Fire Capital Market Update 2Q 2020
UNCHARTED TERRITORY
What’s Going On?
The COVID-19 global pandemic threatens to have a multi-trillion dollar negative impact on the world economy. At the time of this writing, much is in flux: single day market movements set records, in both directions, only to be beaten later that same week. OPEC members have resorted to feuding and oil prices are the lowest in history. Throughout the world, central banks have responded with enormous measures of Monetary Policy to calm the volatility and to keep markets functioning. Governments are in the process of designing & deploying fiscal stimulus packages as relief aids to lessen the blow to tens of millions of displaced workers.
It is with this backdrop that necessitates an unusual caveat that, by the time you have the opportunity to read this update, new information will be released; and our views may adjust. But our focus here now is not to transcribe current events that have led us here. Instead, we aim to provide thought leadership as to what we know, where we are likely headed, what we are watching, and offer potential divergent paths forward beyond 2Q 2020.
As the COVID-19 virus has spread throughout the globe, governments have responded, nearly unilaterally, in an attempt to flatten the curve of new cases. This has called for significantly reducing human movement and interaction through social distancing. With the subsequent temporary closure of all non-essential places of business and public venues, the potential for permanent impairment of business activity grows exponentially as time passes.
We are fortunate that today’s modern technology allows for a relatively seamless transition to telecommute for many workers. However, not all industries are so lucky. Particularly vulnerable sectors such as Consumer Services (travel, hotels, restaurants, casinos, etc) are at risk of massive losses in vital business activity. With an estimated 15M workers in the hospitality industry within the U.S. alone, the disruption is of unprecedented scale.
And indeed, we are just starting to see the impact. For the week ending March 21, weekly initial jobless claims reached nearly 3.3M people in the U.S. This figure does not capture workers from the “Gig” economy such as Uber drivers who may not be eligible to receive unemployment benefits. This is by far the largest weekly unemployment figure the U.S. has ever seen. Global financial markets have struggled to settle on what the total impact of these sudden and prudent stoppages will be and have swiftly discounted future growth estimates.
While we wait for the further readings of the vital economic indicators to assess the damage already done, we can look to places further along in the process to establish a timeline. As the origin of the virus, and the first to respond, China serves as an initial guidepost to judge our future. Over the span of 70 days, China first acknowledged COVID-19 cases, expanded significant quarantine measures and re-opened business activity. The crucial period, from isolation to starting to return to normalcy, took over 45 days.
The risk of ending the quarantine prematurely, for all nations, entails a re-escalation of the spread and the potential for more severe restrictions in response. This would have the grave effect of effectively prolonging the economic disruption and rendering stimulus efforts ineffective.
While the true economic impact is yet to be known, it is very likely that the global economy is already in a recession (defined as two consecutive quarters of negative GDP growth). As has been done previously, in response to economic downturns and crisis alike, central banks reached into their toolkits. This included: lowering interest rates, engaging in asset purchases to provide liquidity to financial institutions & support market function, and requesting that their governments also contribute with fiscal stimulus.
Given the magnitude and uncertainty around the damage done, we have decided to lay out two diverging paths forward — A Bear (negative) Case and a Bull (positive) Case. The reality is likely somewhere in the middle, but we believe that by outlining two opposing cases, the path forward will reveal itself more clearly and readers will have a better sense of what to expect in the future.
A Bear Case Thesis
At the end of March, equity markets rallied on optimism about the Coronavirus Aid, Relief, and Economic Security Act (CARES Act) passage after a historically drastic, and fast, sell-off. It took only 22 days to end the longest bull market in history. While one could argue that the speed of the sell-off is a reason for a quick recovery, history tells us to be cautious here. Past recessions marked by large market drawdowns like the one we just experienced almost always experiences further losses following a relief rally.
In this bear case thesis, we worry very much about a deep recession akin to the 2008 Financial Crisis and a stock market “double dip” that has historically lured investors back into the market before hitting new lows.
Global: The World Will Recover Unevenly
Around the world, the timing of the response to address the health and economic impact of the coronavirus has been uneven. This indicates that some countries will “re-open” faster than others, which means “social distancing” among countries will likely continue for the foreseeable future. Anecdotal reports from China indicate the country may be dealing with a second wave of coronavirus infections from non-local people bringing the virus back in from other infected countries. That has led to China banning entry to almost all foreigners. Without coordinated global efforts to minimize the spread of the virus, turning the “switch” back on in short order seems less likely than current public perception.
