As much as I wish the current pandemic subsides as soon as possible and our social and economic livelihood revives to normality rapidly, a V-shaped economic recovery in the US seems so farfetched and unrealistic. Despite the monetary and fiscal crisis programs already released by the Federal Reserve (“the Fed”) and the Congress, the efficacy of those programs has merely reflected in recent stock market rallies (or rather distortions). Their impact on the economy is yet to show.
The economic recovery will be disappointing.
First of all, the end of the lockdown is still uncertain. Certain states recently implemented Phase I reopening plan in the past week or so and the real impact on infection numbers will soon be assessed considering the typical 14-day incubation time of the virus. As we move into summer, the long-stated negative correlation between the infection rate and temperature has not yet yielded any convincing result. On the flip side, Dr. Fauci, among many other health experts, has alarmed the raising likelihood of future waves of infections.
Second, many of the lost jobs will not come back any time soon. The latest job report (from May 14, 2020) shows that more than 36 million people in the US have lost their jobs and filed for unemployment benefits since mid-March. As horrid as the number gets, due to meager economic activities and behavioral changes in the short term, many of the unemployed may not go back to work immediately even when the economy reopens. We may have to face the reality that once companies realize they can operate as efficiently or even more efficiently with fewer employees, those temporary layoffs would become permanent job losses.
Third, the economic impact could probably traumatize consumer confidence. Before the pandemic, survey showed the median individual savings amount was less than $500 in the US. Even worse, most of the layoffs so far have been posed upon the most financially vulnerable households. What the Fed chairman stated in his speech on May 13, 2020 below was beyond shocking and unfortunate. If it took almost a decade to heal the wound from the Financial Crisis for a lot of families, then the impairment of living standards and confidence from this crisis would not cure itself within a few years. Remember that consumer spending attributed to approximately 70% of the US economy (GDP) pre-crisis.
“Among people who were working in February, almost 40% of those in households making less than $40,000 a year had lost a job in March”
— Jerome Powell, the Fed Chair, on May 13, 2020
Fourth, disruption to corporates and small businesses is pervasive and not all businesses will reemerge post crisis. A decade long loose monetary policy and low interest rate have encouraged public and private corporates to indulge themselves with cheap financing while ignoring risk management and long-term development visions. The consequence is most corporates were heavily leveraged coming into the current crisis and now their very survival largely relies on federal bailouts or even cheaper financing (e.g. zero interest rate) to roll over their debt. The problem is, in the early stage of the crisis, it is a liquidity problem which could be temporarily solved by cheap funding from the Fed. However, as economic shutdown drags long, the liquidity problem will become a solvency problem since the Fed’s funding cannot (and hopefully will not) sustain the survival of all indebted corporates forever in face of collapsing business demand in many industries. After all, crises ought to serve as a cleansing mechanism to filter out ghost or mismanaged companies in capitalism.
But, isn’t the Fed saying it is trying to save everyone as it has turned on its money printing machines through infinity QE and trillions dollar debt monetization?
Yes, the Fed threw the kitchen sink at the financial markets in March to provide liquidity and save the US capital markets from slipping into a financial crisis on top of an economic crisis. However, there will be considerable unintended consequences out of its policies, particularly after the Fed announced it would start purchasing corporate bonds (both investment grade and high yield) and ETFs backed by those corporate debt, resulting in dramatic credit spread tightening after announcement. What does this mean? One, the Fed is now taking corporate default risk onto its own balance sheet for the first time in its own history. Two, from a professional perspective, credit investors who had applied rigorous risk assessment in constructing their portfolios will be simply under rewarded by this policy. Three and most importantly, this policy essentially dampens the cleansing mechanism of capitalism to sift out uncompetitive companies through the process and, in Scott Minerd’s words, creates “a new moral hazard by socializing credit risk”.
The fallacy of the Fed policies is that they mostly targeted the symptoms and skipped the roots of problems. As mentioned above, many public and private corporates were already highly levered pre-crisis to a degree that their daily operations depended upon these cheap credit funding. The Fed’s minimal willingness and courage to allow mild market declines, as shown in the 2018 market correction, accelerated price distortions in the capital markets. At the end of the day, the Fed does not have the magic wand to convert bad loans into good ones.
The question remains, as addicted and dependent as the markets get, will they ever allow the Fed to roll back its purchase of corporate bonds? For me, the answer is highly doubtful, just as the Fed would never roll back QE (or whatever they rename it). One step further, since high yield is only one notch above equity, perhaps it is matter of when not whether the Fed will start buying equities. Well, this is worth another blog post on its own.
One of the ramifications out of the 08–09 financial crisis was the division between the Wall Street and the Main Street, i.e. the widening financial inequality between the ‘haves’ and ‘have-nots’. The division itself has already attributed to many social and political impacts, such as the rise of populism and political polarization. The longer-term social and political implications from the current crisis will likely be more complicated and long-lasting. For example, the widening financial and opportunity inequalities have and will become even worse. Throughout history, inequality at similar levels was not sustainable, and policymakers may be forced to address the issue to balance out increasing populist revolt. Productivity growth may also be hampered for years to come as people and business need to adjust to reoccurring infections and interim lockdowns.
