How Hard Has the Coronavirus Already Hit the Economy?

Besides the toll on those afflicted, the coronavirus known as COVID-19 is spreading global anxiety and uncertainty. As we have seen recently, the markets do not behave predictably when there is uncertainty, which makes it difficult to say how will the virus affect the economy. Without a vaccine (said to be a year or more in the making) or adequate testing procedures, will COVID-19 become widespread, overwhelming hospitals and medical staffs? Or will efforts to contain the virus through voluntary quarantines, common-sense safety precautions, and reduced contact from large gatherings be enough? The recent declaration from the World Health Organization that the outbreak is a pandemic does not inspire confidence that worst is over.

The data from the first quarter does not reflect the impact of COVID-19  (the virus was first publicized in late December), and the economy in January and February was in decent shape. February job gains were higher than expected. Payrolls rose much more than expected, powered by huge increases in a wide range of sectors, although some of this may have been weather-related. The labor market remained tight, but that did not translate into strong wage gains. Hourly wage gains were up solidly over the month, but one would expect much more over the year than the 3% rise we saw in the first quarter.

The data will not likely start reflecting the impact of the virus until we get the March numbers.  COVID-19 concerns are curtailing travel, tourism, and social activities; this will likely lead to payroll cuts in leisure and hospitality and other related industries in the spring. Supply chain disruptions will directly impact manufacturing payrolls and will also show up in trade and transportation jobs.

At this point, the future negative impact of COVID-19 seems all but certain; what remains uncertain is the magnitude of the hit. If businesses brace for a long disruption in activity and a possible recession, there will be jobs cut. But if the plan is for a short disruption, employers will be less willing to cut jobs, since rehiring staff with the same skills and training may prove difficult with the labor market as tight as it is now.

Added Ingredient: An Oil Price War

Compounding a drop in demand for oil due to the pandemic, Saudi Arabia and Russia are in the middle of an oil price war. This drove the price of oil below $40 a barrel at the beginning of March and added to the stock market turmoil. Both the Saudis and the Russians are facing pain from the lower prices and both have reasons to compromise, but that may take a while, since both countries have a cushion to absorb financial losses for a few months at least.

As oil prices dropped, Morgan Stanley put out an estimate saying that if these low levels remain, it could shave 0.15 to 0.35 percentage points off U.S. gross domestic product (GDP) in the first quarter. Low oil prices will not necessarily result in increased demand, due to the firm commitment of many countries to decarbonization. The uncertain trend line for COVID-19 suggests recovery in demand will be slow in coming.

Many smaller American oil companies could face bankruptcy if the price pressure goes on for more than a few weeks, while larger ones will be challenged to protect their dividend payments. Thousands of oil workers are about to receive pink slips. Diamondback Energy, a medium-size company based in Texas, slashed its 2020 production plans, cutting the number of hydraulic-fracturing crews to six from nine. Other companies are expected to follow suit in the coming days.

Those in greatest jeopardy are small, private operations with large debts, impatient investors, and less-productive wells. These small companies—with a couple of hundred wells or fewer—account for as much as 15% of American output.

The big winners, and perhaps the only ones gaining, may be the motorists who will pay less for gasoline—particularly drivers with older, less fuel-efficient cars, who tend to have lower incomes. According to the AAA Motor Club, the average regular gasoline price has declined by 5 cents over the last week to $2.38 a gallon and is 9 cents below what it was a year ago. Each drop of a penny means a savings of roughly $4 million a day for American drivers, according to energy economists.

Fiscal or Monetary Policy a Cure?

The Federal Reserve cut its benchmark rate 50 basis points in early March to a range between 1% and 1.25%, leaving it more room than most other developed-economy central banks to cut further. This was an emergency cut occurring before the appearance of any weakening economic data. The markets are expecting a further 50 basis points cut by the Fed at its March 17 and 18 meeting and another 50 basis point cut at its April meeting.

But can you fight a pandemic with rate cuts? The economy will slow because of the actions taken to fight the spread of the virus and those actions will not change because rates are lowered. The Fed’s mandate is for growth and inflation and this move seems to be targeted at the equity markets, though it is unlikely to do anything for the equity markets or have any effect on growth or inflation.

The Fed increased the amount of temporary liquidity by significantly bumping up the size of its overnight repurchase agreements. The Fed said its expanded repo operations are designed “to mitigate the risk of money market pressures that could adversely affect policy implementation,” adding that the operations “should help support smooth functioning of funding markets as market participants implement business resiliency plans in response to the coronavirus.” The rising amount of Fed repo liquidity is being fueled by unsettled markets, with huge demand for Treasury securities as a safe-harbor investment.

The global economy is slowing—and, in some cases, shutting down. Other central banks with interest rates above zero cut them this week. The Bank of England’s monetary policy committee voted unanimously to slash the bank rate from 0.75% to 0.25% at its first unscheduled meeting since the depths of the 2008 financial crisis. The Bank of Canada reduced its policy rate by half a percentage point, and the Reserve Bank of Australia reduced its policy rate by one-quarter of a percentage point to a record low of 0.5%. Countries already experiencing low rates of growth—such as Italy, Japan, and Germany—are very likely to sink into recession in the coming months. The Organization for Economic Cooperation and Development said in early March that global growth could be cut in half, to 1.5 percent in 2020, if the virus continues to spread.

