There appears to be emerging two sides to this story, one where economists continue to assess the relative damage to growth from the unprecedented lockdown of about a fifth of US productive capacity for the past month. That news is indeed grim. The other side of the story stems from a market that has advanced 27% since scratching out a bottom on the 23rd of March. Much, if not all, of this advance comes with an equally unprecedented monetary and fiscal response from the Federal Reserve and Congress designed to both backstop and stabilize the market which, I would argue, displayed clear signs of breakdown in the waning days of the 1st quarter—irrespective of Covid-19. Both stories continue to develop in startling separation one from another as underlying details catch up to the rapid-fire pace of real-world events.
Stocks were on a rollercoaster tear to the downside for much of the month of March as the coronavirus pandemic savaged major populations centers across the country and around much of the world with the potential of shuttering from 20% to 30% of GDP in G7 countries. The last time the US witnessed such a disruption to its productive capacity dates back to the market crash of 1929 and its aftermath. After peaking in the 19th of February at 3,386, the S&P 500 plunged to 2,237 through the market close of 23 March. The door on the benchmark’s bull run, the longest continuous run in market history, slammed shut with the clang of the closing bell on the 12th of March, down almost 27% from its February high—a mere three days into its eleventh year.
The final trading days of the bull market were indescribably wretched. Unemployment insurance claims for the week ending the 10th of March hit a staggering 3.3 million, almost five-times the previous weekly record set in 1982. By the fifth week of the pandemic, an equally staggering 26 million workers—16% of March’s labor force count—had filed unemployment benefit claims across the country. All the jobs the economy produced since 2009 have largely been lost. Nonfarm employment fell by 701,000 during March on survey data gathered in the last two weeks of February and the first two weeks of March—the largest one month increase since January 1975. That pushed the national unemployment rate from a 50-year low of 3.5% in February to 4.4% in March. About 2/3 of the initial wave of claims came from the leisure, hospitality and food/bar service sector. Social distancing and state stay-home mandates shuddered disperate services from hairdressers to real estate showings to sporting events to church services—and practically every other person-to-person contact in the greater economy. Two other reports out earlier in the month sketched out the first indications of job losses migrating beyond the hospitality, leisure and food services/bar sectors. New home construction in the US fell 22.3% while the Federal Reserve Bank of Philadelphia reported manufacturing in the mid-Atlantic region fell to a reading of minus 56.6 for the lowest post since July 1980.
Nationally, the purchasing manager’s index (PMI) for manufacturing fell to a reading of 49.1 in March, dipping into contraction from February’s 50.1 reading. New orders plummeted well into contraction with a reading of 42.2—its lowest post since March 2009. Prices for raw materials dropped even further into contraction with a reading of 37.4, the lowest post since January 2016. Industrial production in the country’s factories, mines and utilities plummeted 5.4% month-over-month, the worst showing since 1946. Total manufacturing output fell 6.3% MOM, the biggest drop in the post WWII period. Capacity utilization during the month fell well below the 47-year average of 79.8%, falling to 72.7% for the month—six percentage points from the all-time low of 66.7% posted during the height of the Great Recession in 2009. Retail sales and food services sales fell 8.7%, the biggest MOM decline since records began to be compiled in 1992. Gasoline consumption fell 17.2% while food and beverage store sales soared 25.6% as consumers picked many shelves bare in grocery stores across the country. Compiling all of these data points, the Adjusted National Financial Conditions Index paints a grim, risk-infused picture of financial and economic activity over the past month. When the weighted readings of the Index are positive, financial conditions tend to be tight which tends to impede growth. When those same readings turn negative, financial conditions loosen, providing stimulus to growth. Inflation tends to be higher as a consequence. The current Index measure of overall financial conditions came to a reading of 0.42, the highest post since July 2009 (see Figure 1, below).
Figure 1: Adjusted National Financial Conditions Index
Liquidity is the sine qua non of market functionality. Simply stated, without adequate levels of liquidity, markets grind to a halt—often at breakneck speeds. Copious levels of market liquidity keep bid-ask spreads—the difference between the buying and selling price of a security—tiny. Liquidity keeps trades, traders, bid-ask spreads and markets honest, allowing transactions to be equitable and willing exchanges for both parties.
