Governments have responded with drastic containment measures that have brought about abrupt changes to everyday life. Quarantines and social distancing have replaced our daily routines of school, work, and leisure activity. Times Square is empty and in Paris, cafés are closed. Main Street USA is no different, with shuttered storefronts, business closures, and restaurants resorting to “take-out only” to try to stay afloat. The immediate economic impact is evident in the initial claims for unemployment. Claims soared to a record 3.28 million during the first full week of “shutdown mode,” and doubled to over 6.5 million claims the following week. These unemployment claims are sure to trend higher in the coming weeks. Small and midsize businesses, which represent almost half of employment in the U.S., are being particularly hard hit and have started to lay off staff or significantly reduce employee hours. From a pre-pandemic level of about 3%, unemployment could exceed 20% in the coming months. The combined effect of business closures, higher unemployment and lower consumption will lead to a sharp drop in economic output during the second quarter. A recession is highly likely, despite widespread expectations for a less severe contraction by the third quarter and improving conditions beyond then.
More important than the weekly claims or estimates of GDP contraction are these two questions: how long will this downturn last and where do we go from here? On this front, we are encouraged and here is why:
• Economic conditions before the global pandemic were relatively strong. The economy was growing steadily, unemployment was at a record low, inflation was contained, and household finances were in decent shape.
• Unlike the 2008-2009 credit crisis that threatened the solvency of the banking system, the COVID-19 pandemic is different. This crisis has resulted in a collapse in demand, which is causing financial distress. Compared to 2008-09, most banks and the majority of large corporations have adequate capital and strong balance sheets. They are better positioned to weather this storm. The same is generally true for households and consumers, though those at lower levels of income will feel an inordinate amount of financial pain from this downturn.
• The fallout from the virus has also led to a liquidity crisis. The sudden reaction in global markets as the virus spread triggered selling across all asset classes, even high quality corporate and municipal bonds, as many institutional investors sought to raise cash to reduce risk and meet investor redemptions. This rapid selling had the effect of creating a “crowded exit,” where sellers vastly outnumbered buyers as they liquidated positions, dragging securities’ prices lower amid a virtual “buyers strike.”
• To combat the growing liquidity crisis, the Federal Reserve implemented a series of bold measures. First, it cut the short-term Federal Funds rate to near zero, thereby dramatically lowering the cost of borrowing money for businesses and consumers. Second, it announced a massive increase in the amount of fixed income securities it plans to buy in order to ensure markets continue to function with ample liquidity. It also expanded the scope of what it will buy to include commercial mortgages, corporate credit, and municipal bonds. Third, it announced a series of interventions to support functioning markets, focusing especially on money markets, bank certificates, and short-term lending markets. Finally, it has the flexibility to make loans directly to eligible small businesses. This is a massive monetary stimulus far beyond what has ever been done before. The Fed’s extraordinary measures are intended to provide an immediate stopgap, preventing the current liquidity crisis from becoming a widespread solvency crisis, marked by business failures and bankruptcies. The goal is to support the markets and the economy until governments can mitigate the spread of the virus, resume economic activity, and get people back to work.
• The impact of the monetary stimulus from the Fed has been enhanced by an equally bold fiscal package from Congress. The wide-ranging CARES Act, signed into law on March 27th, provides an estimated $2 trillion to support unemployment benefits, tax deferrals, loan forbearance, and direct payments to individual consumers. Fiscal stimulus will help “bridge the gap” to an eventual economic recovery and put money into the pockets of those suffering most from the sudden economic shock.
The COVID-19 pandemic is like nothing we have seen before. It will leave a lasting impression on our collective psyche, as well as the economy. The costs to fight this aggressive outbreak will be borne in some way by all Americans, from front line health care workers to displaced students to small businesses to a legion of newly unemployed workers. While necessary in the short run, adding trillions of dollars to the already burdensome level of federal debt in the United States will require even harder choices down the road. It is only with the benefit of hindsight that we will understand the full cost. However, we remain optimistic that we will see improvement in the not-so-distant months ahead.
As we stated in our March 9th communication, we are focused on remaining disciplined and balanced in our outlook. During this volatile time, we are staying the course. Depending on individual client circumstances, we are making some changes to client portfolios with the goal of reducing short-term risk and upgrading portfolio quality; however, we do not anticipate implementing wholesale changes across client accounts. We are opportunistic as we invest for the long-term, an approach that represents a huge advantage in a world full of short-term investors.