It Will Be A U-Shaped Economic Recovery Not A V-Shaped One

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( 19 mins read )

My baseline view is that markets are much too optimistic about the recovery of the US and world economies. Of course, there is a reason for optimism; the infection trajectory in the US is looking better, as shown in Figure 1 on the left below. According to most models, the peak in the USA will be happening in the next week or so, and decline to close to zero in the following weeks. Containment has worked to “bend” the infection curve. However, containment has come at a high cost, as shown on the right-hand side of Figure 1. Unemployment is expected to reach levels last seen during the Great Depression. US will be in a recession, e.g., the IMF pegs USA real GDP growth at -7.9% in 2020 as their base case. With the bending of the curve, comes the debate of how and when to lift containment and allowing the economy to recover vs. the risk of this igniting a second wave of the virus. The view of markets and most economists is that there is a strategy for lifting containment that will allow for the US to go back to work and drive a sharp V-type recovery without igniting a second wave of infections. Add a staggering amount of stimulus worldwide, and you have explosive growth back above pre-virus levels. I disagree and am arguing that the base case should be more of a U-shaped recovery. The economic rebound in the second part of the year will be long and protracted, with a significant risk that we have not even seen the bottom of the U. There no magic wand that will rapidly lift the economy back to its pre-virus; the damage has been done. Here is my thinking.

  • Even without containment, most individuals will still keep to their containment type behavior to reduce the threat of infection, given there is no vaccine, no anti-viral, and no scalable TTT framework
  • Any lifting of containment strategy that is focused on rapidly lifting the economy back to normal would result in a second wave of infections and a move back to containment
  • Consumption and investment will be below pre-virus levels for the foreseeable future, even if lifting containment does not create a second wave
  • Fiscal stimulus only reduces the current downside at a considerable cost of future in future growth
  • Economic growth will be constrained until there is more clarity about the “new normal” of the post-virus economy. Great Depression had a similar effect as it created a new normal in its aftermath by reshaping the behaviors of an entire generation

A U Not V Explained

Figure 2 below walks through my thought process for both a U- and V-shaped recovery. Point A is where we are now. Roughly 20% of individuals are behaving as they were in the pre-virus world. The US economy is about 70% of pre-virus levels. My thesis for a U-shaped recovery is that either we go to Point B, where post-containment behavior looks almost the same as during containment. The move from Point A to Point B means that behavior is being driven by fears of the virus and less by constraints imposed by containment. Economic growth rebounds slowly in this case. Alternatively, the economy gets to Point C with more people returning to pre-virus behavior, but it ignites a second wave of infection. In this case, containment is reimposed, and the economy goes back to Point A. This is an even slower rebound. Both scenarios imply a U- shaped recovery. The V-shaped scenario is illustrated with the move from Point A to Point D. In this case, there is a strategy for lifting containment that will allow most individuals to go back to their pre-virus behavior without igniting a second wave of infection. Given stimulus, this could mean the economy achieves an even higher level than it was on track before the pandemic. I believe that there is no realistic strategy for lifting containment that will not unleash a second wave. And, even if there were, the damage has been done, and the economy will not achieve even pre-virus levels for quite some time.

Right now, fear of the virus is rational, as is the risk of a second wave of infections after containment. It is still out there; it is highly infectious: and, its mortality rate is high. This is the same virus that left unchecked would have infected 50-605 of the US population, mortalities would be over 1mm, and the US medical system would have been overwhelmed. There is no vaccine, no anti-viral treatment, and no large-scale program to reduce infections other than containment. And all of those risk mitigates are unlikely to be forthcoming in the next few months if not the next few years. Start with a vaccine. A vaccine is unlikely to be available before 2021. More importantly, by then, the vaccine will likely only have the effectiveness of the seasonal flu vaccine of about 40-50%, given the typical mutation pattern of the flu virus. That means the virus will be less infectious but still very deadly. The EBOLA vaccine took seven years, and after 39 years, there is no HIV vaccine. The more critical risk mitigant is an effective anti-viral treatment to reduce the mortality rate, such as we have for HIV.

