Coronavirus: “We are all Keynesians now”

An economic depression requires a 10% (or more) decline in real GDP or a prolonged recession that lasts two or more years.

The current contraction, sparked by the global coronavirus outbreak, is likely to be severe but its magnitude and duration are still uncertain. After an initial spike in cases, with devastating consequences in many countries — both in terms of the number of deaths and the massive economic impact — the rate of contagion is expected to drop significantly. But we could witness further flare-ups, as with SARS.

Development of a vaccine is the only viable long-term defense against the coronavirus but health experts warn that this is at least 12 to 18 months away — still extremely fast when compared to normal vaccine development programs.

The economic impact may soften after the initial shutdown but some industries such as travel, airlines, hotels, cruise lines, shopping malls, and cinemas are likely to experience lasting changes in consumer behavior. The direct consequences will be with us for some time. So will the indirect consequences: small business and corporate failures, widespread unemployment, collapsing real estate prices, and solvency issues within the financial system. The Fed is going to be busy putting out fires. While it can fix liquidity issues with its printing press, it can’t fix solvency issues.

There are three key factors that are likely to determine whether countries end up with a depression or a recession:

1. Leadership during the crisis

Many countries were caught by surprise and the rapid spread of the virus from its source in Wuhan, China. South Korea, Singapore and Taiwan were best prepared, after dealing with the SARS outbreak in the early 2000s. Extensive testing, tracing and an effective quarantine program helped South Korea to bring the spread under control, after initially being one of the worst-hit.

Daily Increase - South Korea

South Korea: Initial Cases of Coronavirus COVID-19 (JHU)

The World Health Organization (WHO) did little to help, delaying declaration of a pandemic to appease the CCP. Economic and political self-interest has been the root cause of many failures along the way, including China’s failure to alert global authorities of the outbreak (they had already shut down Wuhan Naval College on January 1st). But this was aided by failure of many leaders to heed warnings from infectious disease experts in late January/early February. When they finally did wake up to the threat, many were totally unprepared, resulting in a massive spike in cases across Europe and North America.

Testing is a major bottleneck, with the FDA fast-tracking approval of new tests, but production volumes are still limited. Abbott recently obtained FDA approval for a new 5-minute test kit that can be used in temporary screening locations, outside of a hospital, but production is currently limited to 50,000 per day. A drop in the ocean. It would take 6 months to produce 9 million kits for New York alone.

Daily Increase - USA

USA: Initial Cases of Coronavirus COVID-19 (JHU)

Daily Increase - UK

UK: Initial Cases of Coronavirus COVID-19 (JHU)

Daily Increase - Germany

Germany: Initial Cases of Coronavirus COVID-19 (JHU)

Daily Increase - Italy

Italy: Initial Cases of Coronavirus COVID-19 (JHU)

Widespread testing and tracing, social-distancing, and effective quarantine methods have enabled some countries to flatten the curve. Australia may be succeeding in reducing the number of new cases but inadequate testing and tracing could lead to further flare-ups. One of the biggest dangers is asymptomatic carriers who can infect others. Flattening the curve is the first step, but keeping it flat is essential, and requires widespread testing and tracing.

Daily Increase - Australia

Australia: Initial Cases of Coronavirus COVID-19 (JHU)

The curves for North America and Europe remain exponential. They may even spike a lot higher if hospital facilities are overrun. Success in flattening the curve is critical, not just in minimizing the number of deaths but in containing the economic impact.

2. Economic rescue measures during the crisis

Rescue measures amounting to roughly 10% of annual GDP have been introduced in several countries, including the US and Australia, to soften the economic impact of the shutdown. More Keynesian stimulus may be needed if the coronavirus curve is not flattened. Layoffs have spiked and many small businesses will be unable to recover without substantial support.

