Clash of the Economic Titans

Massive forces are battling each other for economic supremacy; no one can be certain of the ultimate outcome. In that environment, portfolio exposures should seek balance between aggressive and defensive positioning while investors remain fluid in their views as events unfold.
Titans

The story of two warring parties fighting for dominance over one another is a tale as old as human existence. One of the oldest known examples is the Greek mythological war between the Titans (the old gods) and the Olympians (the young gods) known historically as the Titanomachy, and more recently referenced in the 2010 pop culture film as The Clash of the Titans. In the actual myth (not the movie, which, like most films, completely changed the story to fit modern Hollywood tastes), the younger gods sought to overthrow the old and eventually succeeded after a bloody 10 years of warfare.

In the present day, a version of this story is playing out in a war over economic influence between traditional forces (the old gods) like rising unemployment rates, falling corporate income, etc. and experimental government financial support and stimulus polices (the new gods), like the recently passed CARES Act that provided almost $2 trillion to boost unemployment benefits, offered potentially forgivable loans to small business, and included many other supporting measures. The titanic damage to the global economy from the COVID-19 quarantines and shutdowns is threatening to plunge the world into another Great Depression-like state, while global governments seek to resist that outcome. So far, this war has resulted in a relative stalemate, with major U.S. stock indices only being marginally lower for the year despite being off by over 30% at the March low.1 Future outcomes have a wide spectrum of possibility and it is anyone’s guess at this point which side will emerge the victor. To avoid being a casualty of this conflict, investors will likely have to be nimbler and more creative than usual with portfolio allocation construction in a quickly evolving environment.

Wrath of the Old Gods: Is the Effect Temporary or Permanent?

With the above discussion of gods, it must be noted that pestilence — the COVID-19 virus aptly fitting the term’s definition— is cited by some major world religions as a form of divine wrath meant to bring about destruction. Recent economic data releases have validated these ancient beliefs with unprecedented levels of devastation on display, which in many cases appear like data typos because of their magnitude. For instance, retail sales have imploded far worse than either the 2000 or 2008 recessions.

Source: Sonders, L. (May 18, 2020). Every Picture Tells a Story: “Chartbook” Look at Economy/Market. Charles Schwab.

 

Industrial production has fallen further than any recession on record going back to 1919, which includes the Great Depression and the period after war production ended following the cease of hostilities in World War II.

Source: Sonders, L. (May 18, 2020). Every Picture Tells a Story: “Chartbook” Look at Economy/Market. Charles Schwab.

Unemployment is spiking well above the 2008 “Great Financial Crisis” levels with less educated workers suffering the most. Unemployment for those with less than a high school diploma is over 21%, while just over 8% for those with a bachelor’s degree.

Source: Sonders, L. (May 18, 2020). Every Picture Tells a Story: “Chartbook” Look at Economy/Market. Charles Schwab.

Here are some more detailed statistics about the current unemployment data:

  • In the 2008 recession, professions that primarily employed men were hit especially hard. With the COVID crisis, women have been largely impacted because the industries most affected (ex. servers, daycare workers, hairstylists, hotel housekeeping staff, and dental hygienists) have a larger population of female employees. Until now, women had "never experienced an unemployment rate in the double digits since the Bureau of Labor Statistics began reporting data by gender in 1948… At 16.2%, women's unemployment in April was nearly three points higher than men."2
  • 80% of jobs lost are currently classified as temporary3, but researchers and the University of Chicago’s Becker Friedman Institute estimate 42% of current layoffs will result in permanent job loss.4 There are currently ~22 million people unemployed, which means if the Chicago researchers are correct, then over 9 million jobs have been permanently lost in the last few months.5
  • All employment gains since 2008 have been lost at least temporarily.3
  • Young are suffering more than older workers with a 32% unemployment rate for teenagers. 3
  • The proportion of the employed available prime labor force (aged 25 – 54 years) is lower now than it was at the bottom of the 2008 recession. 3

The above unemployment data is directly related to the various quarantine and shelter-in-place orders that have been issued across the country. While protecting human life should always be a primary goal for policymakers, it must be balanced against the potential negative effects from decisions related to that goal. The question of how quickly economies should be reopened is not as simple as people (i.e. COVID-19 deaths) vs. corporate profits. If high unemployment persists, there are many related negative side effects that have strong historic connections.