Currently, there is no effective anti-viral or any treatment for COVID-19. Drugs in development are unlikely before the end of the year. For example, the early results for the trials of Gilead’s Remdesivir look encouraging. However, the placebo studies are still to be run. It is also not clear yet what the impact is without a more accurate read of the actual mortality rate

The Virus

Right now, fear of the virus is rational, as is the risk of a second wave of infections after containment. It is still out there; it is highly infectious: and, its mortality rate is high. This is the same virus that left unchecked would have infected 50-605 of the US population, mortalities would be over 1mm, and the US medical system would have been overwhelmed. There is no vaccine, no anti-viral treatment, and no large-scale program to reduce infections other than containment. And all of those risk mitigates are unlikely to be forthcoming in the next few months if not the next few years. Start with a vaccine. A vaccine is unlikely to be available before 2021. More importantly, by then, the vaccine will likely only have the effectiveness of the seasonal flu vaccine of about 40-50%, given the typical mutation pattern of the flu virus. That means the virus will be less infectious but still very deadly. The EBOLA vaccine took seven years, and after 39 years, there is no HIV vaccine. The more critical risk mitigant is an effective anti-viral treatment to reduce the mortality rate, such as we have for HIV.

Currently, there is no effective anti-viral or any treatment for COVID-19. Drugs in development are unlikely before the end of the year. For example, the early results for the trials of Gilead’s Remdesivir look encouraging. However, the placebo studies are still to be run. It is also not clear yet what the impact is without a more accurate read of the actual mortality rate of the virus. Even if proven to be effective, it could take until the end of the year to have enough treatments to make a difference. Gilead’s CEO said it is trying to create the capacity for 500,000 courses of treatment in about six months once they are given FDA approval. And, like the vaccine, it may still not be 100% effective since we don’t even know all the reasons for its high mortality rate. But, it would be a game-changer for combating upsurge of infections without sending people back into containment if it works. Keep mind other touted anti-virals such as chloroquine do not work, and it seems it makes it worse. That leaves a ventilator or dialysis machine as the sole barrier to mortality.

So, without a vaccine and, more importantly, an effective treatment, our only remaining strategy other than containment is the framework called TTT, Testing, Tracing, and Treatment. Again, this does not seem feasible at the scale needed to be an effective alternative to containment. Testing would need to be at a level of roughly 10 to 20 times the current 150,000 a day of testing. Tracing the contacts of those who test positive would also need to be scaled up massively from current levels. Such a program would need 100,000s of workers to trace who the contacts of those that tested positive. Only at this could you substantially reduce the risk of infection for the mostly non-infected in the US, and to give those non-infected the confidence to come out and return to their normal lives. However, the TTT scale needed is nowhere close to that required to give people the confidence that a second post containment infection cycle will not emerge. Accordingly, they will not likely come out to work or consumer. Also, without a vaccine, an anti-viral, or a viable TTT system, there is a very high likelihood of a second wave.

Lifting of Containment Will Not Change Behavior But Could Unleashes a Second Wave

As shown in Figure 3 below, the US could look like Sweden does now after containment is lifted, and compliance to rules are voluntary. In Sweden, behavior such as social distancing and stay home are not mandated and rely on individuals to follow the rules voluntarily. However, this voluntary compliance has not worked as infections there are significantly higher than in the rest of Europe where containment is mandatory, followed by almost everybody, and is strictly enforced. Sweden’s infection rate is even higher than the US, with roughly 75% of the population under mandatory containment. Also, even in highly effective containment countries, infections can spike, as shown in the right of Figure 3. So, no strategy will be completely effective and runs the risk of igniting a second wave.

