Thoughts on Surviving the Avalanche

Thoughts on Surviving the Avalanche

Financial markets are in disarray. Indexes are in free-fall one day, bursting upwards the next. Many investors are on the edge of panic.

Some of us have been caught in an avalanche, had near-drowning experiences, been in a car crash, or served in the military and seen armed conflict. When panic comes, and it usually does to everyone at some point, you are advised what to do.

Stop everything. Breath slowly and deeply. Assess the situation fully and dispassionately. Formulate a plan. Communicate it clearly to those around you. Work together. Take action.

So, let’s evaluate the pandemic and the financial markets. Three points stand out.

First, technical problems in the financial markets can be addressed. The vast majority of investors need not spend time worrying about government bond market liquidity, nor the short-term trading suspensions that have been imposed twice thus far. Broadly, financial markets remain functioning and there is every reason to believe they will continue to work. The Federal Reserve on Sunday March 15th demonstrated in the most forceful terms its willingness not just to use interest rates (now zero) or its balance sheet (to be expanded another $700bn) to support economic activity, but that it also stands prepared via emergency discount window borrowing and global swap line extension to ensure that the ‘plumbing’ of the global financial system works. In addition, it is worth noting that most large banks are well capitalized, and the weaker ones are known to regulators.

Second, despite incompetent delays, political pressures on government leaders will ensure that fiscal stimulus will arrive. This has started to happen, with the US House passing a bill providing a series of measures on Friday March 13th including partial funding for sick leave, unemployment insurance, spending on health insurance for the poor, food programs for children and the elderly and critically, free testing. The Senate is expected to pass the bill shortly.

The bill has two significant issues. First, it does not include a payroll tax cut – both parties expressed concern at its cost. Second, and perhaps more alarming, it does not guarantee sick leave for employees of companies with 500 or more workers, which represents 54% of all workers in the US. However, even with its limitations, this is a move in the right direction. Just as in 2008, the process of putting critical measures in place is messy and rarely ideally coordinated. But, to paraphrase, in a crisis everyone becomes a Keynesian. If the virus continues to spread in the US as is expected, further stimulus measures will be announced.

As of now, the scope of fiscal easing remains inadequate to confront the coming recession. Total fresh spending to date in the US is probably around $75bn, only a tenth of the package passed in 2009 to deal with the ‘great recession’. Unlike a dozen years ago, China is not riding to the rescue with credit or fiscal easing either. So, while the responses are welcome and should calm nerves, they do not yet signal a turning point for the economy or markets.

The onus now shifts to the G7 conference call this week. It would be most welcome if the gathering could produce national commitments to cut taxes, increase spending, offer extended and more generous unemployment benefits and provide coordinated commitments to support credit markets as may be necessary. That is a lot to ask for from a group that includes countries, such as Germany, that are reluctant to use the public purse in times of stress. But, at some point, all countries will probably move in varying degrees toward more fiscal support for their economies.

Third, even with the steep falls in global equity markets, most investors are still in good shape. Consider the chart below, which depicts the S&P 500 over the last ten years. Recent declines are small compared to the massive gains since the financial crisis. It is rarely wise to sell when in panic. Holding stocks for the long run typically serves savers well.

Given these three observations, where should investors focus?

The root problem is the rapid spread of the COVID-19 virus. As improvements in testing, containment and quarantine slow the rate of contagion, fears in financial markets and the broader economy will begin to subside.

That will take time. In much of Western Europe and the US contagion has not peaked, so matters will get worse before they stabilize. At the same time, the evidence from China, South Korea, Hong Kong and Singapore strongly suggest that quarantine, testing and clear public communication of ‘best practice’ for citizens are effective in slowing the spread of the virus.

Slowing rates of infection may seem a partial victory, but is essential for two reasons:

First, healthcare resources are finite and can be overwhelmed if the virus spreads too quickly. That is the case today in Italy. In the US, there are about one million hospital beds, of which 75% are occupied at any point in time for patients with other ailments and injuries. If the coronavirus were to quickly infect 3% of the population (ten million Americans), the resulting demand for hospital places could overwhelm hospitals and lead to chaos.

Second, an accelerating spread of the virus will engender even more economically restrictive measures (as is now the case in Italy), which will increase the risk of an even deeper recession and of widespread business and personal bankruptcies. If the transmission of the virus can be contained through other measures, the economic and financial repercussions will be reduced.

What, then, should we expect of governments?

Better communication: this is essential. Calm, effective messaging is always the first step in addressing a crisis.

Broad-based and easily accessible testing and support: Covid-19 test kits must be mass-produced and distributed at the local level as soon as possible. Testing facilities should be established outside hospitals to avoid both overburdening them and potential transmission to existing patients. And authorities should fund and establish delivery networks for food, medical and basic provisions to senior citizens and others unable to provide for themselves.

Local leadership: national governments everywhere should provide ‘block grants’ to local governments (at the municipal, county, city or local community level) where community leaders are best equipped to decide how to use the funds (e.g., build a temporary hospital, import COVID-19 test kits, purchase additional respirators, etc.). Governments should also partner with leading non-profits (e.g., Red Cross, AmeriCares, Doctors Without Borders), whose expertise resides in emergency medical response to natural and man-made disasters.

Further economic stimulus: to mitigate the economic fallout of the virus, all G20 governments should announce immediate plans to aggressively boost aggregate demand. In addition to already announced programs, the G20 should commit to further tax cuts (VAT, sales, payroll) and direct transfers to citizens. Those measures should be targeted and understood to be temporary, not permanent new initiatives (e.g. not dressed up as permanent universal basic income). Yet they should also be large scale. Given the widespread dislocations caused by containment and quarantine measures, as well as uncertainty-related weakness in private sector spending, stimulus should rival the amounts deployed following the great recession. In the US, for instance, stimulus should approach $750 billion, if not more. It is a mistake to worry about the cost – the patient has to be literally saved first.

Monetary policy back-stop: central banks should announce their willingness to intervene to ensure the working of credit markets, the lifeblood of company borrowing. In the US, where legal restrictions prevent the Federal Reserve from purchases of corporate bonds, the US Treasury should establish a special-purpose fund, backed by Treasury bonds purchased by the Fed, to stabilize credit markets. US Treasury intervention, if required, should be coordinated with the deep knowledge of capital markets that resides at the New York Federal Reserve.

An avalanche can be survived, but it takes the right kind of response – calm, evidenced-based and decisive.

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