We remain focused on the path for the virus, and a trend seems to be emerging – the fatality curve for the early-affected countries appears to bend around 30 days into the outbreak cycle. Some of the data is admittedly sketchy (and we must now dismiss the China data as fabricated), but should the U.S. follow the pattern of Italy, Spain and South Korea, the worst should soon be behind us. Some other items of note on the contagion:
- The U.S. plans to maintain social distancing thru April 30. Assuming the quarantine is then lifted, the result would be a total of seven weeks of economic shutdown. This should not be long enough for long-term structural damage to the U.S. economy.
- Seattle, Washington lies in a viral hot zone yet is seeing a marked payoff from social distancing. Their contagion rate (R0) has declined by almost 50%, from an average of 2.7 persons to an estimated 1.4.
- Over one million Americans have been tested for the virus. Once the quarantine is lifted, quick and reliable testing will be critical to contain further outbreaks while allowing industry to resume. Abbott Labs has received FDA approval for a test that delivers results in five minutes. It uses its widely-used ID NOW platform and plans on manufacturing 50,000 tests each day. This is a game changer.
- Estimates for the final tally of U.S. fatalities continue to fall. The University of Washington’s Institute for Health Metrics and Evaluation model predicts 81,000 American casualties in the next four months. We are not virologists, but are gaining confidence that our early estimate of U.S. deaths in the 150k range may now be a worst case scenario.
- The end result for economic damage is impossible to accurately predict. Although the odds for an apocalyptic scenario have dissipated to a small tail risk, there is little question that the economy will take a substantial hit in 2020. It is important to remember the economy was on very sound footing going into the crisis, though. Provided the recovery lifelines from the government allow consumers and small businesses to tread water for the next couple of months, we expect the economy to begin its rebound in the second half of the year.
Most of the attention has been on the virus and the stock market sell-off, but there has been much spectacle in the bond market as well. Thankfully, after the Fed made an all-in entrance as lender of last resort last week, the elevated liquidity and credit concerns that have plagued the bond market have eased considerably. An explanation of the factors that have been in play is a bit technical, but as our fixed income team breaks down below, in our eyes it at least gives us faith in the capital position of the nation’s banks:
- One of the more subtle impacts of the current market scare has been a reduction of liquidity in the bond market. This is seen in two ways: (1) an expansion of the additional premium required by investors to assume credit risk and (2) a widening of the bid/ask spread in market.
- The first factor, known as a widening of the credit spread, is the increased premium that investors require to assume the risk of default. No great surprise here – we are in a difficult economic period and investors rightly have concerns regarding increasing default risk.
- Much of the increase in credit spreads has been seen in the energy sector, hit hard by plummeting oil prices. As can be seen from this week’s headline chart, energy bonds in the high yield sector pay in excess of 20%. Yields for other corporate bonds have increased as well, with the investment-grade BAA sector paying over 4%. As a result of widening spreads, corporate bonds declined 3.6% in the first quarter.
- The quarterly loss for corporates diverges greatly from Treasuries, whose performance leadership was strong enough to propel the overall bond market to a heady 4% gain for the period.
- The second factor for liquidity, the bid/ask spread, is the difference between what an investor can sell a bond for (the bid) and what an investor can buy a bond for (the ask). Normally the bid/ask spread for corporate bonds is somewhere in the 0.25% – 0.5% range, but we have seen it as high as 4%-5% in recent weeks.
- As a result of the 2008-2009 financial crisis, banks are required to carry additional capital to cushion them from losses. Unfortunately that means they have a much smaller appetite for bond inventories. Holding bonds in inventory requires an allocation of scarce capital, so banks and dealers respond by demanding compensation in the form of better pricing and higher yields when they purchase bonds.
- Ultimately though, that stronger capital position gives us confidence in the financial system, a very important supportive factor during our current market turmoil.
It was another difficult week for stocks, with the S&P 500 index declining over 5% for the week. It is hard to be enthused by yet another loss, but we still remain over 10% above the recent low. Though it may prove fragile, it does appear a bottom has formed – reassuring given the economic bombshells (for a deeper economic dive please read our recent update):
- The price of oil shot up 40% last week on news the Saudis and Russians are declaring a truce in their price war. Normally an oil spike is an economic negative, but in this case it takes heat off of domestic energy producers and thus alleviates some of the sector’s credit concerns we previously noted.
- On Thursday, 6 million applied for unemployment claims. This doubled the prior week’s record-setting job losses.
- On Friday came the release of the March employment report. Employers shed over 700,000 jobs and the unemployment rate rose from 3.5% to 4.4%. This was terrible news – particularly since it only reflects the infancy of the unemployment claims cycle.
- In sum, it was an extreme week for the economy. However, we were relieved that stock losses were at least tolerable in the face of such dreadful economic reports. The lesson is that the market always looks ahead, and appears to be focused 6-9 months in the future, when Wall Street expects an economic recovery.