In an email to clients on March 5th titled, “Market Note — Coronavirus III”, we briefly summarized our growing concerns and how we viewed the global economy. At the time of that note there was only 262 cases in the U.S., as of the time of this writing there is now over 200,000. While the situation has escalated, our visibility into the future remains murky at best.
Below is an excerpt from that note:
“We characterize this “event” as a rare demand and supply side shock to the global economy. Essentially, people/businesses want to buy things that are either unavailable or are becoming scarce (e.g. face masks, sanitizer, toilet paper, wedding dresses, raw materials, medicine) and/or they want sell things that unexpectedly have no buyers (e.g. cruise trips, flights, hotels, conferences, oil). Other than a world war, I’m not sure there is an analog throughout modern history that one could point to as comparable. With that in mind, it is nearly impossible to fully understand the real impact this virus will have on the global economy, particularly since the virus’s impact has yet to be anywhere near peak concern in the U.S.”
One of the reasons for concern regarding current supply and demand dynamics is the growing stress on the global supply chain. Air, land and sea freight and logistics are all critical components to a globalized world. Less than fully functioning seaports, cross border travel restrictions and driver health concerns are causing shipping costs and transit times to increase.
Halting commercial air travel has also played a role in the disruption. Airlines normally make somewhere between 5%-10% of their revenue from leasing out extra cargo space to haul freight. Since passenger planes are no longer flying, freight costs have more than doubled, which has some airlines converting passenger planes into cargo planes.
United States: Public Health vs Economic Well Being
The health of the United States economy remains the critical x-factor in terms of understanding how well the world can weather this unprecedented storm. This is because the U.S. economy remains the largest in the world by a wide margin. If the U.S. drops into a prolonged recession, the rest of the world is likely to suffer as well despite the measures that each nation is taking to support their people and economy.
An important consideration is that the U.S. service sector’s contribution (approx. 80%) to GDP is disproportionately high compared to other less developed countries. While various parts of the service sector are affected differently, any business related to travel, hospitality and traditional retail have essentially stopped. Recent congressional action has eased the burden on small businesses by offering loans that may be forgivable, but the terms are unlikely to work for everyone.
The U.S. consumer has been the driving force for the economy for quite some time, accounting for about 70% of U.S. GDP. Today, the U.S. consumer is beaten and battered. Early last week, St. Louis’ Fed President, James Bullard, warned that U.S. unemployment could reach 30%. For context, the Great Depression and Great Financial Crisis peak unemployment figures were approximately 25% and 10%, respectively.
Unsurprisingly, consumer confidence continues to fall, and we continue to hear stories about large investments or purchases being deferred. Part of this is due to uncertainty about how this situation plays out, but risk taking in general will likely be lower well after people return to their “normal” routines. Even if business returns ahead of schedule, it is hard to imagine how most businesses would return to pre-virus consumer demand — a big concern for business owners who decide to take out loans to keep their staff.
Bear Outlook: For Your Safety, Please Buckle Up
Although 2019 was one of the best years on record for the stock market, there were real signs that the economy was slowing and that valuations were elevated. Add a global economic shutdown into the mix with heightened uncertainty of when things get back to normal and it is very difficult to envision a smooth ride from here on out. This Bear scenario indicates that the virus timeline is extended longer than expected and “normalcy” is slow to return as some travel restrictions remain, global supply chain stays in flux and consumers remain nervous (or unable) to pick up where they left off.
Bull Case Thesis
Here we lay out a potential path to recovery that considers an expedient and steady return to normalcy through effective containment of the COVID-19 pandemic. We must also consider the effects of a historic amount of stimulus injected into the world’s financial & economic ecosystem.
Global: Stimulus Bazooka — U.S. Leads the Way
Even after bringing the Fed Funds rate to 0%, the market was unimpressed. Afterall, even negative interest rate policy in other countries has failed to stimulate economic growth under relatively normal conditions — much less a crisis scenario. Massive job loss was inevitable at this point and markets around the world plummeted even as more liquidity was pumped into the system to stabilize it. What was missing? Fiscal stimulus. Central banks have been calling for government cooperation to help manage recessions for many years and now they got their wish.