For example, a higher rate of poverty is related to higher crime rates, drug abuse, alcoholism, suicide, domestic abuse, etc. The chart below demonstrates expected future poverty levels at various levels of unemployment. The longer the shutdown lasts, the higher unemployment likely goes; the longer it will take for businesses to restart and rehire; the more permanent job losses will become; and ultimately the higher poverty levels will probably rise. The current unemployment level is estimated to be ~20%, which would estimate future poverty levels at highs not seen since the 1960s.

Source: DeParle, J. (April 16, 2020). A Gloomy Prediction on How Much Poverty Could Rise. The New York Times.

There is also a strong historic correlation between loan delinquencies and unemployment rates. If unemployment levels remain elevated, sharply higher levels of debt default are likely right around the corner. This will harm both lenders and borrowers alike as well as potentially lead to tighter future lending standards (i.e. higher borrowing costs and stronger credit score requirements).

Source: Slok, T. (April 16, 2020). Duration of the Shock is Key. Deustche Bank.

Higher debt delinquency levels eventually lead to a higher rate of bankruptcy. Logically, that means higher unemployment levels can also be associated with more bankruptcies.

Source: Slok, T. (May 4, 2020). Policymakers Will Decide If We Move from a Liquidity Crisis to a Solvency Crisis. Deutsche Bank.

To prevent a further increase and begin lowering the level of unemployment, businesses need to reopen. The longer the economic shutdown continues, the longer business leaders expect restart to take. This trend is demonstrated by a recent set of Price Waterhouse Cooper surveys taken over several months. In the most recent study, managers expect a full restart to take one to six months, where previously they answered just zero to three months.

Source: PwC’s COVID-19 CFO Pulse Survey. (May 11, 2020). PWC.

On top of the above data, 50% of small business owners, per a recent National Federation of Individual Business survey, say they will not survive the next two months under current conditions. More than 70% say they will not survive the next three to four months. Small businesses (companies with fewer than 500 employees) make up 46.8% of private sector payrolls.6

Source: Michigan Small Business Severely Impacted by Coronavirus. (April 6, 2020). NFIB.

Based on the data from the two directly above surveys, it is unsurprising that the vast majority of small business owners think the economy should open completely this month.

Source: Slok, T. (May 14, 2020). Small Business Outlook is Key. Deutsche Bank.

Reopening the economy may not be the ambrosia many business owners are hoping for, however. Employees can be rehired, and the “Open” sign can be turned on, but that does not guarantee customers will come in the door. It is very possible that businesses will open to lackluster customer demand, with the vast majority of respondents to a recent CBS poll reporting they would be uncomfortable doing previously routine activities.

Source: Salvanto, A. (April 23, 2020). Americans Prioritize Staying Home and Worry Restrictions Will Lift Too Fast. CBS News.

It remains to be seen if the fear shown in the above poll has a lasting presence, especially after small numbers of people start trickling back to those activities and social pressures for normalization mount. That trickle could turn into a deluge in short order if there does not appear to be a new related spike in COVID-19 infections and the feared second wave of COVID-19 infections does not materialize later this year.

Whether reopening is successful or not, a tremendous amount of economic damage has occurred, and it will take a herculean effort to keep the country and world economy from sinking into a nasty recession or even possibly a depression. Recessions and depressions are challenging environments to invest in successfully.

The New Gods Hold Up the World

Considering the horrific economic damage created by global work stoppage, it is hard for most people to fathom how stock market losses are not worse for the year. The Nasdaq composite index, which heavily favors technology companies, is ~7% positive as of May 18, 2020; no Great Depression-like economic crisis is apparent there!1 This is a testament to the power of the new economic gods of monetary and fiscal policy. In the United States, monetary policy relates to the responses and tools available to the Federal Reserve bank that it employs to either stimulate or slow the rate of economic activity. Alternately, fiscal policy is the dominion of the federal government via policies regarding taxation, government borrowing, and government spending. These forces have so far successfully stymied the slide towards economic collapse — but that has come at an extreme cost, which may result in its own set of problems in the future.

Starting with monetary policy, the central banks have thrown the kitchen sink, and a few other household appliances, at the COVID-19 shutdown problem. Through efforts called quantitative easing, which help keep debt borrowing costs low and ensure a functioning bond market through buying various debt instruments with newly printed currency, many central bank balance sheets are expected to increase dramatically by the end of the year. The table below shows just how enormous these efforts have been across the globe as a ratio of the respective countries’ gross domestic product (GDP).

Source: Rabouin, D. (May 7, 2020). Nowhere Near the "Phase 1" Trade Deal. Axios.

