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Economic Monitor – Weekly Commentary
by Scott J. Brown, Ph.D.

Radical Uncertainty into March Sadness

March 13, 2020

In recent weeks, we’ve seen economic concerns about COVID-19 moving from supply chain disruptions, to expectations of softer global growth, to fear of the impact from social distancing. The odds of a recession have been rising day by day. Some economists believe that we’re already in one. Yet, a sharp, brief downturn should be followed by a strong rebound. Low interest rates, low gasoline prices, and fiscal stimulus may limit (but not prevent) economic weakness, but should support growth on the other side of the coronavirus. The risks rolled quickly into the credit markets last week, suggesting a more critical phase in the crisis, but the Federal Reserve has responded.

The coronavirus is highly transmittable. While 80% of those infected exhibit mild symptoms, the other 20% are severe cases and about 1% die. The elderly and those with reduced immune systems are most at risk. Left unchecked, COVID-19 would spread widely, perhaps infecting 100 million or more Americans. The need for care would soon exceed capacity. Hospitals would be overwhelmed. Mitigation efforts, including increased social distancing, will slow the spread of the virus and allow hospitals to respond, but will also prolong the economic impact. By March 12, the U.S. has tested fewer people than South Korea does in a day. The lack of adequate testing makes it impossible to pinpoint where we are in this contagion. The number of infected is surely a lot higher than what is reported.

Life comes at you fast. Within the last week, we’ve seen the cancellation of the NCAA tournament, the suspension of the NBA, MSL, and NHL seasons, the cancelation of spring training, and the delay of the start of Major League Baseball and the Masters Golf Tournament. Major music festivals have been cancelled or postponed. Broadway has gone dark. The loss of these events and the reduction in spending in leisure and hospitality will reduced consumer spending significantly. Many workers who would be supporting these sectors won’t be paid. The virus-sensitive sectors of the economy account for about 30% of nonfarm payrolls.

Fiscal stimulus is on its way, or rather, will be on its way once the folks in Washington find agreement. Cutting payroll taxes is easy, but that doesn’t help if you’ve lost your job, and workers in other sectors would be more likely to save the windfall, then spend it. As tax revenues begin to dry up, aid to the states will be important. Targeting relief for those laid off due to the virus would be most effective, but could be tricky.

The Fed has done its part and will continue to act. The Federal Open Market Committee lowered the target range for the federal funds rate by 50 basis points, to 1.00-1.25%, on March 3. It’s widely expected that the FOMC will follow that intermeeting cut with a further reduction following the March 17-18 policy meeting, most likely by 100 basis points. Some have argued that the Fed should save its ammo. However, given that short- term interest rates are already low, the Fed should be more aggressive in cutting rates (sooner and more steeply). There is also a more immediate concern for the Fed.

Last week, the credit markets (including Treasuries!!!) experienced liquidity issues. That this would show up now, before much of the economic impact of COVID-19 has been felt, is especially troublesome. Debt doesn’t matter until it does, and some issues were anticipated in the high-yield area, but a general seizing up in the credit markets is not good, generating fears of the type of issues seen in the fall of 2008. The Fed has responded quickly. On Thursday, it provided $1.5 trillion in liquidity to the repo market. On Friday, the New York Fed announced an expansion of asset purchases ($80 billion per month) “to address highly unusual disruptions in the market for Treasury securities associated with the coronavirus outbreak.” The Fed’s actions, and likely more to come, will help to reduced credit market strains – otherwise, the economic downturn would become more severe.

Lower gasoline prices, lower interest rates, and expected fiscal stimulus should help to limit (but not prevent) the downturn in the economy and help to propel the recovery once the coronavirus has passed. However, social distancing may go on for a lot longer. We may get lucky. The virus could fade as the weather warms up, but that’s uncertain. Even if it does fade, it could come back stronger later this year. However, at this point, we can’t even make an educated guess because of the lack of adequate testing. It may be a few weeks before we get widespread testing. We’ll know more then.

On Tuesday, W. W. Norton & Company will release “Radical Uncertainty,” authored by Mervin King (who headed the Bank of England during the financial crisis) and John Kay (an economist and Fellow of St John’s College and Oxford University). Some uncertainties are resolvable, such as the probability of various poker hands. However, many situations involve a deeper level of uncertainty, where there is no historical guidance to future outcomes. That isn’t to say economic modeling is worthless in the current environment. It helps to bring out key relationships and risks.