Another way to stimulate the economy is fiscal policy. However, in this unfolding occurrence, the size and scope of the stimulus must be broad and deep enough to forestall what could be a severe economic decline not just a Band-Aid to the economy and the stock market.

Fourth Quarter: Growth and Weakness

The economy was growing at an annual rate of only around 2% before the virus hit. U.S. fourth-quarter GDP, which measures the value of goods and services produced inside the U.S., grew slightly faster than forecast at 2.1%. The forecast was for 2.0% in the year’s final three months. For the full year, the economy grew at a 2.3% rate, which is a slowdown from the 2.9% pace of growth in 2018. Many economists have argued that the recent 2.0% growth is now the trend. This data does come with some big caveats over clear weakness that emerged across the economy in the final quarter of 2019.

Business investment fell at an annualized rate of 1.5% in the fourth quarter, the third straight quarter of decline. Nonresidential investment in structures fell 10.1%, its fifth decline in the past six quarters and a trend broad-based across property types. Equipment spending was off by a 2.9% rate, led by a slump in industrial equipment, the most since the third quarter of 2012. Early signs of stabilization in factory activity and easing trade tensions in January suggested a modest rebound in investment growth in 2020.

Government spending also provided a boost to economic output. Real federal spending increased at a 3.6% rate last quarter and was up 4.3% for the year, the most since the Recovery Act boosted spending in 2009.

Net trade represented the largest optical illusion in the GDP report, providing an artificial boost to GDP growth of 1.5%. The U.S. trade deficit narrowed more than expected in January as imports declined, and further decreases are likely as the coronavirus outbreak disrupts the flow of goods and services. While the smaller trade deficit would provide a boost to the calculation of gross domestic product, declining imports mean less inventory accumulation, which could offset the lift to GDP. Falling imports are also likely to lead to shortages, which could hurt both consumer and business spending. The deficit can also fall because the pace of the American economy is slowing, making consumers less likely to buy imported goods and businesses less likely to invest. And that has been the situation in the U.S., economists say.

Goldman Sachs projected in early March that the U.S. would register GDP growth of just 0.9% in the first quarter and wouldn’t grow at all in the second quarter—representing the worst six-month window the economy has seen since the Great Recession. Officially, a recession is at least 2 quarters of negative GDP. By the time it is announced, you are already in it and could even be coming out on the other side.

However, a recession is more than just a dip in gross domestic product. As most economists think of it, a recession involves a cycle that feeds on itself: job cuts lead to less income, which leads to less spending, which leads to more job cuts. Consumer spending being 70% of the economy, one would have to see it on the consumer side to take the U.S. economy down. Oxford Economics estimated that 40% of consumer spending is linked to social situations. Some of this spending may be gone for good.

What’s Next?

Here’s how COVID-19 could cause a recession: as fear of the virus spreads, Americans stop going to tourist attractions, restaurants, concerts, sporting events, the theater, movies, and vacation spots. Airlines cancel domestic flights. Sports leagues scrap games. Hotels, museums, and amusement parks close.

Then, with less revenue and no certainty on when business will bounce back, companies start laying off employees. Newly unemployed workers pull back spending further, and others, fearful that their jobs could be next, do the same. That hurts demand for an even wider array of products, forcing more layoffs and pushing some companies into bankruptcy.

Or imagine a slight twist: supply-chain disruptions make it hard for manufacturers to get parts and for retailers to stock shelves. With nothing to sell, they lay off workers, setting off the same cycle of job losses and reduced spending.

Conclusion

We are currently almost at the end of the first quarter. We are also at the beginning of the COVID-19 outbreak in the U.S., the steep drop in oil prices, and any supply-chain disruption. Thus, we expect that earnings for the first and second quarter will be down. Also, because of these expectations, we expect that companies will report any other earnings negatives, i.e. “throwing everything in.” There is also a seasonal adjustment to consider. The mild winter may have hyped some numbers such as the payroll increases. Thus, as we move through the spring, these numbers may back off.

Will there be a comeback in the last half of the year? Nobody really knows. It all depends on the virus and how long oil prices remain low. Will the virus fade in hot weather? Qatar, one of the hottest places in the world, is reporting hundreds of cases, making this look less likely. Will there be a vaccine available in time for the next flu season? Again, unlikely, since estimates are that it may be late in 2021 before a vaccine is ready.

How bad will the mortality rate be in the U.S? Will there be any fiscal stimulus for companies and people that are hurt by it? Will companies tied to oil and gas have credit problems and lay off employees? Once the all-clear signal is given, how quickly will activity ramp back up? Getting to the bottom here will be painful. The more important question over the long run is: will the recovery be V-, U-, or L-shaped?

As always, a well-diversified portfolio is designed to help reduce volatility over time. It is advisable to check with your financial adviser in turbulent times.

As always, if you have any questions about this article or any financial questions in general, please reach out to Bowen Asset at info@bowenasset.com or (610) 793-1001.

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