NEW YORK (April 10th) – Perhaps it was a fundamental misunderstanding of the nature of the virus; a delayed response by political leadership; by public health authorities (Dr. Fauci told podcaster John Catsimatidis “I don’t think so. The American people should not be worried or frightened by this. It’s a very, very, low risk to the United States” when asked at the end of January whether the American people should be scared of COVID-19); or a fundamental decision by policymakers to address COVID-19 on a macro basis – to “Bigfoot” it from state capitals – instead of on a micro basis at the county, municipal, and regional level, with federal and state support. Whatever the cause, we find ourselves in the current situation with COVID-19: Living in a depression-level economy with over 10 million unemployed.
As the coronavirus continues to eviscerate the US economy, there has been a great deal of speculation about the shape of our economy – and the markets – after the COVID19 virus progresses.
How Things Will Look On The “Other Side” OF COVID-19
Economist and New York Times columnist Paul Krugman has described the shutdown as the “economic equivalent of a medically induced coma, in which some brain functions are deliberately shut down to give the patient time to heal.”
But the question investors, governments, and Main Street wants to know is: How long will this malaise last?
A V-shaped Recovery
Some have suggested that the economy would recover quickly, given the strength of our economy prior to the onset of our COVID-19 concerns. This would be the “V”-shaped recovery, meaning that the economy takes a quick, sharp, decline and then ramps up again immediately after the virus passes us by. Our view originally anticipated a “V”-shaped recovery the early days of the outbreak. We had assumed as late as early March that the US public health authorities, the best in the world and dispersed and responsible to local authorities, were capable of containing the outbreak with aggressive testing, monitoring and quarantining to ensure against community spread. But micro management of the disease at the county and municipal level – the first line of defense in most public health crises – was made largely impossible by the lack of fully deployed test kits and a rapid confirmation of results.
But even after testing became more widely available, the “Bigfoot”, statewide, response of some governments – particularly New York State, which shut down the entire state weeks before there were any cases in the rural counties of upstate or Western New York – did needless damage to those local economies well before there were signs of community spread. (Even Governor Cuomo would likely admit this error were he honest. He has spoken multiple times about COVID-19 being a “wave” that will “spread” from its epicenter in the NYC Metro area. So why close businesses in counties hundreds of miles away, in the rural counties of Western NY, weeks before there was any appreciable spread?).
The “U-” and “L-” Shaped Recoveries
We no longer accept that the recovery will come in a “V”-shape. That leaves a “U” shaped recovery, or an “L” shaped recovery; or perhaps something worse. A “U” shaped recovery assumes a period of economic dormancy continuing for a period of 12 to 24 months, followed by a strong recovery.
We don’t see that, either.
As the coronavirus spreads, more businesses will be affected, both on the supply and the demand side. At the same time that production has virtually seized up, and the non-critical services economy is all but frozen except in “white-collar” jobs that can be done remotely, consumers have had their wealth – and thus their wealth effect – diminished significantly; middle-income working people and are likely dreading opening their first-quarter §401(k) statements. We expect that the Federal Reserve Beige Book, due next week, will present a dismal picture of regional economies, particularly in so-called “hot spots”.
Many small- and medium-sized business employers may be facing imminent bankruptcy, or have already violated loan covenants that will complicate their future cash flows and their future ability to access credit.
Even the expeditious delivery of loans in the congressional rescue packages – increasingly unlikely from what we’re hearing anecdotally – will likely not save these businesses barring the United States becoming a 21st Century version of the Weimar Republic, with a veritable adoption of Modern Monetary Theory.
Those businesses that survive will likely have to resolve debts with landlords, suppliers, and other service providers and restore their balance of working capital as well. Capex, aside from inventories, will likely cease altogether until all those other priorities for future cash flow are resolved.
Source: Center for Disease Control via Wikimedia Commons
Replacing SMEs that were forced into bankruptcy will take a considerably longer time. New enterprises and “2.0” versions of companies wiped out by bankruptcy will need time to amass start-up capital, create banking relationships, negotiate lines of credit, acquire necessary licenses and permits, negotiate and sign leases, perhaps renovate newly leased space (especially likely among food service and bar businesses to respect social distancing), hire and vet new employees and contractors, and approve vendors and customers. It will be three months, at a minimum, and likely much longer for the overwhelming majority of independent businesses, for them to be up and running.
For the unemployed, debt is accumulating rapidly for the costs of basic living expenses. Even those who can continue to work will also likely stay away from big purchases as they restore their own personal financial balance sheets from the losses on their retirement and college savings accounts, and pay down debt they might have accumulated during the national shutdown. They’ll also likely increase their savings rate in light of the experience their unemployed friends and neighbors suffered with COVID-19.
Investors’ Business Daily reports:
“The IBD/TIPP Economic Optimism Index fell by 6.1 points, or 11.3 percent, in April, to a reading of 47.8, its first descent into pessimistic territory since September 2016, bringing to an end a record 42-month optimistic streak. This is the largest monthly decline in the index since October 2013, when the federal government entered a 16-day shutdown that took around $24 billion out of the U.S. economy and furloughed approximately 800,000 federal workers.”
The survey, which occurs at the beginning of the month for which it is released, is likely to be far worse come May. This brings us to the (hopefully) “L” shaped recovery, which is what we see going forward. That means a flat level of GDP and a flat market, overall. Once we get the 2020 Q2 print of GDP, we anticipate that it will remain mostly flat; maybe within a range of +/- 0.5% from the 2020Q2 level, if we’re lucky. Things could plummet further if we’re not.
