Reality is setting in, but only slowly

I woke up in the middle of last night. And I checked my phone really quickly. I know I shouldn’t do it. Studies say it’s bad sleep hygiene. But I couldn’t help myself. I was on edge about all of the market volatility and I needed to know what was happening in Asia and Europe.

I immediately went to the screen with the oil market quotes and my heart sank. I saw WTI trading with an $11 handle and Brent with a $17 handle. And then I looked at the indices. The Euro Stoxx 50 was up. The DAX was up. It was a total disconnect.

What’s going on?

I don’t know anymore than you do, of course. But I’m going to tell you how I am thinking about it and why it matters. That’s what this post is about – reality setting in, but only slowly.

Oil as a proxy

Somewhere in the last few days of hysteria in the oil market, my colleague Ash Bennington and I decided to start looking at oil as a proxy for the real economy. I don’t know how we settled on this. But, I think it owes to a lack of price discovery in a plethora of markets due to central bank intervention. That’s where the disconnect between markets and the real economy comes from.

But oil is different. It’s a huge market. And it’s distributed. it’s much harder to distort the market signal. And we need market signals because there’s a huge amount of uncertainty about what the future holds.

Let me give you an example. I caught this Reuters article this morning (actually last night after I checked oil prices. I know, it’s not a good habit). The headline was “U.S. economy likely set for U-shaped recovery after deep rut: Reuters poll“. I’ve been saying that for a long time. It’s obvious. But here’s how Reuters put it:

The U.S. economic recession underway, caused by the coronavirus pandemic, will be worse than previously thought, with more economists polled by Reuters over the past week expecting a “U-shaped” recovery rather than any other option.


In the latest Reuters poll taken April 15-20, before the price of U.S. crude oil fell below zero per barrel on Monday, just under half of 45 respondents based in the U.S. and Europe who answered an additional question said the U.S. economic recovery would be “U” shaped, as represented on a chart tracking economic expansion or deceleration in percentage terms.

Ten said it would be “V” shaped, seven said it would resemble a tick mark, and five said it would be “W” shaped.

But economists, who have spent the last several weeks slashing forecasts by greater and greater amounts, were more doubtful than ever about the country’s growth outlook, now that the longest expansion on record has abruptly ended.

“We’ve never gone through anything like this before. So, anyone who claims to have real expertise in these sort of issues, I think is not being honest. Right now the weakness is pretty dramatic, the economy is weakening pretty sharply,” said Jim O’Sullivan, chief U.S. macro strategist at TD Securities.

A couple of comments here

Who still thinks we’re going to get a V-shaped recovery? I don’t get it. That’s delusional frankly. Maybe their definition of a V is different from mine. But a full 10 of 45 respondent economists think that’s what’s going to happen.

I understand we lack information. But, right now, oil is sending a signal that demand has vanished. I am thinking of it the same way we have thought about electricity usage in China. When you have doubts about the numbers, you look at proxies that can give you meaningful information about directionality and magnitude. In China, electricity usage could do. In the global economy, oil demand can do.

Processing the downturn

My conclusion is that people have thrown in towel on the current situation. They recognize that the global economy is in tatters now and will be for the foreseeable future. They get that. But people are still hoping the economy will snap right back after this episode. That’s where we are right now.

And the equity markets reflect this optimism as much as they reflect central banks pushing people out the risk curve. My sister texted me yesterday because a friend was speculating about a bottom in oil prices and wanted to get into the Oil ETF USO. She knows nothing about oil and is not a financial services veteran. This is emblematic of the period we’re in. There is still a certain sense of denial, a mental unwillingness to believe the longest expansion in history could come crashing down into a pandemic and Depression.

The flip side of that denial is hope. That’s why my heart sank when I saw the oil prices overnight. I guess my hope was that oil prices would stabilize and that this would be a sign that we could muddle through. The hope is that stimulus will be sufficient to eliminate worst case outcomes long enough for the economy to restart. And when it restarts, things will come roaring back because of pent-up demand. That’s the hope. This is why 10 of 45 economists are talking about a V-shaped recovery.

How reasonable a hope is that?

Here’s a thought. Sweden, which has had one of the softest lockdowns so far, could show us what the economy looks like post lockdown. There, bars and restaurants are open and social distancing is suggested, not mandated. That’s the world we are likely to have after our lockdowns finish. So I looked to see what’s happening there economically.

Here are a few tidbits:

That looks like a decent outcome if Sweden is able to keep its infection rates in check over the longer term. I am not advocating the Swedish approach or disavowing it. I’m trying to look at best case outcomes, even as I am generally more focussed on downside risk. And I think this look at Sweden shows you there is some reason for hope. Earnings hits have been less than expected as stimulus and policy support cushions the blow for individuals, businesses and municipalities.

