COVID-19 Diary Number 2 (April 6, 2020)

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Though no one can yet say how the virus will continue to develop in the U.S., and therefore how the markets will go, a review of the past few weeks can allow this conclusion (with apologies to Winston Churchill at the end of the Battle of Britain): This is not the end or even the beginning of the end, but it is the end of the beginning.

Whenever markets suffer a shock – a collapse somewhere in the economy, natural disaster, war – participants panic.  This happened in March as the extent and severity of the Covid-19 pandemic became apparent.  Such panic could of course return if markets were to suffer another terrible surprise, but their recent behavior suggests this beginning phase of the market correction seems to have ended:

  • Equity prices have clawed back some of the ground lost to March’s panic. Stock prices fell precipitously between February 21, and March 23, with the benchmark S&P 500 stock index sliding almost 35 percent in just some four weeks, wiping out all the impressive gains of the prior three years.  Since then, investors seem to have recovered the sense that perhaps pricing had anticipated the worst, especially since the Federal Reserve (Fed) and the government have initiated policies to mitigate if not erase the recessionary effects of the measures needed to fight the spread of the virus. Pricing has begun to improve.  Stocks have risen some 19 percent from those lows, still some 21 percent below the highs of February, but a sign that panic has passed for the moment. 
  • Bond markets, while still fearful, remain relatively stable. On the first news of pandemic, Treasury yields fell precipitously, with the yield on the 10-year note dropping from just under 2.0 percent at the end of January to just over 0.6 percent by mid-March. To a large extent, the move reflected the Fed’s efforts to drive down all interest rates and bond yields. A flight to quality also was an element here.  As investors sold off bonds issued by entities with lesser credit ratings and put the proceeds into presumably safer Treasury issues, the yields on all other bonds actually rose, widening the yield spread lesser credits offered over Treasuries from a little over 3.5 percentage points late in February to just over 10.5 percentage points late in March.  This was not as high as the 20 percentage point spread that prevailed for a while in the Great Recession of 2009, but it’s hardly a sign of confidence. (This post will brief you on how bond prices and yields interact.)  The past few weeks have seen only modest improvement.  these yield spreads have declined to some 9 percentage points –– hardly much improvement but nonetheless a tentative sign of relative calm.
  • Commodity markets tell a similar story to bonds.As the lockdowns and quarantines effectively shut down the economy, industrial materials prices dropped quickly. Copper prices illustrate the common story, falling by almost 20 percent from early to late March. Oil prices did worse, falling some 40 percent during this time, though extra pumping by Saudi Arabia (because of a dispute with Russia) exaggerated the general price retreat. Prices of oil, copper and most industrial materials have since risen slightly –– again, not a sign of confidence but at least a halt to the earlier panic.
  • Currency markets, in contrast, have all but corrected their earlier panic.  When the seriousness of the pandemic first became evident, money moved toward dollars, as it does in almost every emergency.  A global index of the dollar’s value rose some 5 percent, but has nearly returned to its level of early March.  Some might interpret this as a sign that Covid-19 infections in the U.S. have risen, but on a per-capita basis the American infection rate is no worse than in most developed countries and a good deal better than some.  The movement away from the dollar speaks to a lessening of panic.

All this could change if COVID-19 changes its course.  If it worsens, panic could reappear, and the markets would return to their levels of late March or even lose more value.  But if the effects of the disease ease and promise a return to more normal levels of economic activity, the relative calm of recent weeks suggests that markets could regain ground quickly.

The Computer’s Role in the Recent Wild Market Swings

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Computerized stock trading has played a not-insignificant role in recent violent stock market swings.  Of course, behind these swings are the perennial drivers of market lurches: fear and greed.  Fear rules whenever investors feel insecure or uncertain, but it’s greed’s turn when investors judge that the fear has created a buying opportunity that despite uncertainty and insecurity, they feel they cannot afford to miss.  But computerized trading exaggerates what otherwise might be significant swings into wild volatility.  We have been seeing a lot of this.

The computer’s role exaggerates market swings because most if not all of the algorithms running these programs react to the momentum of the market.  If investors begin selling out of fear and stock prices fall at a particular rate or beneath a certain point, the computers “see” further losses and “order” even more sales, thus ensuring that further losses take place.  Investors  rushing to buy a stock will trigger the computer programs to join in.  These investor moves, once they prompt the algorithms to act, become self-fulfilling and greatly exaggerated.