Lifting of Containment Will Not Change Behavior But Could Unleashes a Second Wave

As shown in Figure 3 below, the US could look like Sweden does now after containment is lifted, and compliance to rules are voluntary. In Sweden, behavior such as social distancing and stay home are not mandated and rely on individuals to follow the rules voluntarily. However, this voluntary compliance has not worked as infections there are significantly higher than in the rest of Europe where containment is mandatory, followed by almost everybody, and is strictly enforced. Sweden’s infection rate is even higher than the US, with roughly 75% of the population under mandatory containment. Also, even in highly effective containment countries, infections can spike, as shown in the right of Figure 3. So, no strategy will be completely effective and runs the risk of igniting a second wave.

In the absence of any mitigant to the virus, individual behavior will be driven by the fear of the virus not by government announcements that they can resume their normal lives. Look at Figure 4 below. As shown on the left, a survey last week showed an overwhelming number of the US is still concerned about the virus. Also, as shown on the right, a majority of the population still believes a higher risk is opening up the economy rather than taking too long and risking the economy. There is a political affiliation factor as well. This factor probably reflects the differences in urban vs. rural and coastal areas vs. interior areas. This is a problem for a V-shaped recovery because the most substantial portion of US GDP is on the coasts and in urban areas, and is mostly democratic. Accordingly, their behavior will continue driven by fear of the virus and less by the demands of the economy. Consequently, yet another factor is a U-shaped recovery, not a V-shaped one.

Even in a command economy such as China, individual choice does show through looking at Figure 4 below. In this figure, traffic jams in Beijing are shown by the day of the week. During the workweek, the government mandate has push people to drive to work. However, on the weekends, when they don’t have to go out, they don’t.

The Damage Has Been Done, Expect Lower Investment and Lower Consumption

Microsoft Word – SOM Macro Commentary April 20 2020 Final.docx

Now let’s look at the components of GDP growth that need to get back to normal to get V recovery, consumption, and investment. Consumption comprises 2/3 GDP, but I believe it will be lower than pre-virus levels for quite some time for several reasons. Income uncertainty will reduce consumption if the economy does not get back to work soon. As shown in Figure 6 below, both households and small businesses are very vulnerable to a longer than anticipated recovery. Now think about that typical household living from paycheck to paycheck or a small business owner trying to survive. My guess is that the household will reduce consumption in the short-term and likely in the longer-term given the experience of living under the COVID-19 economy. The small business owner will be unlikely to hire that extra worker or hire back a worker they let go given their existential experience. In both cases, neither consumptions nor employment will return to normal anytime soon. Consumer credit tightening is also going to be a headwind for consumption. Banks will likely tighten credit given both the rise in default in their loan books, while household credit quality will deteriorate form missed payments. The major banks, for example, have increased their consumer credit loan loss reserves by 30% in the 1st quarter, reflecting concerns about consumer credit. Again, a U not a V.

Consumption will also be lower, driven by a rise in saving rates. Historically, as shown on the left-hand side of Figure 7, private savings have grown along with deficits. As shown on the right-hand side, savings will need to reach historically high levels, given the surge in the deficits. On the right-hand side, savings growth will not be enough to offset the surge in the deficit, and future economic growth will lower as net capital stock shrinks.

High Savings rates will also have an impact on private fixed investment accounts, which is roughly 1/3 of GDP growth. Given the current state of the world, what is the investment plan for the rest of the year if you were a company? Are you going to build an office building, a mall, or a factory, or just build up cash? Look at figure 6 below. The uncertainty of the current pandemic is reflected in the left-hand side that shows that policy uncertainly is at historically high levels, and substantially above that in the GFC. As shown on the right-hand side, the collapse of the oil market will add even a stronger headwind to investment than it did in the 2014/15 oil crash. The collapse of oil will clearly have an impact on the oil patch economies, particularly Texas.

Also, given the turmoil, a company could have a difficult time finding investment capital. Not only are they being hit by falling revenue, but they will also have to compete with the government as the government funds its deficit.

