The crisis is over, but at terrible cost

To date, the most consequential result of this novel coronavirus has come from the hand of government, thanks to multiple decrees from governors, mayors, and public health officials mandating the closure of a broad swath of the US economy. Arguably, the cost of shutting down the economy in terms of jobs, living standards, and money has been far greater than the cost of virus-induced deaths, which have turned out to be orders of magnitude less than initially predicted, even by models which factored in severe social distancing. As I like to put it, "The shutdown of the US economy will prove to be the most expensive self-inflicted injury in the history of mankind.™"

Earlier this year. headlines were screaming that millions would die and hospitals would be overflowing with desperately ill patients. Early estimates (mid-February) pegged the fatality rate at 2-4% (20 times more lethal than the common flu!). More recently, better-informed analysts, including Dr. Fauci, have estimated the lethality rate to be 0.2%, only double that of the common flu. Several other estimates of lethality can be found here, many of which say it is far lower than most have thought, but do read the entirety of this linked page as it will amaze you. Some speculate that covid-19's lethality could be much less than the flu, based on the (still unproven) theory that it began to spread rapidly through areas such as the California economy beginning in October of last year, and has thus left millions with protective antibodies. One curious fact about this virus is that the majority of people infected never even realize they have it, while for the unlucky few (mainly the elderly and those already besieged by another grave illness) it is quite deadly. We are now learning that only 0.9% of US deaths from coronavirus correspond to people who were younger than 65 and had no pre-existing conditions!

The IMHE—which has repeatedly and greatly over-estimated the dangers of the coronavirus—now predicts that we have seen the peak in daily US deaths, and they should begin to decline. Further the IMHE now predicts total deaths in the US will be a little over 60,000, which is somewhat more than the 45,000 or so deaths we would expect from the seasonal flu. All of the current predictions are significantly lower (about one-third lower) than the IMHE predicted just one week ago.

In Europe, the evidence is strong that the worst of the viral contagion has passed. Daily new cases and daily new deaths have been declining in almost every major European country for the past week or two. Nearly every country in the world is experiencing a flattening curve; the rate of growth of daily new cases is steadily decreasing.

Meanwhile, there are multiple vaccines in the pipeline and therapeutics aplenty, most notably hydroxycholoroquine, which I noted in a post over two weeks ago.

Regardless, and unfortunately, the millions-of-dead nightmare scenario was enough to persuade public officials to take the most drastic course of action ever contemplated, with the result that at least 17 million American workers have lost their jobs in just a few weeks and economic activity has plunged so drastically that the world is awash in unwanted petroleum. To make matters worse, our federal government had no choice but to offer extraordinary unemployment benefits to tens of millions of workers who could no longer work, and many hundreds of billions in loans to otherwise suddenly-insolvent businesses. Estimates of what is deceptively called fiscal "stimulus" start at $2 trillion and the final tab could easily reach $4 trillion. The problem with all this, of course, is that it is not stimulus, it's just an attempt to compensate people who lose their jobs and businesses who were forced to shut down.

If we had known at the outset that the virus would end up being far less lethal than it was predicted to be, and instead only somewhat more lethal than the ordinary flu, would we have agreed to surrender our liberties and allow the government to order tens of millions to stop working? I seriously doubt it, and that leads to the inevitable conclusion: this shutdown was a terrible and tragic mistake.

Ultimately, the cost of this mistake will be borne by all of us. The rich will pick up a goodly portion of the tab because they always end up paying the lion's share of taxes, thanks to our very progressive tax code. Everyone will pick up part of the tab in the form of reduced living standards (and lower-than-otherwise incomes), since it will likely take many years for the economy to make up for all the ground lost as a result of the shutdown. We will also pay an invisible price in the form of less social interaction, less travel, less community, and more government control of our lives, and that is far from insignificant.

Another cost: government is likely to find it difficult to persuade itself and the public of the need to re-open the economy (which it should do now, asap), if only because the public has come to understand that the shutdown is necessary to avoid deaths. It's not. The only justification for the shutdown was to "flatten the curve," because otherwise our healthcare system would suffer a meltdown. We now know that this will not happen, as hospitals around the country have ample unused beds, and the rate of infections is declining. The virus will run its course regardless of whether we shut down the economy. It won't end until we have sufficient herd immunity, and that will be acquired only through illness (which produces antibodies and future immunity) and through vaccines (which induce the production of antibodies, but which are still many months in the future). For more details on this, see the anonymous FT reader's comment at this link. Failing to understand that more deaths are inevitable is likely to prolong the (now unnecessary) shutdown.