For those who find this unnerving, here are four things to keep in mind:

  1. For the computer, eternity begins and ends each day. They go with the momentum until the market closes (or, less likely, something like human action alters the momentum despite the influence of computer trading).  The computer action does not follow from one day to the next.  
  2. Though computerized trading exaggerates up and down moves, it has no effect on prices over time. Such trading can be an irritation for the fundamental investor seeking to meet the basic objectives often referred to in these posts, but don’t consider it anything more than that.  The market in the closing weeks of 2018 certainly demonstrated this:  Computerized trading pushed the downdraft in stock prices much further than it otherwise might have gone, and then exaggerated the upswing the following dayThe same thing is happening now.
  3. Individual investors who try to gain from computer-induced swings by buying and/or selling stocks ahead of the swings are as likely to lose as to win. Traders buying and selling algorithmically make money because computerized trading enables them to move blindingly fast –– faster than most professional investors and certainly faster than any retail investor –– that would be you.  (In fact, most of these operations have their computers physically near the exchange, because a profit opportunity can be missed in the less-than-instantaneous time it takes an electronic order to reach the exchange from, say, an office in Connecticut.)  Even at such speed, algorithmic traders can only make money by squeezing pennies or less out of a single transaction; it is worthwhile for them because they deal in huge stock volumes.  No individual investor can do this.
  4. Computerized trading violates a fundamental rule for the retail stock investor: Even without the added volatility of computerized trading, stocks exhibit considerable volatility. This is a fundamental aspect that should warn investors off stock investing if there is any chance they will need their invested money in a hurry.  If you cannot wait for the  market’s ups and downs to cancel each other out and give you the long-term positive gain of stocks, then you should not be in them in the first place.  Better to be in bonds or savings accounts. 

 

An Update: The Covid-19 Recession

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The U.S. economy – and the rest of the world – is at the gates of a severe recession.  The economic downturn is emerging neither from the COVID-19 virus nor from its threats of debility and death.  It is the quarantines, the lockdowns, and the supply constraints that have created a powerful recessionary thrust, because the longer those pressures last, the greater the possibility of more fundamental layoffs, shutdowns, and bankruptcies.  Efforts by the Federal Reserve (Fed) to ease monetary policy may blunt the recessionary dynamic, as will the fiscal stimulus measures, such as tax cuts, contemplated by the White House.  But what would really help is if Washington and the states focused on the specific drivers of today’s emergency and thus break the chain  dragging us into recession.

The situation today is very different from a typical recession.  Downturns usually grow out of shortages in demand.  Governments combat demand shortages by spending themselves and by offering people inducements to spend, for example through low interest rates or tax cuts.  The coronavirus emergency has instead imposed a shortage of supply.  Quarantines are keeping people from productive jobs, first in China and now globally.  Working from home cannot fill that gap, especially with factory work as well as many service industries.  The consequent shortfalls in production have denied other production operations the parts and materials they need to meet their output schedules.  Consumers who are otherwise eager to spend face a paucity of options as public health measures have closed restaurants, events, and retail facilities.  Though the demand for goods and services remains, it is supply constraints that are limiting economic activity.

A recession will arise because these stymied demands cannot last if the shutdowns and quarantines persist.  Businesses may keep idle workers on the payroll for a while, either in response to government mandates or from loyalty, but the businesses (which must also pay taxes, rent, and interest on their debts) cannot long meet these expenses in the face of shortfalls in revenues imposed by the closing of businesses and public spaces.  Companies are reaching that limit quickly and when they do they will have to turn to more permanent layoffs and staff reductions.  Many businesses––small firms especially––will face bankruptcy, leaving employees without income and many suppliers and landlords facing additional revenue squeezes. Other businesses in less difficult straits will nonetheless shelve expansion plans, leaving producers down the line facing a shortfall in demand for their products. The number of companies in this situation will grow the longer the present economic pause persists, and the greater that number gets, the deeper into recession the U.S. and the world will fall.

Monetary easing, such as the Federal Reserve (Fed) has recently implemented, and the kinds of fiscal measures being contemplated by the administration, could blunt such recessionary effects. But it is highly doubtful that such measures can fully counteract these recessionary forces once they gain momentum.  It would be better to take additional, if less common, measures to help stop the transition from today’s “pause” to the layoffs and other cutbacks that will bring on recession. Though not a complete list, here are five suggestions for what needs to be done:

  1. During this time of emergency, Washington should enable the Small Business Administration (SBA) to make low-interest or zero-interest loans to help small businesses sustain payrolls and stave off bankruptcy. Under the standard rules of disaster relief, the SBA has made provisions for loans of up to two million dollars, but this emergency requires larger amounts extended over a longer repayment period.
  2. States and cities could bolster such an effort with similar programs of their own, and the federal government could support them by changing the rules to allow states and cities to raise money by offering tax-free bonds for such targeted lending.
  3. Though large firms have the financial resources to hold out longer than small ones, these larger ones, too, cannot survive the current pressures indefinitely. They could get essential help if Washington were to offer them “special lending,” perhaps contingent on maintaining payrolls.  Such loans could come from the federal government directly or they could be organized between the Fed and the banking community.  While the Fed has never made such arrangements for commercial and industrial endeavors, it certainly has done so for banks and other financial firms.
  4. Washington and the states might prepay (in effect, pay ahead) existing contracts for one or two years enabling those firms to use the immediate cash flow to cover expenses during this emergency.
  5. The nation’s retailers might obtain similar help from arrangements that allow consumers to prepay future purchases at a local shop or favorite restaurant, with the inducement, perhaps, of a discount. Many firms already offer such “gift cards,” but today’s greater need might involve help from local chambers of commerce or even city governments.

