Markets are trying to find their footing after another Sunday night surprise.
Our Top Market Takeaways for March 16, 2020.
Beware the Ides of March
If you missed last week, it was a wild one. When the dust settled, the S&P had lost -8.8% last week (its second-worst week since 2008), 10-year U.S. Treasury yields were at 0.97%, investment-grade credit spreads were around 250bps, and high yield bonds spreads were close to 760bps. If you want to catch up, check out our updates from last week here.
It’s already been a busy week, and it’s only Monday morning. The Fed stepped in overnight on the Ides of March with another emergency dose of monetary stimulus and cut interest rates to zero (ahead of its scheduled meeting on Wednesday). Equity markets tumbled following the news, with S&P 500 futures opening trading down -5%, triggering their limit-down circuit breaker. The Stoxx Europe 600 is already down around -8% this morning, adding to losses in Asian equity markets overnight (China’s onshore CSI 300
-4.3%, Japan’s TOPIX -2.0%). U.S. 10-year Treasury yields fell as low as 0.62% amid the announcement but have since ticked back up to 0.81%.
Let’s get you up to speed with some Q&A.
Q: So what exactly did the Fed do?
A: Well, the Federal Reserve lowered the policy rate to zero on Sunday night and re-launched Quantitative Easing (there won’t be any pedantic arguing this time, this is QE for real). The Fed will purchase at least $500 billion worth of Treasury bonds and $200 billion of agency mortgage backed securities. The Fed also lowered the discount window rate to 25 bps and reduced the reserve requirement ratio to zero. They also announced joint action with five other central banks that will increase U.S. dollar liquidity though swap lines.
If you don’t remember Monetary Theory and Policy class from college, just remember that all of these measures are robust ways to keep markets functioning smoothly and to keep credit flowing to the real economy.
Our sense is that Chair Powell was probably hoping that markets would cheer his decisive action, but we won’t judge efficacy on a few hours of trading. Overall, this seems like a good first step from the Fed.
Q: Remind me, what is QE and what is the point?
A: Quantitative easing is a fancy way to say that a central bank buys securities with newly created money. This has a couple of results. The first of which is that banks have more liquidity to use to fund loans to the real economy. The second is that asset prices rise, which reduces the cost for companies to issue debt and equity, and should stimulate consumption. Finally, asset price inflation also makes holders of assets wealthier, which induces more spending.
Q: What about those other things? The discount window and the reserve requirement and all that?
A: Remember, all of these things are to make sure that credit is flowing effectively to the real economy. Banks from around the world can borrow from the discount window to make sure that they have all the liquidity they need. The Fed lowered the discount window rate all the way to the upper bound of Fed Funds. This is all to incentivize banks to forget the stigma and to use the discount window to meet any unexpected funding needs.
The reserve requirement is the amount of money that banks have to keep on deposit at the Fed. By lowering that amount to zero, it frees up more money to be lent to households and businesses.
Q: And the swap lines?
A: Basically, swap lines are inter-central bank facilities that allow central banks to provide foreign currency funding in their own jurisdiction. For example, the European Central Bank can provide borrowers with U.S. dollars during times of market stress. In recent days, there were signs of stress in USD funding markets, and the reduction in rates for the swap lines will make it easier for foreign banks to access dollars.
Our view is that this should increase the supply of dollars around the world and push down the dollar relative to other currencies.
Q: So what else can the Fed actually do? And is it going to be enough?
A: The Fed’s main concern is making sure that credit can continue to flow to those who need it. The basic premise is to make sure borrowing costs overall are below expected returns one might earn.
One possibility if things deteriorate further is a program that incentivizes the financial system to keep credit flowing to stressed corporate borrowers. This would help bridge a gap in cash flows that is likely to come from decreased economic activity due to COVID-19. This could generally be similar to the TALF program during the financial crisis, which offered funding to the financial system at below-market rates, as long as the proceeds were used to make loans to the most stressed companies.
Outside the United States, Australia, Norway, Hong Kong, the United Kingdom and many others all came in with rate cuts last week. The UK government also announced a comprehensive fiscal stimulus plan to support the UK economy during this time of duress. The European Central Bank (ECB), however, disappointed investors last week after its announced stimulus measures fell short of expectations. The ECB kept its deposit rate unchanged, and only marginally ramped up QE and its targeted longer-term refinancing program. With Europe the new epicenter of the COVID-19 outbreak, investors are calling for pronounced fiscal stimulus to cushion the economic blow—however, while most seem to be in agreement such fiscal stimulus is needed in Europe, it remains politically difficult.
If you are overwhelmed, you aren’t alone. Just remember that the Fed and Central Banks around the world have to make sure that the financial system is incentivized to keep lending to the parts of the real economy that are most at risk from coronavirus. They are off to a good start, and the Fed’s surprise announcement may (eventually) be positive for markets.
