Yesterday, March 12, I made a presentation to a group of people here in Birmingham about the macroeconomic impact of COVID-19. More correctly, I was one of three speakers in a brief morning seminar. As such, they gave me 25-30 minutes to make a few remarks and field a few questions.
Obviously, this isn’t my standard economic speech, which I can practically recite in my sleep after 20 years. So, I had to actually draw up some prepared remarks for the first time in a very long time. Unfortunately, as you might be able to tell, I did so prior to President Trump’s speech on Wednesday evening.
After reading what I had written aloud to myself and then to my co-worker Sam, I thought: “why write a separate Common Cents this week when I can post this?” Indeed. So, here they are: my prepared remarks from yesterday’s speech. Please note, this is a speech, so the syntax and grammar might not be up to snuff.
“Good morning…
I was flattered when Laura asked me to speak at this seminar about the economic ramifications of the coronavirus COVID-19. If you know me, you know I love to have a public opinion on just about everything. The reason is pretty simple: at home, I don’t get to have an opinion on anything.
With this in mind, I was more than happy to accept this speaking invitation. Laura asked me to make a few remarks and leave some time for Q&A, for a total of about 25-30 minutes. So, without any further ado, let me give you my thoughts on the economic impact of this global pandemic, or should I say panic:
“I haven’t the foggiest idea, and no one else does either. Now, are there any questions?”
In all seriousness…
No one really does know the ultimate impact of this, as it is incredibly fluid with announced closures here and there virtually every minute. I suppose you could say our economic fate undoubtedly hinges less on the actual virus itself, and more on the actions (or reactions) of, well, all of us. You, me, them, those guys over there.
So, I am going to give you a best-case scenario, a worst-case scenario, and a probable-case scenario…and a reason or two for each of these. After I do this, I will share with you what we, our investment committee, has done in our target asset allocation(s) in what we call our strategy portfolios. After that, I will recap the scenarios ever so briefly and then open it up for a few questions (if time allows).
First, the best-case scenario:
The world’s scientists develop a protocol or make significant progress in the development of a vaccine/treatment. The sooner ‘they’ come up with this, the sooner we can lift quarantines and other, arguably well-intentioned, stoppages or postponements in economic activity.
You see, the problem with COVID-19 is it is a completely new virus to us. I submit THAT is what is causing the panic, the uncertainty. After all, the flu will probably end up infecting and/or killing more people in the US this year. However, we take some measure of solace, strangely enough, in knowing the flu’s certainty.
If these advances, and noticeably warmer weather, are in place by the end of March or Easter at the latest, we can probably put a negative sign in front of 1Q global GDP, revise quarterly earnings estimates downward, and chalk one quarter up as loss. The short-term dislocation in the global economy probably won’t be enough to derail financial systems around the world, and the US could very possibly escape the carnage with a 0-1% GDP number for 1Q…by far the economic bright light in the G-7.
Even so, this will put some pressure on certain sectors of the economy, notably transportation and leisure & hospitality here in the US; however, this won’t lead to wholesale massive layoffs, etc. The reason for this is simple: the 4-6 week freak out, if that is the best term and it might be, didn’t derail economic growth and consumer demand…it simply postponed it. As a result, by May, COVID-19 will be in the rear view mirror and both sectors will ramp up for a, possibly, more robust summer season than they would have had anyhow. After all, the lower interest rates and cheaper crude oil we have recently seen have to be good for something.
This will or could put the NBER (the National Bureau of Economic Research), the folks that define recessions, in sort of a corner. Will a 2-4 month cooling in US economic activity truly be enough to call a recession? In other words, will a short-term postponement in growth be “enough” to call one?
We shall see.
Second, the worst-case scenario:
Ah, this is where the fun begins. Admittedly, I have a strange definition of fun. However, for some reason, Doomsday forecasts are more interesting than the alternative. They are morbidly fascinating, and we just can’t help ourselves. So, what is it?
Contrary to popular opinion, the global economy doesn’t collapse due to a massive slowdown in Chinese economic activity. While China will have its problems, Beijing essentially owns the money center banks and the provinces own the regional financial firms. As a result, loans losses somehow vanish or aren’t accounted for exactly by our standards here in the US. Lost capital and liquidity are easily replaced by the proverbial swipe of President Xi’s pen. Auditors and regulators are completely complicit, and global investors will take a blind-eye to the financial sleight of hand because…“why not?” Further, Beijing will ‘front’ employers with interest-free, and ultimately forgivable, loans. Few will lose their jobs, and the government will continue to stifle dissent.
It has been a thinly veiled shell game over there for decades, why would it change because of this?
Nor will the US be the cause of a global meltdown…nope. The strong labor market and growing household income leading into the COVID-19 panic will provide just enough tailwind for the US economy to mitigate the worst of the global downturn. The money center banks will have sufficient capital, and the FDIC will be able to handle some regional and local bank failures with relative ease. Yes, the US will have a recession, but it won’t be like 2008…it will be somewhere in between the relatively mild recession we had to start this century and that doozy a little over a decade ago.
It won’t be fun, and folks will lose their jobs, but ‘we’ have had worse.
