All eyes today are on the Federal Reserve because the Federal Open Market Committee is due to release its policy statement. There is an unusual amount of interest in what Fed Chairman Jay Powell says at the subsequent press conference because of unusual amounts of speculative activity driving US equity markets of late.
Meanwhile, some downbeat real economy data is starting to come through that makes me doubt how long-lived the re-opening recovery will be. And so, the continuing and increased disconnect between asset markets and the real economy will be a central focus regarding Jay Powell’s commentary later today. Thoughts below
The US economic recession
We now know that the US economy fell into a recession in February 2020. And while I mused in early March that we might have been in recession, that February date still requires a little explaining since it is so early in the calendar year.
As the National Bureau of Economic Research puts it, “a recession begins when the economy reaches a peak of economic activity”. That means the start date of a recession is from the peak of an economic cycle. And so, the deceleration phase of the economy from that peak is part of the recession.
What the February date indicates is that the US economy was indeed accelerating before the Covid-19 pandemic, just as I was saying at the time. But when China was hit and supply chains broke, sometime in February that acceleration turned into deceleration. And when the lockdowns in the West began, growth deceleration turned into contraction, confirming a recession, rather than a mid-cycle slowdown. But, the NBER has dated the recession from February because that’s when the slowdown into contraction began.
Recently, I have been writing as if the recession is already over without explicitly saying so. That’s because I don’t know when the recession end date will be set by the NBER. Nevertheless, I strongly suspect that an initial economic snapback from the re-opening will be so large that the NBER may be forced to date the recession end in May or June. For me, it all depends on how economic and employment growth proceeds in the coming months. But, the jobs numbers released last week suggest that the recession may be over.
Forward-looking economic analysis
But that’s the past. What about the future? I look at last month’s jobs data with scepticism. The jobless claims data, which is the real-time economic data series I like best in following cyclical turns, says we are still mired in a period of extreme job losses. So, I am going to need to see much more corroborating data to believe the last jobs report represents a turning point.
What concerns me going forward are three things:
- Consumption shortfalls and consumer preference shifts
- Bankruptcies and the related economic distress and job loss
- Second or third waves of coronavirus outbreaks
Let’s look at each of these in turn. And I am going to start with a recent German account to make my point on the first item. And that’s because the re-opening there is further ahead than it is in the US and there is no longer a great fear of a big second wave in Germany.
Here’s what Handelsblatt is saying about the restaurant industry (link in German with my translation below)
After just a week, the tradition-rich Munich Hofbräukeller has closed again. “All interior seating will be closed from June 2nd 2020 until further notice!”, the owner family Steinberg said on their homepage. Several hundred guests can be catered to inside the Hofbräukeller.
But many tables have remained empty. It’s especially tourists, both from inside Germany and abroad, that are missing, who otherwise come to Munich in droves. The self-service beer garden and the outside terrace remain open, but only in good weather. “Unfortunately, this path is currently the only sensible solution for us,” said the Steinberg family.
Since mid-May, restaurants, cafés and beer gardens in this country have been allowed to gradually open again – after around two months of forced closure due to the coronavirus pandemic. But as with the Steinberg family, the joy of most restaurateurs is limited: With strict rules for the distance between the tables, no guests and high running costs, operating is often not financially worthwhile.
The balance sheet of restaurants and cafés after the reopening is sobering: Eight out of ten restaurateurs say that economic activity is not possible under the coronavirus requirements. This is shown by a survey by the German Hotel and Restaurant Association (Dehoga). For the full year, the companies expect a decline in sales of at least 55 percent. Various state aid schemes won’t even come close to making up such a shortfall.
This is a catastrophe. The restaurant industry in Germany employs 775,000 people. By comparison, the auto industry employs 800,000. So, the restaurant sector is very important for employment. But the fact that it is dominated by small and medium-sized businesses makes it hard to bail the industry out as consumer preferences and coronavirus restrictions kill business. That will mean bankruptcies and massive job losses in the future – not in the past, but going forward, as altered consumption preferences remain in place.
Retail bankruptcies
The retail sector is another industry where the rubber hits the road for bankruptcies. Yesterday, a national study predicted up to 25,000 retailers could close this year alone. Bloomberg has written that many of these are in malls. And so, there is a limited number of companies that can replace these businesses given that all retail companies are under assault, particularly in places of mass gathering like malls. No one is going to take over these leases. So, that tells you commercial real estate and commercial REITS will be hit. Again, this also means job losses going forward, not the past.
Obviously retail and restaurants aren’t the only industries that will see major bankruptcies. There will be a lot of other bankruptcies too. So we have to think about how that impacts credit provisioning.
When we see major bankruptcies, we are going to get credit writedowns in the financial sector. I am mostly sanguine about the ability of the US banking sector to handle the writedowns. First, large bankruptcies will have much of the risk distributed amongst asset managers rather than banks. And second, US banks are better capitalized now than they were in the last credit cycle. So that means lending can remain buoyant, even in the face of credit losses as long as there are creditworthy companies willing to take on and roll over debt.