Trading conditions almost always deteriorate when market turbulence rears its Cerberus head. In the closing weeks of March, market turbulence turned into the perfect storm. The opening volley came with the Federal Reserve dropping the federal funds rate (brown line) to zero bound in two separate moves. Treasury yields (lime line), already falling as investors began to pile into familiar safe harbor vehicles, continued their downside trajectory. Equities (candlestick line) dip quickly below their 200-day moving average (blue line), began to fall in earnest. Gold (gold line) mirrored the descent. Orders for S&P 500 contract guarantees on existing equity positions soared, sending the CBOE VIX (cyan line) skyward. The dollar (black dotted line), already garnering outsized heft in relation to its market peers, got all the stronger (see Figure 2, below). A market liquidity squeeze was in cue. Needing to raise cash to meet margin requirements in an already heavily leveraged market, algorithmic programs flooded exchanges with sell orders—value, momentum and growth equities precious metals, treasury bills and notes and any other position that historically carried low correlation measures one with the other. Unfortunately, in the midst of such market exercises, algorithmic sell programs across quant-based hedge and private equity funds bore an eerie resemblance such that heretofore low correlation sells performed under more normal market conditions became highly correlated in March’s liquidity squeeze. This is contagion risk. Everyone suddenly finds themselves selling similar portfolio mixes simultaneously into markets, all chasing fast disappearing cash positions held by market makers.
Figure 2: Gold Futures, The Federal Funds Rate, CBOE VIX, the Dollar Index against the S&P 500
As liquidity in the market fell, bid-ask spreads began to widen. Microsoft (MSFT) is the largest publicly traded and one of the most widely-held companies in the S&P 500. As market liquidity began to tighten, Microsoft’s bid-ask spread widened dramatically, doubling from the 19th to the 20th of February. It would more than double from the 26th to the 27th of February and double again from the 2nd to the 3rd of March. Falling back on the 5th and 6th of March, Microsoft’s bid-ask-spread would peak again the following week on the 18th and 19th before falling back to levels seen in the latter part of February (see Figure 2, below).
Figure 2: Microsoft Bid-Ask Spread through the 1st Quarter
Congress responded to the market’s wild ride with a $2 trillion stabilization bill which was passed on the 25th of March and signed two days later. On the 15th of March, the Federal Reserve intervened in the bond market, buying Treasury bills. The Fed also started buying mortgage backed securities and, for the first time, investment grade corporate debt. Treasury purchases would be unlimited moving forward until such time when market liquidity issues had been sustainably resolved. With that statement, the Federal Reserve assumed the mantle of undisputed lender of last result.
Recently, the US Treasury has literally flooded the market with Treasury bills in its role of securing the financing for the $2.1 trillion stabilization package signed into law last month. So far, the market appears to be digesting the deluge as investors’ appetite the world over for safe haven vehicles continues unabated. According to estimates, the Treasury will need to issue some $3 trillion in new Treasury securities to fund the effort. Unlike the Great Recession where foreign buyers lined up to buy US debt, institutional and sovereign investors from abroad may not be as accommodating on this round of financing. Of the top five foreign holders of US Treasury securities, China and Brazil have been net sellers of Treasuries through February, YOY. Meanwhile, the Fed has set itself up to be the primary buyer. This means low borrowing costs are here to stay for the foreseeable future. Market measures of inflation-- ten years out--remain negligible.
One of the primary lessons for policy makers that came out of the Great Recession was never again to be forced into the position of having to bail out banks. The political fallout cost the Democrats their majority in the House of Representatives in 2010 and their majority in the Senate two years later. For Democrats, it was a crushing political price to pay. Out of the Great Recession experience came sweeping legislation with strict capital reserve requirements and a remake of the depression-era Glass Steagall Act (1933), once again separating commercial and investment banking operations. The Volcker Act put an end to proprietary trading.