So, if not the Chinese or Americans, who gets slammed the hardest? Quite simply, the Europeans do, and it could get ugly and ultimately threaten the very existence of the EU and Eurozone. The reason? The Italian economic slowdown, caused by the effective quarantine of the entire country, blows up the Italian banking system. Already the weakest, by some estimates by far, of the major European financial systems, Italy has been skating on proverbial thin ice for a while, as its banks struggle with a large number of problem loans and assets.
Rome’s decision to effectively quarantine the entire country all but seals/sealed the banking system’s fate. There is little to no way the Italians will be able to repay their bank debt in full after even a relatively short-term stoppage in economic activity. As a result, a bailout has to come from somewhere. Will it be Rome? The ECB? Berlin? Some combination? Probably.
However, what happens to interest rates in Italy if that happens? What happens to interest rates in the rest of Europe, Eurozone, IF the powers that be have to come up with even more liquidity, or borrowing, out of thin air in order to keep liquidity and credit flowing in a major G-7 European economy? Intuitively, it would put UPWARDS pressure on rates, even if European interest rates have been a mystery for some time now.
The problem with this is the inverse relationship between asset prices and interest rates. As interest rates rise, starting in Italy, bank asset values throughout the remainder of the continent will fall…by definition. Since liabilities won’t fall in tandem, bank equity will get squeezed. When this happens, banks don’t lend money. When banks don’t lend money, the money supply stagnates. When this happens, well, it generally isn’t terribly good for economic activity. Despite assurances to the contrary from certain political types, bank capital does matter.
As a result, Europe, particularly the Eurozone, will experience an extremely sharp economic slowdown, potentially rivaling or even surpassing 2008…seriously. Unlike then, which Franz and Jacques Everyman could blame on the US, perhaps rightly, the severity of Europe’s economic slowdown will be due to its unique financial structure where sovereign nations share monetary policy but NOT fiscal policy or even banking regulations. It is craziness.
As the scope of the problem becomes more apparent, nationalist parties will gain in the polls, promising their nation’s equivalent of Brexit. It will be interesting to see which country will pull the proverbial ripcord first, but, make no mistake about it: the British will look like geniuses, the EU will lose a few member states, and the Eurozone will either disintegrate completely or is substantively changed.
Whew…
Finally, the probable case scenario:
The worst-case scenario in China looks eerily similarly to the probable case one. No one, and I repeat no one, in the world will ever know the true extent or scope of COVID-19 on either the Chinese medical system or economy. Beijing will alter or otherwise misreport the data in order to put the central government, and more importantly President Xi and the communist party, in a favorable light. Domestically, the state-run media will hail the great leaders’ efforts to stem the contagion, and everyone will look a blind-eye to the truth.
As for the remainder of the world, thanks to an unusually warm winter in much of the northern hemisphere, the spread of COVID-19 begins to slow dramatically by the end of April. By Memorial Day, it is essentially contained until the end of summer. This will give scientists and policy makers enough time to develop better protocols and treatments in order to contain COVID-19 when temperatures start to cool in the Fall. Fortunately, by Halloween, an American biotechnology and/or pharmaceutical company will have developed a treatment which the FDA fast-tracks (behind the scenes), and the scare will essentially be over.
Officially, the US will have a mild recession, particularly when compared to 2008, which the NBER will define as 1Q and 2Q of 2020. Now, thanks to the combination of significantly lower interest rates and energy prices, the US will be poised to have a stronger than originally expected second-half of the year. Amazingly enough, 3Q and 4Q growth could be strong enough to actually push 2020 US GDP close to the 2.0% number everyone was predicting at the start of the year.
There are two important lessons here: 1) don’t look a gift horse in the mouth, and; 2) they don’t ask how, they ask how many.
With that said, the Federal Reserve will have used up a lot of ammunition, and the O/N lending target will be in the 0.50-1.00% range at year-end. All told, most folks here in the US will think we will have ‘dodged a bullet,’ even if we didn’t really.
As for Europe, as in China, the worst-case scenario will also be close to the truth. The recession might not be quite as strong (but it will be stronger than America’s) and nationalist sentiment might not gain as much traction (but it still will). However, when the dust settles and the smoke clears, Franz and Jacques Everyman will close out 2020 far less confident about the EU, the Eurozone, and Europe’s ‘place in the world.’ This is with good reason, as Europe will emerge from the COVID-19 scare weaker in both absolute and relative terms to both China and the US.
Whew.
So, what does this all mean for US investors? What should you be doing in your investment portfolio? What have we been doing for our clients?”
…and this is where I leave you gentle readers. If you would like to know more of our investment strategy, please contact an Oakworth client advisor. Have a great weekend. Wash your hands. Get outside as the weather allows, and don’t hug any strangers. That is good advice anyhow.
John Norris
Chief Economist
As always, the opinions and thoughts expressed in this newsletter are mine and mine alone, and should be considered as entertainment or educational information only. They do NOT necessarily reflect the opinions of Oakworth Capital Bank or any of its directors, associates, and shareholders, apart from myself. My opinions are subject to change at any time and without warning. Further, nothing in this newsletter should be construed or considered an offer to buy or sell financial services/products of any type AND no one should make any financial decisions based off this newsletter alone.