However, investors should take current economic forecasts with a big grain of salt. Relying on a specific GDP forecast is silly, given the wider degree of uncertainty. It’s much better to envisage a range of scenarios, then work to assess their likelihoods as information unfolds.

The current pandemic may seem similar to past health crises, but epidemiologists tell us that “if you’ve seen one pandemic…, you’ve seen one pandemic.” Each is unique. Modeling the spread of a virus is well established and relatively simple, but the parameters (the degree of contagion, the level of mitigation, etc.) are initially unknown – and again, we’re at a loss now due to inadequate testing.

Radical uncertainty is a challenge for investors. Individuals will have different time horizons and different tolerances for risk. The economy will recover from COVID-19 and current valuations do not seem to reflect that fully. Herd mentality can led to market panics. Rebuilding confidence can take time, but as we saw in the aftermath of the financial crisis, optimism should eventually return. Market routs usually end with a lot of volatility.

Data Recap – Increased social distancing added to fears about the economic impact of the coronavirus, now officially a “pandemic.” The Federal Reserve moved quickly to address credit market liquidity issues. The economic data reports were irrelevant.

The Federal Reserve offered $1.5 trillion in support for the repo market “to address highly unusual disruptions in Treasury financing markets associated with the coronavirus outbreak.” The New York Fed announced an increase in asset purchases “to address temporary disruptions in the market for Treasury securities.”

The Consumer Price Index edged up 0.1% in February (+2.3% y/y). Food rose 0.4% (+1.8% y/y). Gasoline fell 3.4% (-3.8% before seasonal adjustment, +5.6% y/y). Ex-food & energy, the CPI rose 0.2% (+2.4% y/y).

Real Hourly Earnings rose 0.3% in February (+0.6% y/y). For production workers, the increase was 0.2% (+1.0% y/y).

The Producer Price Index fell 0.6% in February (+1.3% y/y). Food sank 1.6% (fruits and vegetables down 28.9%, after rising 22.4% in January). Wholesale gasoline prices fell 6.5% (-6.2% before seasonal adjustment, +9.8% y/y).Ex-food, energy, and trade services, the PPI fell 0.1% (+1.4% y/ y). Pipeline inflation pressures retreated. Ex-food & energy, unprocessed intermediate goods rose 0.7% y/y, with processed intermediate goods down 1.7% y/y

Import Prices fell 0.5% in February (-1.2% y/y), reflecting a 7.6% decline in petroleum (-5.5% y/y). Ex-food & fuels, import prices rose 0.2% (-0.8% y/y).

The UM Consumer Sentiment fell to 95.9 in the mid-month assessment for March, down from 101.0 in February. The decline reflects concerns about the coronavirus and the sharp decline in the stock market. The report noted that “the data suggest that additional declines in confidence are still likely to occur as the spread of the virus continues to accelerate.”

Reporting on a special survey taken in late February and early March, the Institute of Supply Management noted increased supply chain disruptions related to China.

The Bank of England’s Monetary Policy Committee voted to lower the Bank Rate by 50 basis points, to 0.25%.

The European Central Bank left short-term interest rate unchanged, but increased its longer-term refinancing operations (LTROs).

The Bank of Canada today lowered its target for the overnight rate by 50 basis points, to 0.75%, citing the corona virus and low oil prices. The unscheduled move follows a similar-sized cut on March 4. (M20-2995661)

The opinions offered by Dr. Brown should be considered a part of your overall decision-making process. For more information about this report – to discuss how this outlook may affect your personal situation and/or to learn how this insight may be incorporated into your investment strategy – please contact your financial advisor or use the convenient Office Locator to find our office(s) nearest you today.

All expressions of opinion reflect the judgment of the Research Department of Raymond James & Associates (RJA) at this date and are subject to change. Information has been obtained from sources considered reliable, but we do not guarantee that the foregoing report is accurate or complete. Other departments of RJA may have information which is not available to the Research Department about companies mentioned in this report. RJA or its affiliates may execute transactions in the securities mentioned in this report which may not be consistent with the report's conclusions. RJA may perform investment banking or other services for, or solicit investment banking business from, any company mentioned in this report. For institutional clients of the European Economic Area (EEA): This document (and any attachments or exhibits hereto) is intended only for EEA Institutional Clients or others to whom it may lawfully be submitted. There is no assurance that any of the trends mentioned will continue in the future. Past performance is not indicative of future results.