Bondholders might be the biggest monetary losers. They will be funding many trillions of dollars of "stimulus" at historically-low interest rates. If and when the economy recovers, interest rates are bound to rise, if only because right now they are well below the current rate of inflation. But with so much money being dumped into the economy—money which now is desperately needed and wanted—it might be difficult for the Fed to withdraw it when things improve and the demand for money returns to normal. There could be a significant excess supply of money at some point which would almost surely result in rising inflation.

A quick and dirty, back-of-the-envelope calculation:

Suppose Treasury sells $3 trillion of bonds with an average duration of about 7 years (equivalent to an average maturity of about 8 years) at the prevailing rate of roughly 0.5%. Suppose further that inflation rises from the current 2% to 4%. Bond yields would have to rise to at least 5% in a 4% inflation world (and a world that is once again growing), and that rise in yields would depress bond prices by almost one-third. That, in turn, would represent about a $1 trillion loss born by bondholders and a $1 trillion gain which would accrue to Treasury, because the effective burden of the debt—and the purchasing power of the bonds—would be reduced by inflation. Even if nothing changed, 0.5% Treasury yields represent a 1½% annual loss of purchasing power to bondholders in a 2% inflation world. Bondholders will pay an inflation tax to Treasury even if inflation and interest rates don't rise. Memo to investors: if you think this scenario is likely, you should buy assets (e.g, houses) that will benefit from rising prices, and fund the purchase with fixed-rate debt.

And now it's time for some charts, followed by some conclusions:

Chart #1

As Chart #1 shows, stocks have rebounded—recovering almost half of what they lost—and investors' fears have declined. But fear is still quite palpable: 10-yr Treasury yields are extremely low, far lower (currently 0.7%) than at any time in the past century, and the Vix, currently at 40+, is still exceptionally elevated. Conclusion: the stock market is looking across the valley of despair and seeing an exit from the shutdown and a taming of the virus, but the market has yet to conclude that much good will come of this. The road to recovery is going to be slow and bumpy, but the worst is over.

To what degree the stock market will continue to recover, and by how much, is above my pay grade. But looking out over the long-term horizon, it seems clear that the economy will recover and growth will resume. So I won't be selling. Cash is paying almost nothing and most risk-free bonds ensure you will lose significant purchasing power for years to come (see below for more about this). Stocks, distressed debt, commodities and real estate are the only sensible asset classes at this point, since they give you exposure to rising inflation and/or a growing economy.

Chart #2

Chart #2 compares private sector jobs (blue) with public sector jobs (red). Wow: almost overnight we have wiped out all the net job gains of the past 14 years, and the losses aren't over yet. Private sector jobs have dropped more than 13% to date. Here's a thought: to my knowledge not a single public sector employee has lost his or her job. Some or many may have been sent home, but have any been forced to endure a visit to the unemployment office? Would politicians have been so quick to decree a shutdown if that meant that 13% of public sector employees were fired along with 13% of private employees? Doesn't fairness demand that the public sector share in the pain of the shutdown? There is potential for great anger here.

Chart #3

As Chart #3 shows, consumer confidence has been shattered, and it's likely to fall further in the next survey, probably coming close to what happened at the depths of the Great Recession. It could take years for confidence to be rebuilt, just as it did in the wake of the Great Recession. And don't forget the younger generation, which has been traumatized by fears of catching or passing on a deadly virus. Our grandchildren won't come any closer than 10 feet from us, and they haven't had any contact with the outside world in weeks. When I see a person walking on an empty street in Southern California and wearing a mask, I see a person who won't lose his fear of social interaction for years.

Chart #4

As Chart #4 shows, the Fed wasted no time in responding to a sudden increase in the demand for money by supplying the banking system with more than $1 trillion in additional bank reserves. 

Chart #5

The virus panic, the shutdown, and the one-third drop in stock prices combined to produce a tremendous demand for the safety of cash, money, and money equivalents. The last time this happened (late 2008) global financial markets were on the cusp of collapse because there was a sudden and drastic shortage of cash and liquidity. Without functioning financial markets, which absolutely require liquidity and safe assets, there is no hope for an economic recovery; cutting off the free flow of money would be like shutting off the oxygen to a desperately ill economic patient. So it's a very good thing that the Fed has responded forcefully to the coronavirus crisis. Chart #5 shows the 3-mo. annualized growth in the sum of demand deposits and savings deposits at US banks: it's explosive, and the Fed has successfully accommodated this.

Chart #6

Chart #6 gives you the big-picture view of money, as measured by M2. Demand and savings deposits now represent about 75% of M2. As the chart suggests, about half of the recent increase in M2 was to make up for the unusually slow growth in money in recent years, and the other half was likely the result of a massive flight to safety. You may think we are in uncharted monetary territory, but we're not there yet.

