COVID-19 vs Global Financial Crisis | John Hancock Investment Management
As we consider today’s predicament, it’s only natural to think back to the last big dislocation that shook the global economy: the global financial crisis of 2008/2009.
That event was a gigantic liquidity crisis—a situation where access to cash, or the convertibility of assets to a more liquid form such as cash, became severely limited. It led to a recession but proved to be largely treatable through monetary policy measures and fiscal support.
In the United States, these steps included novel monetary and fiscal solutions, quantitative easing (QE), and the Troubled Asset Relief Program (TARP).
In my 50 years of working in finance, it was my most terrifying experience to live through. The world as we knew it felt it was perpetually on the verge of imploding. But it didn’t, thanks in large part to the mixture of TARP and QE.
How is the current environment different?
The COVID-19 pandemic of 2020 is a very different situation. From an economic perspective, we face a huge demand shock rather than a financial liquidity shock. Consumers and businesses have radically curtailed or rerouted their consumption habits.
As huge swaths of the population reduce their time outside the home or are forced to “shelter in place,” that will have a drastic, immediate, and potentially long-lasting impact on businesses of all sizes.
Without an offset, we're ly to then face a supply shock as unemployment may rise substantially and productivity measures crumble.
In my view, this important difference from 2008 must be solved with fiscal policy rather than monetary policy, as the latter cannot address the problem we face today. For one thing, the current crisis comes at a time when corporate balance sheets are highly leveraged.
1 In addition, COVID-19 emerged as the global manufacturing base was already flirting with recession, as reflected in global manufacturing Purchasing Manager Indexes (PMIs).2 What’s more, lingering trade tensions with China and the deglobalization of supply chains were already undermining global economic stability.
Just as margins were peaking, manufacturing PMIs were falling, corporate debt leverage was touching new highs, and the outlook for global trade was anything but certain.
From demand shock to recession
As we begin to grasp both the human and economic consequences of this pandemic, a recession appears to us to be inevitable. This is especially the case when one considers the forces in motion and the growing consensus that only fiscal policy can address the broadening consequences of the exploding demand shock.
Think of COVID-19 as a point on a curve. Early on, the incidence of the virus expands as it rides up the curve. Every data point is higher than the previous one, and the rate of change increases as well. At some level, we reach an inflection point. After that, the curve continues to rise, but at a decreasing rate before it reaches an asymptotic state (which means it becomes flat).
We still don’t have a good picture of where we are on the curve globally. China and South Korea appear to have passed the inflection point, but that doesn't appear to be the case elsewhere, as of this writing.
3 The key is to hit the inflection point as soon as possible and hope that we can bend the curve to something close to flat. Achieving that will require significant social distancing now, and eventually a COVID-19 vaccine.
The faster we flatten the line, the better for our health. However, the actions we take to accomplish that are ly to worsen the economic outlook. This is why we need fiscal stimulus—and it will have to be big.
Only the federal government is adequately equipped to minimize the length of any economic slowdown.
We must offset the demand shock arising from the “treatments” (primarily social distancing policies) required to eliminate the virus.
Consider the following model, which demonstrates the linkage between the real economy and the financial economy.
Real GDP is the sum of the levels of employment and productivity. The growth rate is the sum of the growth rate of the work force plus the growth rate of productivity. Add inflation to that number, and you have nominal GDP.
If one holds profit margins constant, the growth rate of nominal GDP tends to equal the growth in corporate earnings over long periods of time. The valuation metric for those earnings is largely driven by the inflation rate as reflected through interest rates. The absence of inflation would cause one to use what economists call a “normal” interest rate.
Here's where many things changed during the last decade. QE dropped—or even eliminated—the “normal” rate, causing the present value of financial assets to soar.
The idea was that the higher level of financial asset values would induce higher GDP because higher wealth, combined with the marginal propensity to consume, would accelerate growth in employment and productivity and lead to overall GDP growth accelerating.
While it was helpful to the economy—even if not to the degree that was hoped for—it was fabulous for financial asset valuations.
Now, let’s look at the model through the lens of the demand shock induced by COVID-19. Services represent more than 50% of the U.S. economy, and services require human interaction.
