Market Update: Finding Positives Amid Covid-19 Uncertainty
The Covid-19 outbreak is a human tragedy that we need to be mindful of and sympathetic to. It’s much too early to judge the potential scope of the fallout, but this is a crisis that involves us all, in one way or another. Currently, the global economy is more fragile than we probably want to admit and the de-wealth effects of containment measures could be costly, especially for the everyday worker. However, here’s some good news: those who take a pragmatic approach and find pockets of positivity amid dire circumstances typically prevail.
Below, I offer some views on this rapidly evolving situation and what we can reasonably expect right now.
A circular supply and a demand shock
China accounts for about a quarter of the world’s manufacturing production. So a supply shock seemed inevitable after Beijing moved aggressively to shut down major parts of the economy and quarantine a large percentage of the population.
As an authoritarian state, China has the ability to implement such a dramatic measure quickly. Other governments cannot move as decisively. The lack of proactivity and testing showed early, likely contributing to Covid-19’s spread. However, South Korea’s was one government that mobilized quickly and set a new standard of care. South Korea can now run about 15,000 diagnostic tests per day, free of charge. To date, it has conducted 196,000 tests nationwide. Korean officials have even set up drive-through testing booths for convenience and safety.
Obviously, governments implementing quarantines and encouraging businesses and individuals to be cautious is a good thing, and a necessary step toward containment. Though as time goes on, these measures are likely to create a demand shock. Workers who can’t work can’t get paid. And workers who see their wages fall can’t spend. Monetary and fiscal policy will be critical to restoring a normal demand curve.
A likely hit to GDP growth
Covid-19 exposed the economy’s weak spots. I see two main possibilities: containment measures take effect, the virus shock proves temporary and consumption bounces back quickly. Or, the impact is more severe with a major hit to gross domestic product (GDP).
GDP growth for Q2 is now expected in the 1.0% range and Q3 likely won’t look that much better at about 1.4%.1 Further destruction of imports is the likely culprit. Trade volumes were already down globally due to the trade war that no one talks about anymore. Now, the Covid-19 effects will compound the issue.
The current panic brings the 2008 Financial Crisis to mind as a comparison, especially after the market crashed, circuit breakers kicked in, and trading halted on March 9th. But the Financial Crisis was a situation bubbling under the surface for a long time due to sub-prime lending and lax bank regulations. The response to Covid-19 feels different because of the life and death human element, and its uncertain scope. But like other events, there are multiple factors at play. Currently the underlying risks are how long the uncertainty will persist and whether companies have access to and can service their credit. See below for worst case scenario for banks.
An oil price plunge at the worst possible time
Saudi Arabia starting to play chicken with its oil has not helped. The sell-off in crude began when OPEC failed to strike a deal with Russia over production cuts. Saudi Arabia’s calculated move to ramp up production and damage oil-revenue-dependent Russia in the process caused prices to decline. So now we have more supply just as demand fell due to Covid-19.
As a result, I expect lower production from shale and other high-cost producers, which could be exacerbated by the decline in oil demand. If inventories build and OPEC continues to push the market down, Brent prices could even drop into the teens.
Here are two hypotheses of why the Saudis did what they did:
- A final attempt at OPEC having meaning. As the world moves away from oil, their influence is reduced, this could be one of their last opportunities to have this much power on geopolitics. As such, there is the risk that they will take this price dispute much further than they were previously willing to do.
- To cause disruption to the U.S. shale industry.
Either way, a credit squeeze in the oil and gas sectors is likely. But this situation could be short lived as Saudi Arabia’s current account balance is sensitive to swings in crude prices. Low production costs help the Saudis, but a protracted price war is not in their best interests. The same is true for Russia.
A potential worst case scenario for banks
The biggest concern I have is credit. The potential for a credit crunch coupled with deteriorating loans damaging bank balance sheets is unnerving. Credit shocks have big and persistent effects on labor market conditions.
In a worst-case scenario, banks can’t sell their private debt, compromising their ability to lend. Companies could begin to have cash flow issues, like those on the frontlines of this virus scenario, including airlines, energy companies, and hospitality-focused REITs. When banks can’t lend, defaults increase, and the entire banking system weakens while the economy plummets. Also, a large number of corporate bonds could be at risk of downgrades, creating excess capacity with no demand.
Currently there is no market for Energy related debt. And companies who supply the Energy sector are also facing funding challenges. And don’t forget, the banking sector got burnt in 2015/2016 following the capex cycle within the Energy sector. Don’t expect a repeat this cycle.
On the positive side, for now many companies seem on solid-enough footing to remain solvent until the pandemic passes and supply chains unfreeze. There are segments where revenue is likely to only have a temporary impact. While people are cancelling holidays currently, when the virus is over, there could be an increase in people taking holidays if employment and the broader economy is not severely impaired.
In the case of secured borrowing, the collateral is potentially also impacted in the case of Energy debt. This is not the case for other sectors.
However, the world’s not over and people are resilient
Coordinated efforts from multiple areas can help solve this problem. In the U.S., state and local municipalities seem like they have picked up the slack left by the federal government’s initially slow response to containment. Fiscal and monetary policy responses are likely, and soon. The Fed delivered an emergency 50-basis point cut last week, which seemed to concern markets more than help. Another cut, perhaps by as much as 75 basis points, will likely provide better relief. On the fiscal side, the payroll tax cut will help. And talk of paid sick leave for hourly workers continues to gain steam. The administration could also implement emergency measures that help businesses service debt. Governments around the world are likely to take similar paths.
Yes, the economic impact of this event could be severe and market corrections like this are painful. But the people who comprise the broader economy and the market prove their resiliency over time. Since 1930, if an investor sat out the 10 best return days per decade of the S&P 500, they would experience about a 91% return. If that same investor stayed in the market for the entire period, their return would be 14,960%. And there have been more than a few crises since 1930. So even though the Covid-19 scenario is unprecedented, it’s important to see through the breaking news headlines and hyperbole to focus on solutions.