Chart #7

Chart #8

As Charts #7 and #8 show, banks have been quick to expand their lending to small and medium-sized business.  C&I Loans are up more than $500 billion in the past 3 reporting weeks, and more is sure to come.

Chart #9

Chart #9 shows that 2-yr swap spreads in both the US and the Eurozone have risen of late. But they are not excessively high. Indeed, at 20+ bps in the US, they are smack in the middle of what might be called a "normal" zone. They were exceptionally low not too long ago, and I speculate that was due to a shortage physical bonds that could be used as collateral for hedges (i.e., the market had to resort to buying swap spreads instead of buying Treasury notes). Swap spreads today tell us that systemic risk is low liquidity is abundant, and that is a very good thing.

Chart #10

Chart #10 shows Credit Default Swap spreads, which are highly liquid and generic proxies for corporate credit risk. Spreads shot higher as the crisis deepened (and in particular as collapsing oil prices threatened the solvency of indebted oil producers), but the Fed's aggressive actions of late have reversed this. Today's recently-announced deal to cut oil production will surely help. The market has pulled back from the edge of the abyss, and thank goodness!

Chart #11

Chart #12

Chart #11 shows actual corporate credit spreads, which have behaved similarly to CDS spreads. Chart #11 makes the point that the energy sector has been the principal driver of higher spreads. Wider spreads are mostly about extremely low oil prices, which ought to improve as producers slash production and the economy begins to re-open.

Chart #13

Chart #14

Charts #13 and #14 show that energy prices are the principal source of fluctuations in the CPI. As Chart #13 demonstrates, if we subtract energy prices from the CPI, inflation has averaged 2% for the past 17 years. In the absence of tight monetary policy (and there is no evidence right now that the Fed is too tight), it is reasonable to expect inflation to average about 2% or a bit less in coming years.

Chart #15

Chart #15 compares 5-yr Treasury yields with ex-energy consumer price inflation. Yields are far below the current level of inflation, and that is unsustainable for the long term. Inflation is unlikely to decline significantly, given the Fed's aggressive accommodation of soaring money demand. Once the economy stops contracting and returns to growth mode, all interest rates should rise, and by a significant amount.

Chart #16

In their traditional roles, both gold and TIPS are hedges against rising inflation. As Chart #16 shows, the prices of both are quite elevated, suggesting a market that is very worried about the potential for rising inflation. This runs contrary to the relatively low expected level of inflation (about 1%) that can be inferred by comparing the yields of nominal and real yields in the Treasury market, but it is possible that Treasury prices are being skewed by the current level of panicked demand for anything deemed safe.

Conclusions:

Whether we experience a near-term recovery, and whether it's V-shaped or U-shaped or strong or weak will depend on how soon and how rapidly the economy is allowed to re-open. If it were up to me, I'd start the re-opening tomorrow. Unfortunately, I don't think the current political climate would support that, and it's doubly disappointing to hear so many people talking about a May 15th re-opening. The worst has passed, but it's going to be an agonizing wait for good news, which means continued volatility.

The Fed has done what it needed to do. It hasn't been "stimulative" because monetary policy can't create growth on the printing press. The Fed has accommodated the sudden increase in the demand for money and money equivalents, and that's their job. 

Fiscal policy to date has helped, to the degree it has attempted to compensate economic actors for their enforced losses. But it hasn't been stimulative. Stimulative fiscal policy involves something that gives workers and companies an incentive to work harder. Paying out larger unemployment checks for longer doesn't do that. A payroll tax holiday lasting through year-end would (which is what Art Laffer has been recommending), because it would increase the after-tax reward to work and reduce the cost of labor for what is left of the current calendar year. (Workers would see an immediate increase in their paycheck if they were working, and employers would see an immediate reduction in the cost of paying salaries.) If we see that policy emerging from the current mess that would be very positive. 

Even if the current mess continues for too long, the stock market should be able to look across the valley of weak-to-zero earnings and focus instead on the long-term, since eventually we will get back to something close to normal. A one-year cessation of earnings does not materially affect the present discounted value of decades of positive earnings.

The current elevated level of gold and TIPS prices is, among other things, symptomatic of a market that worries about higher inflation in the future. And as I've explained above, that is not unreasonable at all. Thus we should disregard the risks of deflation and focus instead on what will benefit from steady to higher inflation (e.g., commodities, emerging markets, distressed debt, real estate, nominal wages, and federal finances—through rising tax revenues and reduced debt burdens). The losers, of course, will be those things negatively affected by rising interest rates.

Above all, pray for a speedy re-opening of the economy.

UPDATE, as of market close April 14. I just love tracking the evolution of this chart (Chart #1 from above):

(note: you can make any chart much larger just by clicking on it.)