3. Economic stimulus after the crisis

This is not a time for half-measures and the $2 trillion infrastructure program proposed in the US is also appropriate in the circumstances. Australia is likely to need a similar program (10% of GDP) but it is essential that the money be spent on productive infrastructure assets. Productive assets must generate a market-related return on investment ….or generate an equivalent increase in government tax revenue but this is much more difficult to measure. Investment in unproductive assets would leave the country with a sizable debt and no ready means of repaying it (much like Donald Trump’s 2017 tax cuts).

Conclusion

Social-distancing and effective quarantine measures are necessary to flatten the curve but widespread testing and tracing is essential to prevent further flare-ups. Development of a vaccine could take two years or more. Until then there is likely to be an on-going economic impact, long after the initial shock. This is likely to be compounded by a solvency crisis in small and large businesses, threatening the stability of the financial system. The best we can hope for, in the circumstances, is to escape with a recession — less than 10% contraction in GDP and less than two year duration — but this will require strong leadership, public cooperation and skillful prioritization of resources.

—–

“We are all Keynesians now.” ~ Richard Nixon (after 1971 collapse of the gold standard)

The Fed has no vaccine for COVID-19

The World Health Organization has not yet declared the COVID-19 coronavirus a global pandemic but investors are not waiting.

Spooked by the rapid explosion of cases outside of China — South Korea now has 2,931 confirmed cases and Italy 889; — and dire warnings from health professionals, investors are fleeing to safety.

The CDC on February 21st announced:

“We are not seeing community spread here in the United States, yet. But it is very possible, even likely, that it may eventually happen.

…..This new virus represents a tremendous public health threat. We don’t yet have a vaccine ….nor do we have a medicine to treat it specifically.

…..We are now taking, and will continue to take, unprecedented aggressive actions to reduce the impact of this virus.”

China claims to have the disease under control, reporting a sharp decline in new cases. But they have zero credibility after the massive suppression of information, frequent revision of statistics, and rapid disappearance of anyone who contradicts the official CCP line.

This report from Trivium China shows how CCP temporizing allowed the virus to spread:

China’s National Health Commission website published minutes from a meeting the NHC held with its provincial branches on January 14:

  • “The epidemic prevention and control situation has undergone important changes, and the spread of the epidemic may increase significantly, especially with the arrival of the Spring Festival……
  • [We must] implement the most stringent measures, control the epidemic locally, and do our best to avoid the spread of the epidemic in Wuhan.”
  • But the NHC didn’t give any public warning about the virus before January 20.

Severity of the disease should also not be underestimated. Of 43,940 active cases, 18% are listed as serious or critical, while 7% of 39,439 closed cases have died. The growing number of relapses, after the patient initially recovered, is also concerning.

China is going to find it difficult to restore business as usual with the constant threat of another outbreak. Activity remains well below normal levels.

China coal consumption

Official PMI figures point to a “brutal contraction” for China. February Manufacturing PMI plunged to 35.7, while Services were even lower at 29.6.

China PMI

It is difficult to estimate the economic impact of COVID-19 on the global economy. Profs. Warwick McKibbin and David Levine take a stab:

The novel coronavirus COVID-19 may become a footnote in history – a disaster narrowly averted. It could also become a global pandemic similar to some of the worst pandemics of the twentieth century. For example, assume the COVID-19 is as easy to spread and as dangerous as the 1957 Asian flu. Based on the epidemiological estimates of mortality and morbidity rates from that experience, our best estimate from a 2006 study on pandemics was that such a virus might kill more than 14 million people and shrink global GDP by more than $500 billion. These estimates are far higher than the costs were in 1957 because our world is increasingly connected and urban. Preliminary results currently being updated in 2020 suggest even higher numbers for worse case COVID-19…..[Brookings]

This is not a problem that the Fed can handle.

No doubt they will cut interest rates. Short-term Treasury yields (gray) are already falling in anticipation of another rate cut (green).

Effective Fed Funds Rate (EFFR), Interest on Excess Reserves (IOER), and 3-Month Treasury Yield

When consumers are scared, rate cuts will not restore normal consumption patterns. This is both a demand and a supply shock. A virus outbreak would cause consumers to drastically curtail demand: use of public transport, holiday travel, business travel, hotel occupancy, visits to restaurants, shopping malls, sporting events and other public venues. Fast food consumption and discretionary shopping would be especially hard hit.

