The coronavirus health crisis has deteriorated materially, with the World Health Organization declaring it a pandemic and the world literally shutting down for a month or more. In this note, I offer my thoughts on the US economic impact and the critical role of fiscal policy.
Looking ahead, I believe three things in particular matter for the US economic and profits forecast:
- Early in the crisis, a key question was which model would work: Italy or China? We have learned that the answer is the China model (i.e., severe restrictions). The takeaway for the US is that the drop-off in activity near term (to contain the virus) will be steep, with the decline in growth dependent on how long we stay locked down.
- We also have an energy market collapse to deal with in the US. Energy accounts for 8% of US-structures investment spending (3% of total investment spending). In 2015–2016, this number was 16%. It will shrink at an incredible pace from here. While the declines following prior energy routs suggest activity could be down 75%, one has to consider the ancillary industry impact, which is inevitable and always harder to quantify. If activity were to be wiped out 100%, it would seem realistic to assume at least a 0.5% hit to growth.
- The deterioration in credit markets in the US is a concern. Investment-grade credit is the lifeblood of US credit markets and the multiplier effect of stress on activity in this market is manifold. I would highlight two areas in particular: private equity, which has been funded to some extent via the corporate debt market, and foreign money that has been sitting in the US thanks to higher yields. Confidence here is critical for the smooth functioning of the US economy. It will be up to both fiscal and monetary authorities to restore this confidence. The tightening of credit conditions, if persistent, will bring growth down further.
Recessions: The Four “Ps”
When thinking about a recession, I would focus on four Ps. The first two, Pervasive and Pronounced, clearly apply to the current situation. The third, Persistence, is still an unknown. How long does this go on? China’s experience offers reason for some optimism, with evidence on the ground that normalcy is starting to return (in multiple months instead of a year or two as in most recessions). To this point, it is worth noting how the National Bureau of Economic Research defines US recessions: as “a significant decline in economic activity spread across the economy, lasting more than a few months, normally visible in real GDP, real income, employment, industrial production, and wholesale-retail sales.” In Figure 1, I offer some perspective on the duration and depth of past recessions.
US Recessions: On Average, Output Down 2% Over Four Quarters
Peak-to-trough decline (%)
|Peak||Trough||Duration1||GDP Decline||Industrial Production Decline|
1 Duration is in quarters.
Sources: National Bureau of Economic Research, Bureau of Economic Analysis, US Federal Reserve, Wellington Management.
This brings me to the fourth P: Policy. Policy efficacy is ultimately what determines the depth and duration of a decline after a shock. But if the right policies are put in place, we have the opportunity to avoid the rise in unemployment persisting for a long period of time. To put it another way, activity could see a snapback at some point if policymakers adequately help hurting industries and consumers. This requires action from central banks, but most importantly it requires action from Congress.
Is There Any Good News?
Yes! First, lower bond yields could be a big help for the US economy. US long-term rates are now down by more than 1% and the last time we saw such a big decline, in 2003, refinancing surged. Rates at such levels could release US$65–US$75 billion to consumers if roughly two-thirds to three-quarters of all mortgage owners refinance (about 0.4% of GDP). This is a benefit that stays with the consumer permanently even if it cannot be spent in the next couple of months.
Second, while lower energy prices hurt investment, they help consumers. A 40% drop in energy prices would be expected to yield about 0.5% GDP savings for consumers and businesses together. That type of savings tends to get spent, although not right away in this case, given the containment at play.
Third, the private sector and local communities are starting to take action that will help contain the virus. Self-help is rising to the challenge!
Fourth, I view this crisis as an opportunity to bring fiscal policy to the forefront. The most effective policies in such an environment are fiscal, and while Congress typically does not move at the speed of markets, they have moved quickly to address the crisis.
Why Fiscal Policy Matters So Much
The role of fiscal policy in any recession is to act as a countercyclical buffer by spending on unemployment benefits, sick leave, and the like. In this situation, there is an additional near-term role that fiscal policy needs to play: to prevent the health crisis from becoming a deeper recession. This has to do with the cash-flow problem that many companies and consumers are likely to face as the economy shuts down. Missed payments can lead to a cycle of defaults, which in turn can deepen the economic problems (i.e., liquidity threatens solvency).
To put the need for fiscal spending in context: 79% of workers in leisure and hospitality and 62% in transportation are hourly workers—these will be two of the hardest-hit sectors in this stoppage. In addition, about 10% of people in the US are uninsured, about 24% of workers do not have access to paid sick leave, and millions more are underinsured. Aggregate wage and salary incomes could drop 5% if those without sick leave are out for two weeks. Then comes the SME sector (small- and medium-sized businesses), which is critical for jobs but also dependent on much of the economic activity that is being put on hold. These businesses will need the fiscal support Congress can provide. If we can adequately and quickly help these companies, we can prevent a credit spiral, which would make the downturn much deeper.
Why else do I care so much about fiscal? It has been a missing leg of the stool for a long time and has the potential to move us away from the deflationary environment that we have been living with. A combination of an easy Fed and strong fiscal stimulus is powerful!First and foremost, the fiscal spending should be focused on helping to contain the virus and ensuring the safety of the people. Second, I believe policies being put forward thus far can be effective in mitigating the economic impact of the virus, including sick leave, expanded claims, food stamp use, lunch for school kids, and free testing. But for fiscal policy to work and truly make a difference for those impacted by this economic shutdown, the dollar amounts need to be large.
There’s been progress. On March 6, a bill creating a $7 billion disaster-assistance loan package for small businesses impacted by COVID-19 was signed into law. On March 26, the US Senate passed a massive $2 trillion stimulus package that would provide, among other things, up to $400 billion in loans to small businesses. Those loans could be converted to grants, or even forgiven in some cases, if used to cover employee salaries, rent, paid leave, utility payments, health insurance premiums or other necessities. As of this writing, the legislative package had not yet been approved by the US House of Representatives, nor signed by the President, but this is the type of credit backstop I’ve been looking for to help limit the depth and duration of the downturn.
Of course, the upcoming elections are a factor to consider. In the past, we’ve seen a pullback in government spending in the wake of some crises, especially when they prove too costly. However, there is a chance that following the coming elections we could see more government spending, especially if the Democrats win the White House—a plausible outcome given the potential for the current administration to take the blame for the coronavirus crisis. In this scenario, infrastructure spending could benefit.
Meanwhile, I expect the Fed to remain aggressive even though its tool kit is limited when it comes to responding to a health crisis. The Fed’s role is to help with liquidity, the smooth functioning of credit markets, and the reduction of rates. Most importantly, the Fed needs to act as a supportive player to the Treasury. It can restart a quantitative easing program at a much larger scale and with expanded collateral to help ease the financial and credit market distress visible today. Coordination of fiscal and monetary policy is essential to ensure the efficacy of policies that are being put in place.
Some heavy policy lifting lies ahead, but I do see positive steps being made. Those with the ability to look further out and be patient may find gems in this environment.
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