Complex situations defy being summed up in simple words, though that’s what’s demanded in this short-attention-span era. “Exogenous shock” sounds as if you were undertaking some electrical work in your house without tripping the appropriate circuit breaker. “Black swan” is supposed to connote something exotic and evil, but anyone who has spent time around the water knows the usual white variety are nasty creatures.
Yet these are the terms employed to describe the impact of the coronavirus on the financial markets and economy, although they don’t seem apt. Could the extreme reaction to this novel virus reflect the pre-existing weaknesses it has exposed, rather than its impact on public health?
The steep drop in stock prices—the S&P 500 index is down 12.2% from its peak just the Wednesday before last—recalls the reaction to the 9/11 terrorist attacks, writes Joseph Carson, former chief economist at Alliance Bernstein.
“Now that comparison by no means is trying to compare the financial fears of last week with the horrific tragedy of 9/11. 9/11 stands alone in American history as one of the most tragic events ever, as it changed a city and a nation far beyond what any of the numbers say,” he adds. But the stock market’s reaction to the coronavirus has been similar.
Moreover, 9/11 took place in the midst of a recession that followed the bursting of the dot-com bubble. In contrast, the U.S. economy appeared robust when the virus spread to these shores. Employers added 273,000 workers to their payrolls in February, nearly 100,000 more than economists had estimated, with upward revisions totaling 87,000 in the two preceding months, the Department of Labor reported on Friday. But that was treated as ancient, almost irrelevant, data, given the virus’ anticipated effects on business. Even the persistently low level of weekly new claims for unemployment insurance—a component of the Conference Board’s Index of Leading Indicators—didn’t change investor expectations of a looming downturn.
Part of the reason for the violent reaction is that the financial markets have become separated from the real economy, Carson argues. “First, operating profits for U.S. companies have not increased for five consecutive years, and yet the S&P 500 had climbed over 60% during that period. Also, the market value of domestic companies to nominal gross domestic product—a ratio that is often used to determine if the equity market is undervalued or overvalued, relative to a historic average—stood at an estimated 1.85 times at the end of 2019, matching the record high of 2000.”
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That divergence between the stock market and the real economy has been fueled by easy money and the expectation it will continue, Carson says. Given ultralow interest rates, stocks were viewed as low-risk, owing to TINA—there is no alternative to equities.
“What Homer Simpson so wisely said about alcohol—‘the cause of, and the solution to, all of life’s problems’—might equally apply to ground-skimming interest rates,” writes Jim Grant in the current Grant’s Interest Rate Observer. Cheap money lifts asset values and anesthetizes investors to risks.
The Federal Reserve came through with an extra rate cut on Tuesday, and a double at that. But the half-point reduction in the federal-funds target range, to 1% to 1.25%—twice the typical move, and made outside a regularly scheduled Federal Open Market Committee meeting—failed to lift markets. In fact, it appeared to worsen their concerns. Indeed, fed-funds futures are pricing in another half-point cut at the next FOMC meeting, a week from Wednesday. The plunge in Treasury yields, with the two-year note at 0.51% and the 10-year benchmark at 0.775% late on Friday, to well below the fed-funds target strongly implies significantly lower short-term rates ahead.
Even with the most recent data showing the U.S. at full employment and the Atlanta Fed GDPNow on Friday upgrading its first-quarter real growth forecast to 3.1% from 2.7%, markets were calling for more monetary stimulus (along with President Donald Trump). But, as Carson notes, the last two recessions were caused by sharp plunges in asset prices, “so the loss of household wealth and liquidity does raise the odds of a bad outcome. Consumer confidence now may be shaken more by the speed of the decline than the scale.” That would be understandable, given the $4.6 trillion tumble in U.S. stock values from their recent highs, according to Wilshire Associates.
But easy money might not be the cure it was for the previous two recessions; it could make the situation worse. The coronavirus presents a shock to the supply side of the economy, writes economist Kenneth Rogoff of Harvard on Project Syndicate.
“Policy makers and altogether too many economic commentators fail to grasp how the supply component may make the next global recession unlike the last two. In contrast to recessions driven mainly by a demand shortfall, the challenge posed by a supply-side-driven downturn is that it can result in sharp declines in production and widespread bottlenecks. In that case, generalized shortages—something that some countries have not seen since the gas lines of 1970s—could ultimately push inflation up, not down,” he contends.
Globalization has been a major factor in tamping down inflation for the past four decades, Rogoff continues. But the coronavirus, along with trade barriers, threaten to undo those benefits. And he doesn’t mention that both Trump and one of his likely opponents in November, Sen. Bernie Sanders, the self-described democratic socialist, oppose free trade.
“In this scenario, rising inflation could prop up interest rates and challenge both monetary and fiscal policy makers,” Rogoff argues.
If so, it would confound investors who have been hell-bent on buying Treasuries at record-low yields well below 1% and even further under inflation. It appears that Treasuries are more like gold, bought mainly as a hedge against risk assets, comments Cliff Corso, chief executive of Insight Investment. “In a low-inflation world, which would you rather own?” he asks.
That may not be a rhetorical question. The yellow metal surged 6.8% in the past week, its biggest weekly percentage gain in over four years, to $1,670.80 an ounce. And amid ultralow interest rates and the stagflationary potential of the coronavirus crisis, gold investments appear to have further upside, as our colleague Andrew Bary writes this week.
The challenge of the virus is not just that there is no vaccine to prevent it. The standard prescription for the current crisis and other assorted economic maladies—cheap money and ever-lower interest rates—might treat only the symptoms in the financial markets. For the underlying economy, the inflationary side effects of this potion could be toxic, as it was in the 1970s.
Write to Randall W. Forsyth at randall.forsyth@barrons.com
https://www.barrons.com/articles/the-rate-cut-drug-might-not-cure-ailing-market-51583545555
2020-03-07 01:46:00Z
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