The worry with regard to bankruptcies has to be in Europe, where banks are not well-capitalized, and where some banks have taken suspiciously low charges to increase loan loss reserves. Europe is also less geared toward securitizing loans. So, the risk is more concentrated on bank balance sheets rather than in the hands of asset managers. To me, that suggests that credit growth, and, therefore, economic growth will be hampered by European financial sector fragility.
The virus – don’t call it a comeback
The last worry is the coronavirus which is causing all of the disruption. You would think from asset markets that the coast is clear. But, unfortunately it isn’t. And some of our worst fears may already be coming true regarding the virus.
First, there is the ravages in Latin America, India and, soon, Africa.The New York Times is reporting that cases have surged both in places like Brazil that have ignored social distancing protocols and in countries that took early isolation measures like Peru. The case count in Peru is almost as high as it is in Italy. The New York Times also reported yesterday that “[i]n just 24 hours, India reported 10,000 new cases, for a total of at least 266,500, surpassing Spain to become one of the five countries with the highest caseloads.” Outside of South Africa, Africa has yet to make headlines. But, I think it’s only a matter of time before the continent’s healthcare system becomes overwhelmed. That’s negative for supply chains, since many raw materials are exported from these countries.
The US has to also be a big worry now too, unfortunately. Here’s the report from the Washington Post:
Coronavirus hospitalizations rise sharply in several states following Memorial Day
As the number of new coronavirus cases continues to increase worldwide, and more than a dozen states and Puerto Rico are recording their highest averages of new cases since the pandemic began, hospitalizations in at least nine states have been on the rise since Memorial Day.
In Texas, North and South Carolina, California, Oregon, Arkansas, Mississippi, Utah and Arizona, there are an increasing number of patients under supervised care since the holiday weekend because of coronavirus infections. The spikes generally began in the past couple weeks and in most states are trending higher.
Data from states that are reporting some of their highest seven-day averages of new cases is disproving the notion that the country is seeing such a spike in cases solely because of the continued increase in testing, according to data tracked by The Washington Post.
Many of these states that have experienced an increase in cases have also had an increase in hospitalizations, with a handful of states also nearing bed capacity.
Translation: The US is experiencing a second wave spike as we speak. It’s not in the first-wave cities, but in areas that weren’t hit hard and where lockdowns were relaxed prematurely and without adequate coronavirus protocols in place.
The question is what this will mean for public health, the economy and politics. It’s not clear yet. But it does present the US with downside risks.
My View
If I take the information flow presented here in its totality, I would say it is at odds with the euphoria in asset markets and the V-shaped recovery narrative supporting those markets. The forward-looking economic and healthcare risks are large and rising. In terms of the dispersion of likely outcomes, I see a V-shaped recovery as one of the least likely.
Most likely, we will see a snapback that is attenuated by enduring shortfalls and consumer preference shifts, by bankruptcies and the related economic distress and job loss, and by second or third waves of coronavirus outbreaks. How attenuated the snapback is depends on how large these risks become. I believe there is at least a decent possibility that we have a recession-snapback-deeper recession outcome.
In the face of these risks, the rally in shares looks completely overdone. And all of the anecdotal and statistical evidence that this rally is being driven by small retail investors makes me worried about the consequences. The most beaten up sectors are being bought up as people speculate that the worst is behind us. For example, look at this story on Macy’s from Bloomberg:
Daniel Kretinsky’s bet on Macy’s Inc. turned out to be short but profitable, and the Czech billionaire might jump back into the stock again if the price is right.
His Vesa Equity Investment said Tuesday it owned 0.7% of the U.S. department-store chain, down from the 5% stake unveiled less than a month ago. The investment, billed as a strategic move at the time, coincided with a 65% surge in the stock. Kretinsky made roughly $36 million if he bought Macy’s shares the day before disclosing his 5% stake and sold them on Tuesday.
“The reason for our exit certainly isn’t lack of confidence in the company’s future or in the management’s abilities,” said Vesa Equity spokesman Daniel Castvaj. “We will continue closely watching Macy’s and the U.S. retail market in general and we are not ruling out returning among the shareholders of this company.”
Macy’s is beginning to reopen stores following weeks of lockdowns. The company just reported a 45% quarterly sales slump and a net loss of $630 million. Despite the recent rebound, the stock remains down 48% for the year. It was removed from the benchmark S&P 500 Index in March, and Fitch cut the company’s credit rating to junk in April.
Translation: In the crash, it was throw the baby out with the bathwater. Value investors saw good companies like Macy’s trading at compelling prices. So they bought in. But as the retail investor-driven mania bid these prices up, savvy investors sold out because the prices became too rich. They are now waiting for the bubble to burst in order to get back in.
Did the Fed do this?
That’s the question Jay Powell needs to answer today. It does seem the takeaway in asset markets is now that the Fed will do whatever it takes to keep asset prices from falling too aggressively, even if that means buying junk bonds, and, potentially equity ETFs down the line. So, the thinking is that the downside risks are limited. Or as day trader Dave Portnoy put it yesterday, “I’m sure Warren Buffett is a great guy but when it comes to stocks he’s washed up. I’m the captain now. #DDTG”. He says, “all I do is is make money. This game’s so f***ing easy.”
Caveat Emptor