4 Social distancing is ly to impair that activity and eventually result in lower employment and productivity.
As these components decline, so will real GDP, which is highly ly, in our estimation, to lead to a recession.
The shape of the future recovery
Monetary policy cannot address this problem, but fiscal policy can, in my view. Stimulus is needed in the form of a U.S. infrastructure investment program. Such a program could be relatively easy to finance, given the current low interest rates that the government is paying on its U.S. Treasury debt.
If we use only monetary policy to address the current crisis, I believe we'll fail badly. The demand shock will lead to a supply shock as unemployment rises and productivity falls.
We must use fiscal policy to solve this problem, even if it means mailing a check each month to households that are suddenly left without income earners because of the social distancing policies required to defeat the biological effects of the virus.
The U.S. Federal Reserve has cut interest rates to near zero,5 but that step will not be enough, in my view. If fiscal policy is deployed in a timely and efficient manner, the future shape of the economic growth is more ly to resemble the letter V than the letters U or L. The equity markets are ly, in my view, to reflect that shape as well.
1 “OECD warns over pileup of low-quality corporate debt,” CNBC, February 19, 2020. 2 “Global manufacturing sees steepest contraction since 2009 as coronavirus impacts China,” Axios, March 3, 2020.
3 “Grim milestone: Italy's coronavirus deaths surpass China's,” USA Today, March 19, 2020. 4 “The services powerhouse: Increasingly vital to world economic growth,” Deloitte Insights, July 12, 2018. 5 U.S.
Federal Reserve Federal Open Market Committee Statement, March 15, 2020.
Opinion: Here’s how you can prepare your stock portfolio now for the coronavirus recession
The U.S. as of March 4 has 148 confirmed cases of coronavirus COVID-19, but because people can harbor the virus for weeks without displaying symptoms, and because U.S. testing has been inadequate, there is a substantial risk that the virus is already spreading widely across the country.
Yet the U.S. and the rest of the world are anything but underreacting to the virus. Governments are restricting travel from virus-impacted countries and quarantining people who may have been exposed.
Companies are curtailing business travel. People are postponing vacations. I suspect we’ll start seeing cancellations of large public events. Un China, the U.S.
has had a lead time to allow our government and healthcare system to prepare a response.
Clearly, coronavirus will make our lives anything but normal for a period of time, and the media will amplify this. This brings us to the not-so-normal economy.
Let’s start with China — the epicenter of the crisis. China’s impact will be twofold, as a consumer of American-made goods and as manufacturer to the world.
Chinese consumption of foreign goods will definitely decline, impacting some companies more than others (for instance, car sales declined 92% in February). From a big-picture perspective, U.S.
exports to China total about $100 billion — a pimple on the $21 trillion U.S. economy that may shave a few basis points off of U.S. GDP growth.
A greater impact will be felt from the interruption of Chinese manufacturing. Quarantined cities, shut-down factories, and travel restrictions have had an impact on Chinese production.
China reported one of the worst manufacturing numbers for February in the history of this number being collected in China — even worse than in the depths of the Great Recession. The U.S. imports about $350 billion worth of goods from China, which on its own is not a crippling number.
But much of this trade figure reflects components China produces for consumer products. If you are missing a $10 component that goes into a car, you cannot sell the $30,000 car.
The global supply chain has been optimized for just-in-time efficiency (i.e. cost), not resiliency (shocks). If the coronavirus crisis continues for a prolonged period of time, it will definitely hit the global economy in the medium-term and China over the long term.
China’s government has to make a choice: maintain the lockdown and contain the virus but undermine its status of manufacturer to the world, risking a long-term exodus of manufacturing. Or lift travel restrictions and send people back to work, risking a further spread of the virus, leading to more sick people, more shutdowns, and more lives lost.
For better or worse, the latter path seems to be the one the Chinese government is taking now — people are going back to work.
It is hard to know the impact of supply interruptions, but on their own they could further slow U.S. economic growth and maybe even send the country into a light recession.
I’d be surprised if companies do not semipermanently increase inventory levels and diversify supply chains away from China. Increased inventories actually will, at least temporarily, boost U.S. GDP growth.
