The coronovirus shock indeed has come as something truly unexpected, as no thoughtful analysis or a mad guess could've foreseen such consequence of events. However, as for now, we are situated right in the point on the timeline, where prediction is not a guessing game anymore.
As fast as the virus broke into our life, the authorities claimed that it is largely under control: both from medical and from an economic point of view. Every negative news started to be perceived as just another reason for new exceptional stimulus. As the market sentiment suggests, the unprecedented and, so to say, mind-blowing Fed and US government injections are widely presumed to be the end of the story. Nevertheless, there are investors that were waiting for the "blood in the water", but didn't manage to actually taste it. Will they have a chance?
THE INFLATIONARY SCENARIO
Well, with all of the responsibility that an analyst (ideally) must possess, I should say that I don't know. But while there are scenarios that make me agree with the existing optimism in the market, there is a certain one that does seem to be an actual crisis. And it is going to be the topic of this article.
The "helicopter money" injections that we see indeed seem to be a solution to every single concern that investors have. However, does the US economy really possess a flawless weapon, sort of Thor's Stormbreaker that the only US is worthy to hold? Unfortunately, not a single item in the economy comes with no price, as the functioning of such a complex system is undoubtedly a zero-sum game. Therefore, while the US citizens gain from such injections, someone should suffer identical losses. It turns out that someone will be US citizens but in the future. This is the story of incredible growth at the expense of future failure.
Every undergraduate student with economics as a major will definitely tell you that money printing spending is an inflationary scenario due to an increase in the money supply that pushes interest rates lower, thus, causing the positive aggregate demand shock, ending in the acceleration of the inflation. However, the coronavirus situation has caused a quite strong negative demand shock, thus, causing the temporary (very temporary) slow down in the inflation. Therefore, at first sight, a possible acceleration of this parameter looks just like the offsetting measure in action. One would've ended the analysis up here, but I would like to go deeper.
The matter is that this coronavirus crisis (however, I would insist on the "pre-crisis" definition) cannot be compared to any shock the economy has ever suffered. Therefore, investors, especially widely spread algorithmic ones, cannot find a comparable historical situation in order to apply for their portfolio adjustments. Thus, they will "eat up" the current optimism as it is. Indeed, even though the quarantine has stopped the economy for a while, unlike a war there were no non-current tangible assets destroyed, keeping the turning back on still possible. While I don't expect a V-shape recovery, as starting up the economy back is the complex matter to be conducted in the non-momentary form, there will be a coming back to the pre-virus levels in the matter of economy. However, even due to high unemployment right now, the effect on the economy is still temporary: firms will start to hire back quite soon after the quarantine is over.
And in this situation, it turns out that households and firms, stimulated by the government, didn't lose the welfare much. Thus, the end of quarantine will be met by excessive spending, traveling and enormous consumption. Generally, there will be three dominating effects: deferred consumption, a "thirst for consumption" and, unfortunately, lower future life expectancy in minds of individuals - they will realize that inevitable might always come quite sooner that it was invited by nature.
But, wait for a second: does the described consequence look like a positive demand shock? Indeed, it does. Therefore, a massive "helicopter money" injections will be accompanied by the inflationary shock from the demand side, causing a boom in inflation. Surely, such an event will cause a significant rate increase by monetary authorities. And that's where the story really becomes tense.
THE EFFECT ON CORPORATIONS
At that point markets will definitely believe that actual threat is left behind, thus, being excessively vulnerable to any external shock. Fed will think that the threat is behind too. But, as we know, there are no crises without insolvency...
It is no secret to anyone that throughout the last decade the main buyer of the stocks was represented by the corporations themselves. The buybacks were provided by a largely accumulated debt that was growing, relative to GDP, ever since last crisis:
But the actual issue that those buybacks were conducted at the expense of CAPEX, thus, at the cost of the long-term prosperity of the companies. Therefore, at this particular moment of time we see the huge set of highly leveraged corporations without accumulated cash for future projects and even more - a small number of those planned earlier. And if for some companies the development may start at the moment of raising funds, there are industries that require several years - e.g., offshore oil, the revenues of which are generated by the capital expenditures of at least two years ago.
Therefore, many of the companies won't make it through the interest rate raise, thus, it will lead to insolvency flood. And that is the point, where the actual unemployment comes in. But more to come - companies stay helpless, as they cannot prove future credit sustainability due to dark future revenue forecasts, caused by the previous underinvestment. Worsened debt conditions will disallow many to refinance existing debt or gain new for future projects. Therefore, they will simply not possess future cash flows to be promised to either debt or equity investors. Noting that most of such debt is issued at lowest Investment Grade ratings, the downgrades will cause large spreads widenings due to entering the Junk Bonds category.