But supply is also likely to contract due to interruptions to supply chains and shipping logistics, slowing manufacturing output.

Donald Trump may call this a “hoax” but I don’t see him taking any hospital tours, to review preparations. If the virus does spread as anticipated, he is unlikely to win re-election.

The Coronavirus Threat

Spread of the novel coronavirus (2019-nCoV) is a “global health emergency” according to the World Health Organization (WHO). Restricted travel is already having an impact on the global economy, with Goldman Sachs anticipating a 0.4% fall in U.S. annualized GDP growth in the first quarter.

Imperial College in London estimates a dangerously high transmission rate for the disease:

Self-sustaining human-to-human transmission of the novel coronavirus (2019-nCov) is the only plausible explanation of the scale of the outbreak in Wuhan. We estimate that, on average, each case infected 2.6 (uncertainty range: 1.5-3.5) other people up to 18th January 2020, based on an analysis combining our past estimates of the size of the outbreak in Wuhan with computational modelling of potential epidemic trajectories. This implies that control measures need to block well over 60% of transmission to be effective in controlling the outbreak….

Johns Hopkins University CSSE reports 11,374 confirmed cases with 259 deaths and 252 recoveries as of 7.00 p.m. on January 31, 2020. Growth of the  number of reported cases in Mainland China appears linear, with an increase of 1,700 per day.

JHU CSSE 2019-nCOV spread

That seems highly suspicious when one compares to mathematical modeling and to social media reports from medical staff on the ground. Contagion rates are likely to grow exponentially, rather than in a straight line, and will only peak when authorities are able to bring the transmission rate below 1.0 (compared to the 2.6 posited by Imperial College).

A report in the Epoch Times suggests that Chinese public health authorities have suppressed the reporting of confirmed cases:

“The outbreak of Wuhan coronavirus is far bigger than the official figures released by Chinese public health authorities who cover up the severity by limiting the number of diagnosis kits to Wuhan hospitals, according to an insider and an independent journalist.

The insider and the independent journalist both say that diagnosis kits are only provided to certain ‘qualifying hospitals’ and in very limited quantities. Medical personnel at these hospitals have said that the number of kits they are supplied is less than 10 percent of what they need to test patients.

Now these hospitals claim that their responsibility at present is to provide treatment only, and they will not perform any diagnoses.”

UK researcher Jonathan Read projects that the epidemic in Wuhan will reach 191,529 by February 4 (prediction interval 132,751-273,649). Chart A shows total number of infections in black and new infections per day in red.

2019-nCOV predicted infection rate - Wuhan

2019-nCOV predicted infection rate - Mainland China

Restriction of road, rail and air travel to/from Wuhan is expected to achieve between 12.5% and 25% reduction in cases in the above areas.

2019-nCOV predicted infection rate - World

Importations into other countries may also be slowed by travel restrictions.

Mortalities are not limited to young children and the elderly and infirm as with most influenza viruses. Healthy adults, including health care workers, are dying. Reported recoveries (252) are low and provide an indication as to the severity of the infection.

Modelling suggests that the number of cases will double every seven days until it peaks. The peak number of cases will depend on how long it takes to contain the outbreak. Another four weeks would pose a serious threat to the global economy.

Where Fortune is concerned: she shows her force where there is no organized strength to resist her; and she directs her impact there where she knows that no dikes and embankments are constructed to hold her. ~ Niccolo Machiavelli, The Prince (1532)

S&P 500 in a precarious position

A long-term chart of the S&P 500 highlights the precarious position of the index, having now doubled since its October 2007 high at 1576. Any time that a stock doubles in price, you are likely to get profit-taking, leading to resistance. The same holds true for the index. Probably even more so because individual stocks have the capacity to post higher gains — of even 5 or 10 times — while that isn’t feasible for the index. Even in the Dotcom bubble.