Moreover, Chinese losses are an opportunity for other countries to provide needed supply-chain diversity: Vietnam; India, and also the U.S., for example.
Now that the coronavirus has made it to the rest of the world, governments and people are overreacting. That’s ok in response to a highly contagious virus that spreads by a geometric progression.
You want people to overreact and overreact early — the cost of underreacting is simply too great. The less people interact with each other, the less the virus spreads.
The first and most obvious casualty will be the travel industry — airlines, hotels, travel agencies — and then it will impact restaurants, concerts, and sporting events. People will telecommute more.
I don’t know how long this virus will persist, but they do naturally die out. But if the U.S. goes into a lockdown, it will just be a matter of time before we go into recession. In truth, the U.S. economy is overdue for recession; there hasn’t been one in 11 years.
Recessions are not the end of the world; they are a natural process, just a forest fire that cleans out dead wood. Recessions are good for the economy in the long run, though the short term is painful, not just for investors but for people who get laid off.
But the virus that caused it, recessions end and the world goes on.
How to invest
We don’t think the coronavirus will send us back to Stone Age. We do think the coronavirus is most ly a recession-inducing virus, with its own unique characteristics and extra-scary headlines. But despite all the uncertainty and human suffering, the financial consequences are ly to resemble those of a moderate recession (higher unemployment, lower earnings).
Read: Why the Fed cut: The coronavirus is taking aim at consumer spending, the heart of the American economy
Also read: Consumer-facing companies will be the first hit if the coronavirus spreads across the U.S.
I don’t know what I’d be doing if I owned a bunch of stock index funds. The market is expensive and the road ahead for an average (overvalued) stock is anything but exciting.
For our clients, we built an all-terrain portfolio of quality businesses with strong balance sheets, protective moats, top management, and recurring revenues. Many of our companies pay meaningful dividends, and most of them are noncyclical (they will not be impacted by recession).
They’ll survive and strive no matter what the virus throws at them. We have a lot cash and have put hedges on portfolios where it’s feasible.
In fact, this is a good time for you to revisit the “Six Commandments of Value Investing” — a chapter in the book I’d to be working on but am not.
It describes the principles of value investing and provides an overview of our investment process. You can read it here or you can listen to it here.
Also, remember that the quoted prices you see for your stocks is not a final judgment of their value but a temporary opinion by Mr. Market.
Finally, I’ve been asked if my firm has done or will do anything different because of coronavirus. Here is the one thing we did: When it was evident that the virus would come to the U.S., we sold a few stocks (in some accounts) that were very close to their fair value. That was it.
We don’t feel pressured to do anything further. The more rational we are, the better decisions we’ll make; thus we’ll continue to stick to our process.
We’ll continue to dispassionately identify high-quality companies, value them, and figure out how much margin of safety (discount) we need. We may make small tactical tweaks to our buying process. We’ll be buying in smaller increments.
Instead of building a position through one or two purchases, we’ll buy in smaller sizes, because uncertainty induced by the virus may result in greater volatility and thus better bargains.
During market meltups and meltdowns, emotions can start to impact your time horizon – that’s very human. During a market meltup, the time horizon extends from five years to 10 to forever, while during meltdowns it shrinks to months and then weeks.
With every investment decision we make, we are looking five- to 10 years out. This time horizon is deeply embedded into our investment process, and we believe this is the only way to invest.
When we look past the (possibly) ensuing recession, the view is incredibly liberating.
It is possible and even ly that the headlines will get worse before they get better, but any economic crisis in the U.S. probably isn’t going to look anything it will in China, and this virus will eventually die out. That is what viruses do.
Our ultimate goal is to continue to keep our emotions (fear and greed) in check and to remain as rational as possible, even when the world around us is anything but.
Breaking news: Get the latest on coronavirus here.
So, how does one invest in this overvalued market? Our strategy is spelled out in this fairly lengthy article.
Vitaliy Katsenelson is chief investment officer at Investment Management Associates in Denver. He is the author of “The Little Book of Sideways Markets” (Wiley).
Read:Here’s what history says about stock-market performance in past instances when the Fed delivers an emergency interest-rate cut
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