The best case outcome is this muddle through until a vaccine is found (or until we get herd immunity through infection, which would be extremely disruptive and economy-crushing).

My conclusion: Sweden shows us there is some room for optimism. It may not be V-shaped recovery optimism. But it is optimism about the ability to prevent a Great Depression.

Some downside risks

To sum up so far, what I am saying then, is that strict lockdowns have killed the economy. The glut of oil is a proxy for demand destruction. And it shows a very bleak present economic picture. But when lockdowns ease, economies may return to a Swedish state, where some vigour is lost but it is not catastrophic. And we might remain in that sate for a while until the pandemic passes. That’s a U-shaped outcome. And I think that’s a reasonable best case, not a V-shaped outcome.

There are considerable downside risks. I pointed to one in the US yesterday. And that’s shale oil. Yesterday marked the end of US energy independence. I saw Bloomberg echoing this theme today:

For shale companies, the price of West Texas Intermediate crude went from hunker-down-and-ride-it-out mode to crisis mode in just a few days, with many now unsure whether there will even be a market for their oil. Some 1.75 million barrels a day is at immediate risk of shutting down while the number of new wells being brought online is forecast to plunge almost 90% by the end of the year, according to IHS Markit Ltd.

In short, it’s a swift and brutal end to the shale revolution, which only last year had President Donald Trump proclaiming “American Energy Dominance.”


Even at $15, “everything back in the field, except the newest and most productive wells, is losing money on a cash-cost basis,” said Raoul LeBlanc, a Houston-based analyst at IHS Markit. “At this price you’ll start shutting in large amounts of production.”


“A good portion of production, particularly areas of the Bakken and Oklahoma, will go away completely,” said Barrett, whose employer manages $356 billion. “Fresh capital will be needed to grow off that lower base. But there’s zero appetite for that in the foreseeable future.”

It’s a good piece. Read the full thing here.

What it means is massive job losses and an economic malaise in the formerly buoyant shale oil regions of the US. And these good-paying jobs simply aren’t coming back.

Then there’s retail. And we’re not talking about just the most vulnerable but the entire mass of brick and mortar retail shops. The New York Times has a good write-up on this. The risk is liquidations, not just bankruptcies. I like to use Linens ‘n Things as my example from the GFC because I was a customer. Overnight, it went from being indistinguishable from Bed, Bath and Beyond in my head to being closed everywhere, liquidated. Borders is another example. For those of you in the midwest, Bon-Ton is a third.

We all remember the iconic stores that have shuttered after each downturn. In DC, where I am, in the 1970s, we had Kann’s, Woodward & Lothrop, and Garfinkels as three of the largest department stores. They’re all gone. Bankrupt and assets bought or just liquidated. It took three or four recessions to kill them all off.

This process will be greatly accelerated now. Shopping has changed for the long haul, maybe permanently. More and more will get done online. JCPenney, Sears, Macy’s. They’re all in jeopardy. Neiman Marcus is poised to file for bankruptcy in days. Many malls have these stores as anchor tenants. The closest mall to me has Neiman Marcus as its anchor. If it goes, that mall is in a world of trouble.

And, of course, this means a loss of jobs. It also means a collapse in commercial real estate prices as a glut of space comes onto the market. For malls, when the anchor tenants disappear, other tenants disappear as well. At a minimum, rent prices will go down. A co-tenancy clause in many retail lease contracts permits retailers to have their rent reduced if anchor tenants, or even a certain number of tenants, leave a retail space.

For newly-built retail spaces like Hudson Yards in Manhattan, this is a nightmare. I lived in that area years ago and there was no infrastructure to support the massive building that has gone on with the Hudson Yards project. Restaurants, dry cleaners, banks, public transport lines – they are all in relatively short supply. Neiman Marcus is an anchor tenant a Hudson Yards. Given what’s happened in New York City with Covid-19, that project is now in trouble.

My view

I could have gone on and on with the downside risks. They are so innumerable that at least some of them will crystallize. This is one reason to rule out a V-shaped recovery. The Hudson Yards example gives you a sense of where this is headed though. That project is too big to fail. There will be a bailout if things go pear-shaped. And so, the massive government intervention we have seen will likely be with us for some time in order to take worst case economic scenarios off the table.

What does all of this mean for shares? I think the Ericsson and Handelsbanken earnings reports give you a sense of best case outcomes. That’s at least a 20%-30% haircut to earnings for an extended period of time, even after the acute phase of earnings decline is over. I don’t think any of this is priced in yet.

I see the oil price fiasco as a denouement of what’s to come elsewhere. And so, my overall stance here is one where the asset allocation is skewed toward cash and government bonds over shares and corporate bonds.

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