S&P 500

On the one hand we have a massive triple stimulus creating irrational exuberance, while on the other we have concerns over a coronavirus epidemic spreading from China and Donald Trump’s looming impeachment.

CoronaVirus

If you think that Trump is a shoe-in for re-election in November, this analysis of his chances is quite eye-opening.

Trump: Long Shot rather than a Slam Dunk

Expect more erratic behavior in the lead up to November.

Robert Shiller’s warning

Nobel prize-winning economist Robert Shiller warns that cracks are once again surfacing in the US housing market.

“We have had a strong housing market for pretty much all the time since 2012. Just after the financial crisis, the housing market didn’t recover, maybe because banking was in disarray and people were still expecting declines after the event. After 2012, it started going up at more than 10 per cent a year nationwide in the US, and has been slowing down since.”

Shiller says that a worrying pattern emerging in house prices is reminiscent of the property market in the run-up to the Great Recession.

The bursting of the US housing bubble in 2006-07 was a key trigger of the financial crisis…… “I have seen this happen before, we’re like back in 2005 again when the rate of increase in home prices was slowing down a lot but still going up.

Case Shiller Index

Growth in the Case Shiller National Home Price Index is clearly weakening but we need to be careful of confirmation bias where we “cherry-pick” negative news to reinforce a bearish outlook. I would take the present situation as an “amber” warning and only a drop below zero (when house prices fall) as a red flag.

Shiller has an enviable reputation for predicting recessions, having warned of the Dotcom bubble in tech stocks and the housing bubble ahead of the 2008 global financial crisis. He is correct that narratives (beliefs) can become self-fulfilling prophecies. If the dominant view is that the economy will contract, then it probably will — as corporations stop investing in new capacity and banks restrict lending. Geo-political tensions — US/China, UK/EU Brexit, and Iran/Saudi Arabia — combined with massive uncertainty in global trade and oil markets, could quickly snowball into a full-blown recession.

Tectonic shift threatening the global reserve currency system

As Mark Carney observed at Jackson Hole: the global reserve currency system is broken — it has been since Nixon defaulted on gold backing for the Dollar in 1973 — and there is no fix. We have to find a replacement along the lines of Carney’s suggestion. On Macrovoices, two experts on the EuroDollar system, Jeffrey Snider and Luke Gromen discuss the massive tectonic shift facing the global financial system.

https://www.macrovoices.com/683-macrovoices-184-luke-gromen-jeff-snider

This is a complex topic but it is important that we grasp the implications before a tsunami appears on the horizon.

S&P 500: Upside limited, while downside risks grow

Corporate profits (before tax) ticked up slightly in the second quarter of 2019 but remain below 2006 levels in real terms. The chart below shows corporate profits adjusted for inflation using the GDP implicit price deflator.

Real GDP and Hours Worked

Growth in production of durable consumer goods remains week, reflecting poor consumer confidence.

Durable Goods Production

The chart below shows growth in bank credit and the broad money supply (MZM plus time deposits). Credit growth (blue) remains steady at around 5%, slightly ahead of nominal GDP growth (4.04% for 12 months ending June); a healthy sign. Broad money (green) surged upwards in the first three quarters of this year. Not an encouraging sign when there were similar surges in broad money before the last two recessions.

Broad Money & Credit Growth

The S&P 500 is testing resistance at 3000. Bearish divergence on Twiggs Money Flow warns of secondary selling pressure. Expect a test of support at 2800. Breach would flag a reversal, with a target of 2400.

S&P 500

The cyclical Retailing Index displays a similar pattern, with resistance between 2450 and 2500.

Retail

Our view is that upside is limited, while downside risks are growing.

On the global front, the outlook is still dominated by the prospect of a prolonged US-China trade war. More great insights from Trivium China:

Tariff delays may be aimed at creating warm, fuzzy feelings before the next round of talks in early October, but……These small gestures do nothing to resolve the underlying trade conflict. We’re still pessimistic on prospects for a deal.