More imaginative people could add to this list.  Normally such admittedly unusual arrangements would not be necessary, but these are hardly normal times.

 

 

 

 

 

 

 

 

 

More on the Economics of the Coronavirus

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Let me begin by framing this essay with what is obvious: we, and the world, are in a highly fluid situation. With COVID-19 intensifying in the U.S., there has been clamoring for Washington to take action to protect the economy.  The Federal Reserve (Fed) has just cut interest rates again (March 15).  President Trump’s economics team has floated the idea of payroll tax cuts.  To many, these responses seem wholly inadequate and in many respects they are.  Tax cuts and lowering interest rates will not stop the spread of this still-mysterious disease.  Nor will they do much, if anything, to ease the supply interruptions created by COVID-19’s economic havoc thus far.  Such actions would help, however, if the virus endures and precipitates a classic economic retrenchment.  In that case, the present and contemplated policy moves will look wise.

The immediate futility of such policy measures is evident in the nature of today’s economic fallout.  The disease’s spread has kept workers from their work, not only those who are sick but also the far greater number who worry and have been warned about contagion. In reaction, much of daily activity in the country has been curtailed, including public school systems, universities, sports events, restaurants, museums, theaters, concert halls and more.  Output has slowed in China and increasingly across the world.

China’s problems are among the most pronounced.  It is where COVID-19 got its start and remains most severe.  Statistics are scarce.  Most telling is the release by China’s purchasing managers of February statistics.  Their index of production, in which the value of 50 delineates the line between expansion and contraction, showed a drop of more than 20 percent, falling from 51.1 in January to 40.3 in February.  The manufacturing subsector fell to a low of 35.7.

Problems, of course, have extended beyond China.  That country’s quarantines have cut off the huge and lucrative flow of moneyed Chinese tourists to Japan, South Korea, North America, and Europe.  And producers in these and other countries have found it increasingly difficult to get needed supplies and parts from China.  Apple, for instance, sources many of its products there.  The United Auto Workers recently hinted that General Motors may have to close some of its plants because of a lack of parts, and it appears that some 125 prescription medicines in the United States will be unavailable because of a lack of China-based ingredients.  As the virus has spread to Europe and North America, cutbacks in travel and work have repeated the Chinese problem and added to supply and parts pressures elsewhere in the world.  Neither interest rate cuts nor tax cuts can do anything to address these matters.

  • Lower rates might otherwise encourage borrowing for capital investment and expansion, but it is highly unlikely that businesses will invest or expand when concerns about contagion are otherwise idling existing facilities.
  • Tax cuts might otherwise increase take-home pay and thus induce people to work and spend more, but it is questionable how effective such policies would be if people are afraid of catching the virus and managers are telling existing workers to stay home.
  • And neither action will restart the flow of tourists from China or its shipments of parts and supplies.

Tax and interest rate cuts only can help in the case of classic recessions, which involve a drop in demand for goods and services.  The problem today is a shortage of supplies, parts, and workers.  Should, optimistically speaking, COVID-19 run its course relatively quickly, as SARS and MERS and other similar pandemics did earlier, people would soon return to work, supply chains would resume functioning, and economies would soon rebound, which is what happened in the case of past viral outbreaks.  In such an environment, lower interest rates and lower taxes would do little to accelerate the process and would be useless, except perhaps to calm nerves.

But this does not mean that the policies already implemented or contemplated have no purpose.  There is no guarantee that COVID-19 will follow past patterns.  If it persists, continuing supply shortfalls and bottlenecks will generate layoffs (of which there already is evidence) instead of pauses and work-at-home arrangements, leading to a drop in consumer spending.  Supply problems of long duration would lead to other and more permanent cutbacks, including bankruptcies, which would compound the shortfalls in demand and would bring on a classic recession (of which there already is some evidence). In these circumstances, the demand stimulus of interest rate cuts and tax cuts could perform important counteracting roles,  and such stimulus actions would look prescient in retrospect.

It hardly matters whether policy-makers in Washington are thinking about this longer-term possibility or are simply trying to calm nerves by “doing something.” The interest rate cuts announced by the Federal Reserve on March 15 and earlier in the month, as well as ongoing tax cut considerations, though they may look inept in light of immediate problems, would nonetheless position the U.S. to deal forcefully if the world, in its efforts to combat COVID-19, doesn’t have the relative luck it had with SARS, MERS, Ebola, and other outbreaks.