The chart below puts the above table in a bit more context in relation to past efforts. The current efforts dwarf the response to the 2008 Great Financial Crisis, as well as the continued central bank stimulus efforts in the intervening time. The sustainability of such monumental central bank efforts is a significant question for market participants.

Source: Kelly, D. et. al. (March 31, 2020) Guide to the Markets – Asia. J.P. Morgan Asset Management.

On the fiscal side, along with efforts in other parts of the world, the U.S. federal government passed a substantial economic support package in March known as the CARES Act. Here are some points to keep in mind about CARES:

  • The CARES Act is projected to increase the U.S.’ fiscal year 2020 budget deficit by $1.61 trillion, which, along with other spending, will increase the full year deficit forecast to $3.7 trillion, according to the Congressional Budget Office.7
  • The largest annual budget deficit in U.S. history is $1.4 trillion in fiscal year 2009, i.e., the 12 months ending on September 30, 2009.8
  • For those keeping score at home, that means the CARES Act, by itself, is a larger expansion of the national debt than any single year’s deficit spending on record.

While the deficit spending and eventually necessary debt issuance is a concern for fiscally responsible persons, this spending has had an immediate positive impact on the economy. The CARES Act and other efforts are making up for a substantial amount of both lost personal and corporate income. Because of that, both individuals and companies are being largely insulated from the economic damage that would normally suggest the economy is in for a nasty recession, if not a depression — economic environments that typically result in significant losses for stock market investors. This insulative effect may wane a bit in the third quarter of 2020 if no new support packages are passed or current efforts are not renewed.

On top of the traditional unemployment insurance payments, the CARES Act added a $600 per week benefit. The New York Times sums up the “Why $600?” question nicely:

When you add $600 to the national average unemployment payment — $371.88 a week at the end of 2019 — the replacement rate goes from 38 percent to almost exactly 100 percent. In other words, that amount is what it would take for Congress to replace what the average American worker receiving unemployment would have earned.”9

This brings up the issue of dealing with averages and creating a one-size-fits-all policy or, in this case, a one size-fits-all geographic areas policy. Not all locales of the U.S. have the same cost of living or same average salary range, so applying this $600 uniformly has resulted in benefits that will provide workers in more than half of states, on average, with more in unemployment benefits than their normal salaries.9

The above will again rub the more fiscally responsible minded persons the wrong way, but for the time being, this added benefit has almost completely offset the income lost to unemployment. However, unless there is a continuation of this benefit or new support passed, the third quarter of this year and onward could see a sharper drop in net income and a likely related drop in consumer spending.

Source: Hatzius, J. et. al. (April 29, 2020). Income Losses vs. Fiscal Stimulus: Estimating Second-Round Effects from the Virus Shock. Goldman Sachs.

Corporations have also benefited from government policy changes and spending. Changes to tax laws and the potential forgivable loans of the Paycheck Protection Program (part of the CARES Act) has almost completely offset obliterated corporate earnings. Again, the current assumption is these programs will wane into the third quarter and negative economic data may have greater impact at that point.

Source: Hatzius, J. et. al. (April 29, 2020). Income Losses vs. Fiscal Stimulus: Estimating Second-Round Effects from the Virus Shock. Goldman Sachs.

The current economic support effort is also global. Added together, the G-7 (the largest seven economies in the world) have provided almost $10 trillion in economic support (shown by the blue bars and the left axis of the below chart). The combined effort dwarfs any crisis response since at least 1970 and the 2008 crisis barely registers in comparison. This chart also shows a comparably high level of debt-to-GDP for the G-7 group compared to history (shown by the light blue line and the right axis). Higher debt levels will eventually be a problem, though it is hard to say exactly when.

Source: Authers, J. (April 28, 2020). Deutsche Bank Gives Us a View of the Credit Abyss. Bloomberg.

While monetary and fiscal responses have stymied the negative economic impact, that support will come at an eventual cost. To pay for these support programs, analysts are projecting “that the U.S. will need to borrow more than $4.3 trillion, with the bulk of debt being financed as Treasury bonds in the second and third quarters, totaling roughly $3.5 trillion — $1.9 trillion and $1.6 trillion in each quarter, respectively. The previous quarterly net issuance record was ‘a comparatively minimal $569.2 billion’ in the fourth quarter of 2008.”20 Keep in mind those estimates are based on current deficit spending and do not make assumptions about future economic spending bills or bailouts for states or municipalities. It will not be good for interest rates if massive Treasury supply hits the market and/or not good for the dollar’s value if the Federal Reserve monetizes that debt via purchases as part of its quantitative easing program. If rates back up in treasuries, they are going to back up across the entire debt spectrum.