Zhou Xiaoming – China’s former top diplomat in Geneva – expressed the same view in a recent interview (Guancha):
“The two sides disagree too much on the objectives of the negotiations……It is almost impossible to reach an agreement in the short term.”

Zhou urged Chinese officials to be clear on the US’s objective:
“Economic and technological decoupling is the objective of the entire US government.”

Zhou said that officials must prepare for that potentiality, even if it is not their desired outcome.

So should we.

Dow Jones – UBS Commodity Index found support at 76 before rallying to 79. Rising troughs on the Trend Index reflect increased support. Consolidation between 76 and 81 is likely but we maintain our bearish long-term outlook for commodities.

DJ-UBS Commodities Index

On the global front, weak crude oil prices flag an anticipated slow-down in the global economy. Trend Index peaks below zero indicate selling pressure. Breach of support at $50/$51 per barrel would be a strong bear signal, warning of a decline to $40 per barrel.

Nymex Light Crude

We maintain our investment in quality growth stocks but have reduced equity exposure to 40% of (International Growth) portfolio value.

The Long Game: Why the West is losing

Autocracies like China, Russia and Iran are challenging the dominance of Western democracies. Much has changed in the last two decades, fueling this emerging threat to the free world.

China & Global Trade

China joined the WTO in 2001 and disrupted global trade. Subsidy of state-owned or state-sponsored industries tilted the playing field. Manipulation of exchange rates, amassing $4 trillion of foreign reserves, helped to depress the yuan, creating a further advantage for Chinese manufacturers.

Manufacturing employment in the US shrank by more than 5.5 million jobs between 2000 and 2010.

Manufacturing Jobs USA

Europe experienced similar losses.

Manufacturing Jobs UK, France & EU

Output recovered, but through a combination of automation and offshoring labor-intensive activities, manufacturing jobs were never restored. Losses of 4 million US manufacturing jobs (23.5% of total) and an equal 4 million (10%) in the European Union appear permanent.

Manufacturing US & EU

The Global Financial Crisis

The global financial crisis (GFC) in 2008 and the recession caused soaring unemployment and further alienated blue collar workers.

Unemployment US & EU

The $700 billion bailout of the banking system (Emergency Economic Stabilization Act of 2008), with no prosecutions of key actors, undermined trust in Federal government.

The Rise and Decline of Nations

Mancur Olson, in The Rise and Decline of Nations (1982), argues that interest groups — such as cotton-farmers, steel-producers, labor unions, and banks  — tend to unite into pressure groups to influence government policy in their favor. The resulting protectionist policies hurt economic growth but their costs go unnoticed, attracting little resistance, as they are diffused throughout the economy. The benefits, on the other hand, are concentrated in the hands of a few, incentivizing further action. As these pressure groups increase in strength and number, the costs accumulate, and nations burdened by them fall into economic decline.

Olson formulated his theory after studying the rapid rise in industrial power in Germany and Japan after World War II. He concluded that their economies had benefited from the almost complete destruction of interest groups and protectionist policies as a result of the war and were able to pursue optimal strategies to rebuild their economies. The result was that their economies, unfettered by pressure groups and special interests, far outstripped those of the victors, burdened by the same inefficient, protectionist policies as before the war.

Federal government, choked by lobbyists and special interests, failed to prioritize issues facing blue collar workers: global trade, off-shoring jobs and fallout from the GFC. Formation of the Tea Party movement in 2009 created a rallying point for libertarians and conservatives — supporting small government and traditional Judeo-Christian values1 — but it also opened the door for populists like Donald Trump.

Polarization

Exponential growth of social media, combined with disinformation and fake news, has polarized communities.

In 2017, 93 percent of Americans surveyed said they receive news online, with news organization websites (36%) and social media (35%) the most common sources. Trust and confidence in mass media has declined from 53 percent in 1997 to 32 percent in 2016, according to Gallup Polls.

Politics are increasingly dominated by outrage and division, with populist candidates gaining handsomely.

