March 2020 Macro Commentary
Social Distancing and Travel Lock-Downs are Working….
But the economic impacts are unprecedented
Will we see a prototype of Modern Monetary Theory?
by Sanjay Khindri, CFA
The U.S. now has the world’s highest number of total “reported” Covid-19 cases, with 40% of those cases in the state of New York. The trend in the rate of U.S. case growth has slowed in recent days, particularly in New York. The graph belows shows that measures to contain the virus have been working:
Source: www.worldometers.info, Gallatin Capital Management
If the U.S. as a whole follows the experience of Italy, South Korea and New York, we can expect new daily cases to peak in a couple of weeks, followed by the peak in death rates. This is a tenuous assumption, however, given recent spikes in cases in certain states and the White House’s statement that we could see over 200,000 deaths.
The bottom line is that while news reports will focus on the absolute number of deaths, death rates lag new case rates, and new case rates have been falling for the past week.
The more pressing question for investors is: what is the ultimate economic and corporate earnings impact from this global pandemic? Unfortunately, we don’t have any historical data to help us answer this question, because this recession will be unlike any we’ve experienced in the modern economic era. During the financial crisis of 2008/09, real GDP fell for four straight quarters, with the largest quarterly drop in annualized terms at a little over 8%. Annual GDP growth for 2009 as a whole was -2.5%. Current Wall Street estimates for 2Q ‘20 annualized GDP growth range from -15% to -35%.
In a normal recessionary environment, growth deteriorates in a more measured way, allowing firms to adjust cost structures and manage through liquidity constraints. The necessary response to the Covid-19 pandemic, however, has concentrated the majority of economic damage within a very short period of time. This will have consequences for jobs, corporate earnings and company capital structures that we can’t quite comprehend yet.
In last month’s commentary, I talked about the hesitancy to deploy excess cash. While the S&P 500 has declined approximately 28% from its February peak (as of the time of this writing), the decline masks the dispersion in returns beneath the surface. First, note that this decline in markets is mild when compared to the peak-to-trough decline during the financial crisis (-42%). Second, the unprecedented nature of this contraction (“out of sample” in statistical terms), provides no benchmark for a scenario analysis. These two factors render a meaningful increase in passive market risk (i.e. “beta”, or index buying) highly unattractive.
Furthermore, even if the economy realizes a V-shaped recovery, the rapid loss of cash flow and decline in liquidity will leave the over-levered corporate sector in a permanently impaired position. This will lead to structurally higher credit spreads (increased cost of debt financing) which imply a structurally lower price-to-earnings ratio (P/E) for equity markets (see graph below).
That being said, we are, and have been, selectively adding equity risk on a bottoms-up basis. This means increasing exposure to only those companies whose valuations are pricing-in very draconian outcomes, that can manage higher debt loads and/or those companies whose secular growth stories remain intact. These situations are present, for those willing to put the work in.
Leverage in the economy shifted from the consumer before the Financial Crisis to the corporate sector today (red line = consumer leverage, blue line = corporate leverage)
Modern Monetary Theory
Governments and central banks around the globe have responded forcefully to the coronavirus outbreak. Central banks were first to act by supporting liquidity in the financial markets. Governments have followed suit with massive fiscal stimulus measures. In response to the financial crisis of 2008/09, the U.S. government passed stimulus measures amounting to 5 to 6% of GDP. The $2.1 trillion Coronavirus Aid, Relief and Economic Security Act (CARES Act) amounts to 10% of GDP and the White House is now talking of a $2 trillion infrastructure bill, which would have democratic support.
Government spending of 20% of GDP (pre-virus GDP) would generally be regarded as financially reckless, causing an untenable spike in interest rates. However, the Federal Reserve has committed, for the time being, of purchasing as much Treasury debt as needed to maintain market stability. The economy, and markets, cannot handle a meaningful rise in interest rates at this time. The implication is that further government stimulus spending will be monetized by the Federal Reserve (i.e. the printing of new money).
This is in essence what Modern Monetary Theory (MMT) is all about: the government spends as much as necessary to achieve full employment, with the source of funds obtained by printing more fiat currency. If there is any time at which MMT can be tested, the time is now, because the U.S. government and the Federal Reserve are currently inherently linked. Lawmakers may not realize what fundamentally is happening, but investors should pay attention carefully for how this experiment unfolds, and the implications it may have for future economic and fiscal policy.
1Consumer leverage is represented by: “Households and Nonprofit Organizations; One-to-Four Family Residential Mortgages and Consumer Credit as a Percentage of Disposable Personal Income; Liability, Level; right side
Corporate leverage is represented by “Nonfinancial Corporate Business; Debt Securities and Loans; Liability, Level divided by National Income: Corporate profits before tax (without IVA and CCadj); left side
Gallatin Capital Management, LLC
Important Disclaimer: This material is for your information only and is not intended to be redistributed or used by anyone other than you. The information contained herein should not be regarded as an offer to sell or a solicitation of an offer to buy any financial products. This material, including any investment recommendations herein, is intended only to facilitate discussions with Gallatin Capital Management as to its investment offerings and strategies. The given material is subject to change and is not guaranteed as to accuracy or completeness and it should not be relied upon as such. The material is not intended to be used as a general guide to investing, or as a source of any specific recommendations.