Q: Why did the stock market like President Trump’s Friday press conference so much? What other fiscal policy seems likely?
A: Monetary policy can help keep credit flowing, but, as we mentioned in our outlook, fiscal policy seems like a more effective tool to mitigate disruption. In his address on Friday afternoon, President Trump declared the pandemic a national emergency, which allows over $40bn in funding for state and local governments to help combat the virus. The administration is also waiving interest on federal student loan debt (interest of ~$40bn per year) and is increasing crude purchases for the Strategic Petroleum Reserve. Overall, the address displayed a much more credible effort at combating the virus and the economic impacts than the earlier attempt on Wednesday night.
Over the weekend, the U.S. House of Representatives passed a bipartisan bill that also works to offset the disruption from the virus. Key items include requiring health plans to cover coronavirus testing, increasing fiscal aid to states through Medicaid, requiring employers with fewer than 500 employees to provide up to 12 weeks of sick leave (with 2 weeks fully paid) for coronavirus reasons, extending unemployment insurance, and increasing food stamp benefits. The bill could provide ~$100 billion dollars of fiscal support when all is said and done, and seems likely to pass through the Senate and be signed into law by President Trump. Similar to the Fed, this seems like the first of many legislative actions that will be aimed at stimulating the economy to offset the damage done by COVID-19.
The combination of monetary policy (keeping the flow of credit to the economy open) and fiscal policy (aggressively stimulating economic activity and incentivizing employers to keep paying their workers) will play a large part in determining whether the economy will bounce back quickly from the shock, or whether we are heading for a more prolonged recession.
Q: Okay, on to the big one. Is COVID-19 going to cause a recession?
A: Most people use the standard “two consecutive quarters of negative GDP growth” to define a recession.
It seems very likely that GDP growth around the world will contract in Q1 (in Asia) and Q2 (in the United States and Europe). Quarterly contractions happen because of epidemics, natural disasters and climate events (“Acts of God” broadly) every so often. GDP growth was negative in Q1 2014 in the United States largely because the harsh winter hampered consumption and the housing market, for example. If COVID-19 is contained by April or May, the United States could still have a “technical” GDP recession given the substantial decline in activity already in March. If virus disruption lasts into the summer, we will almost certainly meet the two-quarter threshold.
Overall, we think a more helpful metric to anchor our thinking on is unemployment. The longer the virus disruption lasts, the more likely companies are to cut costs and lay off workers in order to service debt. If unemployment rises, and corporates default on loans, it will exacerbate the stress in the economy and lead to a longer and weaker recovery from the shock. This scenario aligns more with the National Bureau of Economic Research’s definition of a true “recession.”
Right now, it seems like markets are expecting rolling growth contractions around the world in the first half of the year, but there could still be further downside if unemployment in Europe or the United States rises and corporate balance sheet stress increases. That is why the policy response on both the monetary and fiscal side is so important.
Q: So what does this all mean for markets?
A: There is a saying that markets stop panicking once policymakers start panicking. Markets haven’t stopped panicking so far, but between President Trump’s address on Friday, the legislation underway in the House and Senate, and the Fed’s surprise announcement on Sunday, it seems like policymakers are taking the threat of coronavirus seriously in the United States.
There is still more to be done (finalizing fiscal stimulus measures, organizing targeted lending schemes, and, most importantly, finding a vaccine or other medical treatment for the virus), but we are in a better place than we were at the middle of last week. It will still take some time for risk markets to find a floor, but the actions over the weekend give us some hope that we will be able to avoid a worst-case scenario of rising unemployment, corporate defaults and weakness in the global economy through the rest of 2020.
Q: The S&P 500 bull market is over. How will we know when the next one can start?
A: We won’t know for sure until we have the gift of hindsight, but we are looking for a few things.
- First, markets have to feel that the containment strategies around the world are effective and peaking. After the spate of cancellations of events that happened last week, and the United States adoption of “social distancing,” it seems like we could be getting closer on that front.
- Then, new-case growth globally outside of China has to peak. The cumulative number of cases can still be on the rise, but markets seem to be looking for deceleration.
- Finally, monetary and fiscal policy must be perceived as effective in keeping the flow of credit to the real economy open, and alleviating pressure on businesses of all sizes so that they don’t have to lay off workers. Again, policymakers are on the right track, but there is still more to be done to ensure this outcome.
We will never be able to perfectly time the bottom, but consider that the S&P 500 has never failed to regain a prior peak. We happen to believe that this time will be no different. Even if it took five years to get back to the new high, an investor would reap a ~8.4% annual return. Compare that to the yield of a five-year treasury bond at ~0.70%.
All market and economic data as of March 2020 and sourced from Bloomberg, FactSet and Gavekal unless otherwise stated.
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