Besides that, such a financial crisis and the real economy crisis are incurable by the monetary stimulus. Yes, surely, as for now, Fed manages to control the situation: e.g., this Monday $500 billion of Fed supply at REPO market met only $7 billion of demand. The liquidity issue seems to be solved. Companies, thus, will start to feel safe again. But at the point, where the actual crisis comes, Fed will be helpless. Historically, monetary stimuli had little effect on the outcome of the existing tensions. I doubt that we can expect such a scenario this time - it looks just as postponing the inevitable.
Moreover, monetary authorities have got themselves into a so-called “market liquidity trap” – Fed had been developing the environment of frequent and significant liquidity injections, distributed to the investors through companies’ debts by buybacks. However, that money rarely comes to the real economy – in fact, around 90% of US citizens get minor benefits from those injections, compared to the rest 10%. Thus, recent stimuli helped only to widen the inequality, but never to push the economy higher, slightly keeping it from falling.
ARGUING AGAINST
Contrary to the stated above, there are certain factors that might prevent the US economy from such a scenario. First of all, the possible second wave of quarantines (in small time period after the first quarantine is over) will smooth the positive consumption shock, likely not leading to the outcome of incredible interest rate raise by Fed at the end of the day, but rather causing a moderate and calm appreciation. Secondly, the qualified economist would argue that inflation is restrained by the unemployment level rise, as the Phillips curve suggests.
There are two facts that disallow such an argument to hold. First of all, the current unemployment turns out to be largely temporary: we will witness the increase in demand for labor shortly after the economy is restarted. Secondly, the Phillips curve always shifts up (each level of unemployment starts to correspond to higher inflation), when inflationary expectations grow. And that is what we witness right now:
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Therefore, the inflationary scenario stays competitive in the long line of predictions, as for today.
BOTTOM LINE
All in all, I suppose that the current macroeconomic state has too many variables to be captured. However, the overall picture always stays possible to be described. And even if such a scenario does not seem a basic one for you, I would strongly recommend hedging your portfolio against it, as it holds to be still probable and very costly for the US economy.
An extraordinary situation, as the considered one truly is, always opens outstanding opportunities for the long-term investors, as the vision of market players narrows down to one day sight, creating possibilities to use the long-term mispricings.
Firstly, an inflationary scenario would imply the long position in inflation-linked bonds, as coupon payment of such might and will rise, should the price growth speed up. Surely, choosing a concrete bond issue depends on a particular investor’s preference, but for the sake of this essay we should avoid the credit risk analysis, thus, simple TIPS (Treasury Inflation-Protected Securities) will be a great choice. The main factor, why does the investment idea exist, is the fact that due to the sharp fall of the markets, current market players favor fixed cash flow assets over the floaters. We expect the long position in TIPS has quite a significant upside potential versus way lower downside due to the small probability of potential slow down in inflation, which makes the expectation of the idea return be positive.
Secondly, we noted that there were huge capital outflows from Europe into the US, when the interest rates differential of those two fairly comparable by risk regions had grown significantly. Since there were investors that favor US assets more due to higher yield, the further QE becomes a negative sign for them. However, as most of those investors are pension funds and passive investors, portfolio adjustment should be expected to stay quite slow, thus, causing any effects only in the long-term. As investors will sell bonds all over the yield curve, but with Fed buying out many of those bonds, we don’t see any particular idea in that. However, one should surely expect significant Eurodollar appreciation throughout 2-3 future years. Contrary, the dollar doesn’t have many “arguments” against euro, therefore, the probability of upside highly overcomes the probability of the downside in our view.
Thirdly, we expect the scenario of QE to come to the end, when the effect of inflation will come into place. Such an idea is of a very long-term nature, but should it occur, the stock and bond markets will react aggressively down. Therefore, buying out the CDS for concrete pools of lowest investment-grade bonds and put options for the stock market might be a good idea, if the timing is chosen correctly. We consider the time period of 2-3 years from now as the optimal time of put options expiration, and time to buy CDS should be set in the moment, when the economy will be getting back into the state of normal – that is when we are waiting for credit reliability issues expectations to be the lowest. However, we would like to note that such idea, while being of the maximum upside level, bears quite high level of risk, thus, it should be applied to the investment portfolio only for an investor that is ready for an extreme downside, if the less likely scenario occurs.