equipment and devices are needed.  Regional coordination capitalizes on economies of scale and could facilitate and formalize the integration along borders.  

The UK and EU plan monthly meetings starting next week to negotiate a new trade agreement.  Prime Minister Johnson has previously warned that if the EU was not moving toward his position by the middle of the year, the UK would walk away from talks.  Apparently, three meetings are planned here in Q2 starting next week.  The EC had already expressed concern about the timeframe prior to the onset of the corona crisis.  

Nevertheless, the UK government should not be expected to change its insistence that the current timeframe is respected.  It gains nothing by even discussing it now.  Yet, its hurdle is not just the negotiations themselves. However, the measures the UK still needs to implement: enhanced borders checks, a new immigration system, and the introduction of a new and complicated customs border with Northern Ireland. The logical window is in June as the agreement allows for, but it would likely be a joint decision, and one blamed on the unforeseeable consequences of the virus.

Still, the UK’s position appears to have hardened.  Johnson has explicitly refused to consider a delay, but last week, a government spokesperson indicated that UK would reject a formal EU request for a delay as well.  That said, lack of agreement and proper preparations would generate a disruption at a potentially vulnerable time (i.e., the normal coronavirus season of the common cold and flu).  

Meanwhile, China’s economic and financial response to the crisis has been underwhelming.  The government and the central bank’s response appear mild compared with the actions in 2008-2009 and relative to the reaction of other major countries.  By first cutting the seven-day repo rate at the end of March and then the medium-term funding rate last week, the PBOC signaled that the new benchmark 1-year Loan Prime Rate will fall 20 bp (to 3.85%) when it is set in the banks’ submissions.  

On the other hand, the Federal Reserve is being accused by many observers for doing too much.  Its encroachment into free-markets is undermining the market discipline that requires as Oaktree’s Howard Marks called a “healthy fear of loss.”  A noted analyst argued because the Federal Reserve is buying assets for the Treasury Department, it has completely lost its independence: The White House is running the Fed.  Leave aside the months that Chairman Powell suffered a barrage of criticism from President Trump and that none of his appointed Governors have dissented from a single decision the Fed has taken before or since the crisis.    

Even for the less zealous, the buying of high-grade ETFs seemed beyond the pale.  The signaling effect of the announcement of its intentions was sufficient to set savings flowing into the largest ETFs in the space and raise valuations levels beyond the Fed’s thresholds.  Others do not approve of the criteria that are being used to buy municipal bonds.  Debating the issues is beyond the scope of this note, but reference points can be useful. 

1.  What happens in a crisis stays in the crisis.  During an emergency, measures are often taken that would not be under normal circumstances.  Emergency measures can be and are often unwound.  The conservative President Nixon imposed price and wage controls. The government’s equity stakes taken during the Great Financial Crisis were sold and for a profit to boot.  

2. The idyllic free-market has not existed for a long-time, if ever.  Keynes published his “End of Laisse Faire”  almost a century ago.  States play a vital role in sustaining aggregate demand.  Government spending accounts for between a third and half of the GDP of most high-income countries.  Between Fannie, Freddie, and Ginnie, the US government invests or insures something around 90% of America’s mortgages.  

3.  Don’t blame the plumber for the architect’s mistake: The reforms in response to the GFC required that there be more democratic oversight of Fed’s asset purchases outside of those for monetary policy (Treasuries and Agencies).  The special-purpose vehicles have been seeded with money Congress earmarked for the Fed and US reserves (Exchange Stabilization Fund).  It would cushion the central bank from any loss.  The Fed is acting as lender-of-last-resort and ensuring that the transmission mechanism of monetary policy functioning to  “bridge” the financial system to the other side of the crisis.  The Fed is concerned about the circulation of capital both in terms of bank lending and capital markets.  It has little direct influence over the disparity of wealth and income in the US.  Among the most helpful things it has done for those without capital was to help manage the longest business expansion in American history that saw a dramatic decline in the underemployment rate.   

4.  Impaled by two horns of the dilemma: On one hand, the Fed is accused of buying everything, and on the other, that its criteria are not fair.  Introducing rules about the kind of assets that it will purchase defines the assets it will not buy.  One bank estimated that the debt of about 10 cities and 16 counties meet its criteria.  It has taken a public health crisis and an economic shutdown of unthinkable proportions for the Fed to move so extensively.  In this unprecedented time, it is impossible to get it right, but one can choose the kind of mistake one is willing to make:  You are driving a car on a narrow twisted mountain road.  You could assume another car is coming around the corner and slow down as you approach it.  If no car is coming, you slowed down for nothing.  Alternatively, you could assume no car is coming, and you speed up to enjoy the thrill, and you find another driver going in the opposite direction had the same idea. As a response to this crisis, it is preferable to do too much than too little.  


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