Trends On The Other Side
We will emerge from this pandemic of COVID-19 in a whole new world with new business perspectives, a government back on its heels, and a workforce with new remote working skills borne of “social distancing”. These are the biggest trends we foresee:
Commercial Real Estate Will Lose Value
We have always felt real estate and REITs, principally in the office leasing sector, had a limited “half-life”. In our view, the children reared in the Internet Age were always going to be moving into a remote work environment once remote work apps were scaled up, made secure, and workable. As those internet kids moved into the C-Suite of corporations and professional firms and questioned some truly ghastly occupancy costs of their businesses, remote work was always going to happen. Expertise with Zoom, BlueJeans and other remote collaborative software during COVID-19 has just expedited it. Retail space will likely suffer as well, as shoppers continue to abide social distancing, though it will be less pronounced in the luxury retail sector where price discrimination will act as a “social distancer” automatically by limiting lower-income shoppers from even entering most upscale stores. In the restaurant and hospitality sector, which already suffers low margins, margins will grow even worse. To achieve social distance, most will need to separate tables and booths far more than they are. Add that to recovery costs from enduring months-long closures, and we will see nearly every independent leased-space restaurant fail, further depressing commercial real estate values.
Municipalities Will Face Grievous Budget Shortfalls
Concomitant with the decline in the high value of commercial properties will be grievous shortfalls in municipal revenues. In New York City, for example, commercial real estate provides nearly 50% of real estate tax revenues which, in turn, provide about one-third of the city’s tax revenue. (More than 15% of city revenue comes from NYS, which will have its own fiscal problems). Municipal finances were already under considerable pressure because their defined benefit pension plans had continued to use absurdly high and unrealistic “assumptions” about their compounded annual growth rate. (New York City has used a 7% CAGR, notwithstanding nearly a decade of the 10-year Treasury being less than half of that). Now, with a substantial market correction, and bonds that chased an unrealistic CAGR yield rather than security, those pensions – “guaranteed” in most instances by law – will force many municipalities into bankruptcy, further pressuring the securities markets.
Private Health Insurance Companies Will All But Disappear
A large number of COVID-19 casualties here in New York State are from those with pre-existing, chronic, and undiagnosed comorbidity conditions, particularly in the African-American and Hispanic community. One doctor reported that a patient presented with COVID-19 symptoms, but also had undiagnosed diabetes with blood sugar over 400 (normal is around 80 to 120). Scores of hundreds of low-income patients with obesity and undiagnosed – but treatable – conditions like diabetes, heart disease and hypertension died because they do not have access to primary healthcare.
The scale of the deaths, and the differentiation in survival rates between the “haves” and “have nots” with similar comorbidities, together with millions of middle-income workers thrown off their benefits package when they were laid off, will compel Congress to pass a minimum, public, universal healthcare program that is the equivalent of universal Medicare, with copayments to address common, chronic, illnesses and to improve personal nutrition and nutritional education. Workers in union and employee plans will maintain private healthcare, but for acute conditions like appendicitis, injuries, surgeries, and the like. Private health insurers will continue as a political compromise, but have a very limited half-life; eventually the United States will go to a national public health system.
Transports Will Operate on Much Lower Margins
Virtually every form of passenger transportation, from airlines to buses to cruise ships, will have to respect social distancing. Load factors in most will have to be trimmed by more than 50 percent, making air and cruise transport costs prohibitive for most middle-income families and altering the economics of the entire industry.
National Security Considerations Will Alter the Supply Chain
There will be both political and practical considerations supporting a move of some production back to the United States for many industries, particularly those deemed to be vital to US security; pharmaceuticals, for certain, but also vital communications electronics. Given threats made by China, there will be national security considerations in the supply chain that will require vigorous and immediate US exploration for new sources of the rare earth elements that China dominates. While not necessarily an element of national security, companies that have suffered production downtime because of the COVID-19 shutdown will likely increase inventories and step away from some of the “Just In Time” inventory model that has been integral to Zero Base Budgeting and Lean for two generations.
Wages Will Be Increased; Margins Reduced and Costs Increased
Returning production to the United States will raise wages that will be absorbed by lower margins and higher final costs to end consumers.
Summary
The global economy is facing a health challenge that is several orders of magnitude more challenging than the devastating scare of polio in the last century. The notion that social distancing will resolve the matter in a few months is optimistic at best; more likely, it is wholly illusory. (The New York Times reported this afternoon that studies indicate even a summer return to normal will spike cases). Coronavirus mutates, both to the better and to the worse. There are already two identifiable strains. Now that COVID-19 is widespread and global, the scope of further mutations is wholly unpredictable, so that the long-awaited vaccine is unlikely to be 100% effective, just as seasonal flu vaccines are not entirely effective. And new vaccines will probably need to be developed every year. We will likely be living with the fallout from COVID-19 for a decade or more and, in the meantime, new viral threats will emerge. The effects on our economy will profound, deeply disruptive, and lengthy.
Investors beware.
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Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.
Additional disclosure: The views expressed, including the outcome of future events, are the opinions of the firm and its management only as of today, April 10, 2020, and will not be revised for events after this document was submitted to Seeking Alpha editors for publication. Statements herein do not represent, and should not be considered to be, investment advice. You should not use this article for that purpose. This article includes forward looking statements as to future events that may or may not develop as the writer opines. Before making any investment decision you should consult your own investment, business, legal, tax, and financial advisers. We partner with principals of Technometrica on survey work in some elements of our business.
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