The Impact of Fiscal Stimulus Could Hurt More than Help

Fiscal stimulus is a stop-gap measure to reduce near-term unemployment with the hope that more will not be needed if the economy returns to normal in the next few months. The risk is that it only delays a surge in unemployment if recovery takes longer. As shown in Figure 9 below, most of the fiscal stimulus of the CARE Act, and the additional one now being put into place, is geared towards keeping people employed at small businesses and to offsetting the income loss of the newly unemployed. If the slowdown is over in 3 months, all sectors of employment and unemployment are covered except a “minor” 60% of the labor force for large businesses. The only substantive income protection for employees of large firm’s income is through unemployment. The employment tax credit small, and the stimulus paycheck amounts to 1 week of income. If they are not fired, they are still subject to lower income from reduced hours or cuts in pay. At any rate, fiscal stimulus does not offer income support if the recovery is a U, not a V, except the airline industry.

A couple of additional observations. This analysis does not include state and local workers who will face income if not a mass reduction in the workforce much as what happened in the GFC, as states revenue will be cut. States are currently working on deals with their workers to get them to take a furlough with guaranteed employment afterword’s so they can attain the general unemployment benefits from the CARE act. Also, think of yourself as a newly fired restaurant or hotel worker. Your boss says come on back to work because the governor has given the ok. My guess is that the former worker is thinking,” I am getting paid more being unemployed than when I was working for the next three months, particularly when you look at after-tax. Also, I don’t have to go back to a world in which I could be infected by a guest or coworker. Hmm. So, I am thinking that a worker is saying to her old boss, ”call me in August.” Consider all those others that have jobs. Do you think they are also looking at the payout of being employed vs. being unemployed in the same way? Consequently, don’t be surprised if unemployment goes up more than models that do not take this calculus into account. Again, a U, not a V.

What I Would Do

Well, in some sense, my strategy is to buy what is under the government’s umbrella–a phrase one of my clients uses–of protection and sell what is not. Having said that, I would also look at assets not now under the FEDs umbrella. For example, the underlying assets of a CLO that are being sold because they have been downgrade and the CLO has hit its CCC capacity. I am also spending time on subprime Autos. In essence, in my experience at Goldman, I found there is no bad asset; there is only a bad price. Here are the two trades I am adding to my recommended strategies:

  1. Short US equities, less government support to prevent downside
  2. Buy MBS Agency REITs

I will send out more on the shorting US equities later because the thesis is pretty straight forward, given I’ve spent eight pages discussing. What is new is my view on REITs, which I give below.

Buying REITs (look at Figure 10 below)

  • REITs are still down 50% from their recent highs and offer historically high 14-16% dividend yield
    • The sell-off was driven by drying up of financing for their highly leveraged positions in mortgages, as well as a sell-off in their underly assets. A perfect storm for a downside event
    • The risk of another such event is keeping valuations low
  • REITs offer are an asymmetric position to the upside
    • Another liquidity event is unlikely given the FED is now providing unlimited funding at close to zero for these assets
    • The underlying asset could tighten given that The FED is once again buying MBS–the assets these REITs own– for their QE operation
    • Their high carry offsets the downside of a sell-off and will rally more than the general equity market in a sustained risk-on market
    • Absent another liquidity event, REITs could add even more yield by releveraging
    • Another liquidity event is unlikely given the FED is now providing unlimited funding at close to zero for these assets
    • The underlying asset could tighten given that The FED is once again buying MBS–the assets these REITs own– for their QE operation
    • Their high carry offsets the downside of a sell-off and will rally more than the general equity market in a sustained risk-on market
    • Absent another liquidity event, REITs could add even more yield by releveraging
  1. Dandekar, Barbastathis “Quantifying the effects of quarantine control in Covid-19 infectious spread using machine learning, April 2020
  2. Bloomberg
  3. One Word Data Set
  4. IPSOS, V arious Polls
  5. WSJ/NBC Poll, April 13-15
  6. TOMTOM
  7. Conference Board
  8. BEA
  9. Preliminary Estimate of the Effects of H.R. 748, the CARES Act, CBO, April 16, 2020
  10. Federal Reserve Bank of St. Louis, FRED system
  11. Mertens, Stricler, Stuermer, “Oil and Gas Sector Increasingly Influences U.S. Business Fixed Investment”, Federal Reserve Bank of Dallas, September 24, 2019

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