Never before has the world witnessed this amount of stimulus being pumped into the economy at one time. Nearly every Central Bank in the word has cut rates at least once (43 since the first confirmed case outside of China). With the added fiscal expenditure, over 10% of global annual GDP has been made available in a massive attempt to stem the tide and right the ship.
But with such disruption already well underway, none of this will be of much use if we can’t get the global economy started again and soon. To do that, we need to slow the spread of the virus until such point that it is safe to return to normal activity without outsized risk of a spike in new cases.
As China was the first to deal with the outbreak, so too are they the first to attempt to return to normal. Much of the supply chain impasse that is hampering industrial production stems from the necessary shutdown China imposed on itself. As workers and consumers begin to return to normal, economic activity from within the world’s second largest economy will be counted on to pick up the slack and supply the globe with the much needed backlog of vital goods once the rest of the world reemerges. China’s March PMI beat expectations and showed an expansion in the manufacturing sector after February had shown a clear and stark contraction. Data coming from China has been sparse, and we would argue that early reads and anecdotes should be viewed with extra scrutiny. Still, there appears to be light at the end of the tunnel.
The number of reported active cases of the virus has steadily fallen in China, after peaking six weeks ago. With an approximate two-week incubation period, it took a month for the containment efforts to stop the spread. Additionally, The World Health Organization recently said the outbreak may peak soon in Europe. We will continue to watch these developments closely for signs that we are on a path to recovery without major setback.
United States: Grief and Resilience Live Together
The U.S. is now in a critical moment to flatten the curve of contagion. With President Trump recently extending the quarantine protocols to the end of April and new daily cases still increasing, we are not yet showing signs that the end is near. While we wait for indication that proposed levels of social distancing is effective, we must turn our attention to measures being put in place that will allow those most deeply impacted to avoid financial catastrophe. With the passing of the CARES Act, the U.S. aims to deliver over $2 trillion in Federal funding to a wide swath of the economy. As an analog, CARES is nearly 2.5x larger than the injection made during the 2008 Global Financial Crisis (GFC).
The CARES Act offers assistance to the business & consumer sector(s) in the form of loans, forbearance & forgiveness, tax relief & rebates, special public health appropriations, and added unemployment benefits.
As workers are laid off and furloughed, fiscal stimulus will be an essential tool called upon by business and individuals alike to see them through to the other side. And it appears that we have not yet seen the end of proposed stimulus possibilities. As he did early in his term, President Trump is once again calling for an additional $2 trillion in infrastructure spend as part of a “Phase 4” stimulus package. This would be extraordinary as the current amount of federal fiscal stimulus to be provided this year through the CARES Act is likely the largest federally funded stimulus since FDR’s New Deal.
But stimulus alone won’t go very far if there’s no one there to spend it. As the consumer plays such an important role in the U.S. economy, we are looking for indication of pent up demand and confidence among consumers. While we’ll likely have to observe the former as it comes, the latter has early indications of stabilizing. Unsurprisingly, consumer confidence has already trended starkly downward but as of the latest monthly reading, it was better than expected. A separate survey conducted daily of 500 individuals has shown early signs of an up-tick in consumer confidence that corresponds with the recent positive gains in the market. While it’s too early to call a bottom with further job losses on the way, the consumer will be called upon to put the stimulus to good use.
Bull Outlook: It’s Always Darkest Before Dawn
While it may seem like a long time ago, we have seen as recently as earlier this year that low interest rates, a confident consumer, and accommodative financial conditions can send equity valuations to new highs. With an unprecedented and historic amount of monetary and fiscal stimulus (20% of annual GDP for the U.S. alone), along with the potential for pent up demand from consumers and businesses alike, the factors are ripe for markets to return to where they were just before the outbreak. Under a best-case scenario, the economy, and by extension, the market will recover in a quick and profound manner.
Disclaimer
The information in this report was prepared by Fire Capital Management. Any views, ideas or forecasts expressed in this report are solely the opinion of Fire Capital Management, unless specifically stated otherwise. The information, data, and statements of fact as of the date of this report are for general purposes only and are believed to be accurate from reliable sources, but no representation or guarantee is made as to their completeness or accuracy. Market conditions can change very quickly. Fire Capital Management reserves the right to alter opinions and/or forecasts as of the date of this report without notice.
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