Dave Donabedian, CFA
March 23, 2020
Officially, recessions aren’t declared until after they are over. But, we are assuming that a recession began in March. The disruption to businesses and employees created by social distancing, shelter-in-place orders and more draconian measures to come will have an increasingly negative impact on activity. In short, hibernation is not good for an economy.
Our expectation is that the second quarter will show one of the biggest drops in economic activity in the nation’s history. The consensus estimate is for a 9% decline in real gross domestic product (GDP)1—worse than any single quarter during the Great Financial Crisis. However, our preliminary analysis suggests the consensus estimate is probably too optimistic. Implicit in this outlook is a significant jump in unemployment and a plummet in consumer spending and manufacturing output. The same trends are unfolding in the rest of the developed world, as well.
A brutal second quarter is largely discounted in financial markets, including a significant drop in corporate profits. The big question is: How long will the recession last? The key variables are the path of COVID-19 and government policy. Those topics are addressed below, but our base case is that the third quarter will probably be “less worse” than the second, and a true recovery likely emerges before year-end.
The answer to this will greatly impact the recession issue. The outcome, however, is very uncertain. We are relying on the knowledge of public health experts and incoming data. So far, the data on the course of the virus in the U.S. does not lend itself to encouragement.
The chart above shows the daily cumulative case count in various countries since confirmed cases reached 100. The hopeful path is that of China (outside of the Hubei province epicenter) and South Korea, where the case count has virtually plateaued and began to do so after 25-30 days. The much more concerning path is Italy, where the case count continues to explode after 25 days. As testing rises in the U.S., the path of COVID-19 is following the path of Italy. Most virologists expect numbers in the U.S. to continue on a sharp upward slope as the rate of those being tested accelerates in the days ahead.
The hope is that social distancing and increasing measures that approach a lockdown in hot spots around the country can slow the growth of the outbreak in April or May. The health threat won’t vanish, but the goal is for it to become more manageable.
The short answers are “somewhat,” and “not enough yet.” There are three forms of policy response: public health, monetary and fiscal. Public health policy is focused on reducing medical risk, monetary policy is focused on alleviating financial market liquidity risk and fiscal policy targets economic risk. The aggressive public health response in the U.S. came later than most epidemiologists recommended. However, measures designed to contain the spread of COVID-19 have accelerated dramatically in just the last week and are likely to continue as we move to a high-speed rolling quarantine of sorts.
Central banks around the world have pulled out almost all the stops. In less than a week, the Federal Reserve (Fed) rolled out 11 different initiatives.2 The highest profile measures came from the Great Financial Crisis playbook: a return to a policy interest rate range of 0.00%-0.25% and the aggressive purchases of government and mortgage securities. The other measures were more technical in nature but are focused on improving liquidity in parts of the credit markets that were not functioning normally: commercial paper, repurchase agreements, certain money market funds and corporate and municipal bonds. The Fed doubled down on Monday morning, announcing unlimited support for the Treasury and mortgage markets as well as massive liquidity backstops for other stressed parts of the credit markets.
The proper functioning of credit markets is a vital component to a healthy economy, and the Fed is working to restore order. Some of the Fed’s programs have already had a positive impact; others need more time to work. The Fed has broad powers to act as a lender of last resort in “unusual and exigent circumstances.”3 Current conditions certainly satisfy that criteria, and we expect further action.
Fiscal policies typically take longer, because they are subject to the political and legislative process. To date, targeted programs have been passed to extend paid sick leave, unemployment benefits and other limited measures. These steps are necessary, but they don’t begin to touch the fallout from the expected economic impact. Congress and the White House are in the midst of negotiations on a roughly $2 trillion stimulus plan. The proposals center around addressing liquidity problems that many businesses and households will have for a period of months. The goal is to provide them with cash to avoid insolvency and the chance to participate in the ensuing economic recovery, whenever that may be.
It is critically important that the legislation provide assistance to small and medium sized businesses. As the chart below shows, over 80% of Americans are employed by such entities, while less than 20% are employed by large companies. Small businesses often have less of a cushion to fall back on in hard times. Without a lifeline, a swift and dramatic hit to the economy can drive a thriving small business into insolvency very quickly.
We will know a lot more about the scope and size of the fiscal package within the week. We believe Sunday’s decision by the Senate not to advance the stimulus package is a bump in the road in a messy and partisan process. It is highly likely that a package will be passed this week, and that the price tag will only grow during bipartisan negotiations. This would likely be a huge stimulus (about 10% of GDP), and unlikely to be the last.
First, let’s lay out where things stand. The longest bull market in U.S. history is over. It ended with an all-time high for the S&P 500 on February 19. From that day forward, the U.S. equity market suffered the quickest-ever descent into a bear market from an all-time high (18 trading days). As of Monday morning’s open, this bear market has already produced a 33% drawdown.4
To provide some context, here are some statistics on the 11 prior bear markets in the post-World War II era:
The catalysts for bear markets can be divided into three categories: financial crises, Fed policy mistakes and event-driven. The COVID-19 bear market clearly falls into the last category. Historically, event-driven bear markets have bottomed more quickly than the others. One study concludes that these bear markets have averaged six months in length, with an average drawdown of 22%.5 This makes sense because the issues around a financial crisis and the economic consequences of a recession caused by tight money can take longer to resolve. Crises caused by surprise events have a predictable pattern: The event occurs for a discrete and usually short period of time, markets fall, policymakers respond and markets recover.
This event-driven bear market is more complicated, primarily because COVID-19 has not yet reached its peak. In the short term, the driver of market direction is likely to be the path of the coronavirus itself. But, we do believe that the policy actions in place, and those to come, are building a platform for recovery.
Dave Donabedian is chief investment officer of CIBC Private Wealth Management, serving in that capacity since 2009. His responsibilities include chairing the Asset Allocation Committee, as well as providing oversight of internal investment strategies and the external manager selection platform.
1. Bloomberg, as of 03.20.2020.
2. www.federalreserve.gov, as of 03.20.2020.
3. Federal Reserve Act, section 13(3).
4. Bloomberg, as of 03.23.2020.
5. Goldman Sachs Global Investment Research, as of 03.11.2020.
CIBC Private Wealth Management includes CIBC National Trust Company (a limited-purpose national trust company), CIBC Delaware Trust Company (a Delaware limited-purpose trust company), CIBC Private Wealth Advisors, Inc. (a registered investment adviser)—all of which are wholly owned subsidiaries of CIBC Private Wealth Group, LLC—and the private wealth division of CIBC Bank USA. All of these entities are wholly owned subsidiaries of Canadian Imperial Bank of Commerce.
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