Higher levels of government spending is not the only issue here, either. Because of poor economics, state and federal tax revenues are taking a massive hit at the same time support spending has ramped up. There are not yet strong projections for lost revenue at the federal level, but state tax revenues are dropping precipitously as shown in the chart below. This trend has significant ramifications since many states were already struggling to meet spending obligations like education and public pensions before the COVID-19 crisis began.

Source: Allen, M. (May 8, 2020). Axios AM: Mike’s Top 10. Axios.

Because of the above carnage, states are now requesting their own bailout packages from the federal government as shown in a recent Twitter post from California Governor Gavin Newsom:

As it stands, the current support efforts of the world’s governments are easing the economic hit from COVID-19 shutdowns. There is a serious question as to how long government finances can sustain such efforts. We shall see if the powers of the new economic gods can outlast the wrath of the old in this clash of economic titans.

Is the Worst Really Behind Us?

At this point, stock markets are well off the March low points and even back to positive return levels in some cases. After reviewing the above information, it is easy to wonder if the worst is behind us or if government efforts only temporarily staunched the economic wound.

The various economic data groups your CWM team examines are suggesting a high degree of caution is warranted at the present. Economic support efforts are providing a strong reason to not become overly pessimistic about the future, but available economic data does not inspire confidence, either. Because of the power those two warring forces possess, and the uncertainty that they create in assessing future market potential, the prudent investor must neither be too aggressive nor too defensive with their portfolio allocation at this point.

Source: CWM Data Analytics. (May 18, 2020).

CWM clients have seen a significant number of changes in their portfolios over the last few weeks. These changes have lowered the investment allocations’ sensitivity to stock market gyrations, which will inhibit both future downside and upside return potential. There is unfortunately no way to completely protect from downward market moves and also fully participate in all upward price moves, which is why CWM pursues real returns for our clients.

Your CWM team believes this is the most prudent positioning to take at the moment, as it allows for both positive future return potential if the government stimulus plans succeed, and also serves to insulate values from potential market downside should economic calamity erupt. Additional changes will be made as necessary based on available data.

Please pass this article on to anyone you know who may be interested in or might benefit from the information. We are always looking for more great clients like yourself and would welcome any opportunity to assist them.

If you have questions or comments about the above subjects or other investment topics, I would love to have a conversation! Feel free to email me or, if you are interested in more regular financial tidbits, follow me on Twitter @MorganArford.

P.S. A firm belief of mine is that most situations will end up just fine as long as we can maintain our sense of humor. Even 2020 will end up being a good year in many ways.

References:

1Yahoo Finance. (May 18, 2020).

2Schmidt, S. (May 9, 2020). Women Have Been Hit Hardest by Job Losses in the Pandemic. The Washington Post.

3Slok, T. (May 9, 2020). This is Not Temporary. Deutsche Bank.

4Barrero, J. et. al. (May 5, 2020). COVID-19 Is Also a Reallocation Shock. University of Chicago: Becker Friedman Institute.

5Long, H. (April 16, 2020). U.S. now Has 22 Million Unemployed, Wiping Out a Decade of Job Gains. The Washington Post.

6Facts & Data on Small Business and Entrepreneurship. (n.d.) Small Business and Entrepreneurship Council.

7Swagel, P. (April 24, 2020). CBO’s Current Projections of Output, Employment, and Interest Rates and a Preliminary Look at Federal Deficits for 2020 and 2021. The Congressional Budget Office.

8Federal Budget Deficit Totals $1.4 Trillion in Fiscal Year 2009. (November 6, 2009). The Congressional Budget Office.

9Koeze, E. (April 23, 2020). The $600 Unemployment Booster Shot, State by State. The New York Times.

20Rabouin, D. (April 23, 2020). We Could Be Here A While. Axios.

This material is for general informational purposes only and is not intended to be a substitute for specific professional financial, tax or legal advice. Individual circumstances may vary.

Investing involves risks including the potential loss of principal. This commentary contains forward-looking statements and opinions. These opinions may not develop as predicted. It is our goal to help investors by identifying changing market conditions. No strategy can accurately predict all of the changes that may occur in the market. Past performance is no guarantee of future results.

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