Extraordinary Measures, Fed action, and What We Might Learn from Past Pandemics – March 23, 2020

Over the past week, our nation has taken extraordinary measures in order to slow and stop the spread of COVID-19. It’s incredibly unsettling. Many restaurants and movie theaters have closed, and public gatherings have been limited. It’s disquieting, and I hope you, your family, and your friends are safe and well.

The reaction we are seeing in the public square has been playing out in the financial markets, too. Yet, I’d like to offer a balanced perspective and hope as we move forward.

Let’s start with last Sunday, when the Federal Reserve felt it couldn’t wait until its Wednesday meeting to act. Before the week began, the Fed slashed its key lending rate, the fed funds rate, by a full percentage point to 0-0.25%.

It announced a new round of quantitative easing (QE, or Treasury bond and mortgage-backed security purchases) totally $700 billion in the coming months. It’s designed to inject cash into the financial system. Per the Wall Street Journal, the Fed has bought about $250 billion already, suggesting a more aggressive round may be in the works.

It also resurrected tools used in the 2008 financial crisis. These tools are designed to ease liquidity issues (lack of dollars) in the global markets.

Before I go on, we are not seeing anything near the stress in credit markets that we saw in the wake of Lehman’s failure in 2008.

Stress in the credit markets has risen, but the Fed is trying to stay in front of the curve, proactively providing liquidity (cash) rather than reacting to a major bankruptcy.

For example, on Wednesday the Fed announced a facility to backstop money market funds rather than wait for potential problems. It is also providing support to commercial paper markets and expanding lending to primary dealers in the Treasury market.

Further, banks are much better capitalized today than in 2008.

Without getting into a lengthy discussion of the details, the Fed is doing what it was designed to do when it was created in 1913—acting as the lender of last resort.

Yet, stocks continue to react to the unknown. Leading indicators of economic activity are just beginning to foreshadow the economic recession we will probably see.

Forecasters are now talking about a very steep contraction in Q2 Gross Domestic Product, the largest measure of the economy, amid shutdowns in restaurants, travel-related industries, and businesses that rely on person-to-person interactions. It’s unprecedented.

It sounds and feels bleak. But let me also say that new cases of the virus in South Korea have slowed dramatically (Worldometer, Johns Hopkins), and the virus appears to have peaked in China.

Given the extraordinary measures being taken at home, there is tepid and cautious optimism the same will eventually occur here.

Modeling the economic impact

There isn’t a modern precedent, and economists don’t know how to model such an extraordinary event. Without data, investors feel as if they are socked in by a fog; hence, the reaction in the stock market.

But let me offer two past epidemics as guidance. The deadly 1918 Spanish flu pandemic caused a 7-month recession in the U.S. (National Bureau of Economic Research). Going back to the 1850s, it is the shortest recession on record.

In Q1 1958, GDP fell 10.0% (St. Louis Federal Reserve), which followed a 4.1% drop in Q4 1957. While the research available is sparse, the 1957-58 outbreak of the Asian flu appears to be the culprit behind the steep decline. GDP rebounded in the second quarter, and the length of the recession was pegged at 8 months (NBER).

I recognize the economy was quite different during both periods. In the late 1950s, we had a larger manufacturing sector, and travel-related industries and restaurants were a much smaller portion of activity. Still, massive stimulus is in the pipeline, and it is designed to soften the blow and set the foundation for an eventual economic recovery.

Anticipating a turnaround

Markets try to anticipate the future. No one rings a bell when we hit bottom.

Investors will likely try to sniff out an economic recovery before it begins. Signs we might look for include:

• The response by the Fed and the government regarding spending and tax stimulus begins to restore confidence.
• Better news out of China might help. For example, the CEO of Kraft Heinz said Friday in a CNBC interview, “Business is back to normal in China.”
• We start to see a peak in new COVID-19 cases, and markets begin to get an idea how long and steep a recession might be.

One final remark. On Friday the U.S. Treasury Secretary tweeted the federal tax-filing deadline has been extended to July 15.

Created 2020-03-23 19:13:14