Many Western governments are now formed of fragile coalitions. Greece, Italy, Germany, even the UK.  Others in Eastern Europe — Poland, Hungary, Austria, Turkey — are heading towards autocracy.

The Long Game

China has been quietly playing the long game. Massive investment in infrastructure, subsidy of key industries, controlled access to its markets, upgrading technology through forced partnerships with Western companies in exchange for access to Chinese markets, and industrial espionage have all been used to gain an advantage over competitors.

The CCP exploits divisions within and between Western governments while expanding their influence in universities, think tanks and the media. The stated aim of the CCP’s United Front Work Department is to influence Chinese diasporas in the West to accept CCP rule, endorse its legitimacy, and assist in achieving Party aims. This includes some 50 million who emigrated after 1979 or are PRC students studying abroad. Stepped up surveillance of PRC students, funding of Confucius Institutes on campuses and growing student activism has raised concerns in Australia over academic freedom and promotion of pro-Beijing views3.

Western governments seem unable to present a coordinated response. Absence of a cohesive, long-term strategy and weakened alliances make them an easy target.

Pressure Groups

Governments are also subjected to pressure from within. The latest example is pressure exerted, by US companies, on the White House to lift the ban on sales of US technology to Huawei. From the New York Times a few days ago:

Beijing has also pressured American companies. This month, the Chinese government said it would create an “unreliable entities list” to punish companies and individuals it perceived as damaging Chinese interests. The following week, China’s chief economic planning agency summoned foreign executives, including representatives from Microsoft, Dell and Apple. It warned them that cutting off sales to Chinese companies could lead to punishment and hinted that the companies should lobby the United States government to stop the bans. The stakes are high for some of the American companies, like Apple, which relies on China for many sales and for much of its production.

Short-term Outlook

The problem with most Western democracies is that they are stuck in a short-term election cycle, with special interest groups, lobbyists for hire, and populist policies targeted at winning votes in the next election. Frequent changes of government lead to a lack of continuity, ensuring that long-term vision and planning, needed to build a winning global strategy, are woefully neglected.

Autocrats like China, Russia and Iran are able to play the long game because they enjoy continuity of leadership. They do not have to concern themselves with elections and the media cycle. They own the media. And elections, if held, are a mere formality, with pre-selected candidates and pre-ordained results.

Western democracies will have to adapt if they want to remain competetive in the 21st century.

Focus on the Long-term

Switzerland is one of the few Western democracies that is capable of a long-term focus. Their unique, consensus-driven system ensures stability and continuity of government, with buy-in from all major political parties. The largest parties are all represented on the 7-member governing Federal Council, elected by Federal Assembly (a bicameral parliament) for four-year terms on a proportional basis. There has been only one change in party representation on the Federal Council since 19592.

Cohesiveness and stability provide a huge advantage when it comes to long-term planning.

Conclusion

Regulating global trade, limiting the threat of social media, ensuring quality journalism, protecting academic freedom, guarding against influence operations by foreign powers, limiting the power of lobbyists and special interest groups — all of these require a long-term strategy. And buy-in from all sides of the political spectrum.

We need to adapt our current form of democracy, which has served us well for the last century, but is faltering under the challenges of the modern era, or risk losing it all together. Without bipartisan support for, and commitment to, long-term policies, there is little hope for building a winning strategy.

The choice is ours: a highly-regulated, autocratic system where rule of law is the first casualty; a stable form of democracy that ensures long-term continuity and planning; or continuation of the present melee, driven by emotion rather than forethought, populist leaders, frequent changes in government — and subservience to our new autocratic masters.

Footnotes:

  1. Wikipedia: Tea Party movement
  2. Current Federal Council representation is 2 Free Democratic Party (liberals), 2 Social Democratic Party (social democrats), 1 Christian Democratic People’s Party [CVP] (Christian conservatives) and 2 Swiss People’s Party [SVP] (national conservatives), reflecting 76.2% of the popular vote in 2015 Federal elections. The SVP gained one seat from the CVP in 2003.
  3. The Diplomat: China’s United Front work – Propaganda as Policy