Investment banking operations were the primary market makers until Dodd Frank (2010) slowly worked its way into the regulatory vernacular. The cumbersome, but highly liquid investment bank market-makers slowly gave way to the speed of high frequency trading, enormous computing power and the complexity of algorithmic programming. Speed replaced liquidity of old. Stocks now trade on electronic exchanges rather than in the call pits of old. The cost of trading has dropped significantly where now major financial houses offer trading for free.
Further bolstering its role as lender of last resort, on the 17th of March the Fed intervened in the $1 trillion commercial paper market, propping up money market funds. In late February, banks and companies with high credit ratings paid several tenths of a percentage point above the 3-month Treasury bill. By the end of March, those rates had soared to more than 2 percentage points—higher than the 1.5 percentage point spread in the heat of the Great Recession. Another consequence of the Dodd-Frank regulations on bank reserves saw banks of old reducing their previous inventory holdings of bonds, stocks as well as commercial paper. The biggest banks have now won more market share while at the same time reducing the number of players in the otherwise low-margin marketplace for commercial paper. The three-month Treasury went negative on the 26th of March, prompting Fidelity to close three of its money market funds that invested in Treasuries to new investors.
In all, the Fed is now juggling nine different lending facilities that will backstop Main Street lending, new issued and secondary market corporate credit, high yield debt for companies that had investment grade ratings prior to the 23rd of March. The Fed will now backstop municipal debt and in conjunction with the Small Business Association, lend to small- and medium-size businesses. Resurrecting the Term Asset Backed Securities Loan Facility (TALF) from its Great Recession playbook, the Fed will support the flow of credit to consumers and businesses through the issuance of asset backed securities (ABS) backed by student, auto and credit card loans that will be guaranteed by the Small Business Administration.
Figure 4: S&P 500 from 9 March 2009 through the end of 2010
The current bear market for the S&P 500 lasted from the 23rd of March to mid-day on the 8th of April for a total 15 and a half days, making the bear market of 2020 to date the shortest bear duration since 1937. The S&P 500 marked its 18th day of the current bull market. Figure 4 (above) outlines the beginning trajectory of the S&P 500 from the 9th of March 2009 through the end of 2010. The Federal Reserve rolled out two of its three large scale asset purchase (LSAP) programs during the period. As with March’s liquidity crunch, gold (gold line), Treasury securities (lime line) and equities (candlestick line) were falling almost simultaneously. The CBOE VIX (cyan line) was through the roof while the federal funds (orange line) rate was largely en route to zero bound by the end of 2009. Unemployment insurance claims (purple line) soared in 2009 with October of that year claiming the highest unemployment rate at 10% since June of 1983. Meanwhile, the dollar (black dotted line) peaked as the market moved in the opposite direction, falling almost in lockstep with the federal funds rate at it plunged to zero bound. Sound familiar? Eleven years later, the gains of the Benchmark had reached 400%.
Are we looking at a déjà vu market play? This is not to degrade in any sense the coming recession which already lurks in our midst. The estimates for GDP growth in the 1st quarter are almost universally negative. We will know the extent of the contraction with Wednesday’s advanced estimate of GDP growth from the Bureau of Economic Analysis.
GDP growth estimates for the 2nd quarter are darker still. The Conference Board sees real GDP growth contracting 5.8% with consumer spending, about 70% of the US economy, dropping 6.5% annualized for the 1st quarter. In the 2nd quarter, real GDP estimates by the group fall by a whopping 33.3% with consumer spending plunging 40% annualized. For the year, GDP growth will drop 6.5% on the heels of an 8.3% plunge in consumer spending. The last time GDP contracted to such a depth was in 1946 when US output bottomed out at 11.6% for the year. The last time annualized consumer spending contracted that much was in 1932 with a drop of 9% for the year. For its part the International Monetary Fund, after projecting global growth at 3% in January, now predicts a 3% contraction—the sharpest reversal in economic activity since the Great Depression. For the US, GDP growth is projected to contract 5.9% in 2020. In the EU the contraction projects out at 7.5%. Japan’s economy is expected to contract by 5.2%. The UK projects out falling 6.5% for the year. We will know the answer to our 2nd quarter GDP inquiry on the 30th of July.
Hopefully, both sides of the story have suitably been outlined. Fight the Fed at your own peril.
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Disclosure: I am/we are long MSFT. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.