Thoughts on the COVID-19 Recession

May 15, 2020
Recession COVID-19

I was browsing over the news the other evening when a particular article piqued my interest; it is titled Trump says schools should ‘absolutely open’ this fall, says Fauci did not give ‘acceptable answer’ In short it was about how President Trump is pushing the agenda to open the economy. In contrast, Dr. Fauci believes opening the economy too soon would cost more lives and more damage with a second wave of the coronavirus. This article points out so much about the current situation, and I just have to step in and give my two cents.

First, what has the President so worried? For starters, the Federal Reserve chairman issued a stark warning that a prolonged shutdown would be catastrophic to the economy, taking much longer to recover. I think it is evident by now that the United States is in a recession. Our model suggested that the recession started back in February, identified with a rapid bull steepening in the yield curve combined with several other indicators confirming. But if I could pick one chart that would explain the severity of the recession currently upon us, it would be the nonfarm payroll statistic. Usually, I would show this chart converted into a growth rate to indicate the level at which it was changing, but in these unique days, I think showing the actual number is more warranted.

It is mind-blowing that nonfarm payrolls have decreased so rapidly that it is near the level that it was during the great financial crisis. I don’t think there is any argument that we are in a recession. That said, there has also been an unprecedented amount of fiscal and monetary stimulus pumped into the market. So much monetary stimulus that we heard the term “don’t fight the fed” almost on an hourly basis. Some predict that the worst is over. They also believe the market is giving a pass on this quarter of economic data evident by how much the market has rallied since the March lows.

With how bad the economic shock is, I can understand why the President is so eager to re-open the economy, but at what cost? For starters, and the most crucial factor, opening the economy too soon would cost additional lives. Dr. Fauci told a CBS reporter there is a real risk that opening the economy will, “trigger an outbreak that you might not be ablbe to control, which, in fact, paradoxilcly, will set you back, not only leading to some suffering and death that could be avoided, but could even set you back on the road to trying to get economic recovery.” On the other hand, not opening the economy will cause economic disaster, possible failure, maybe even worse than the depression; after all, we are already approaching depression levels in unemployment.

With all this mayhem going on, the market has rallied since its March lows suggesting that the worst is behind us, but is it? The rally was only fueled by pumped liquidity provided by the Federal Reserve, not by economic recovery, or even the idea of a turnaround pointed out by the Fed Chairman. Eventually, there will be a point that quantitative easing fails to provide enough benefit to outweigh the disastrous economic failure. If you need proof just look towards Japan, they have been buying up debt and equities for thirty years since their economic collapse. What makes matters worse is they have yet to reach the highs set back in 1990. Furthermore, let us assume that QE does work and turns around this massive amount of deflation entering the economy. Even a small surge in the velocity of money could send inflation soaring, or worse parabolic rising, aka hyperinflation.

How does one weigh economic collapse against human lives? I don’t know the answer to this after all a deep world depression would also cost millions of lives from starvation alone. I am glad I am not in a position to make these choices.

In all of this chaos, I weight the probability that we have seen the lows in the market. And my conclusion is well frankly unknown. There is a possibility that enough stimulus from both the government and the Federal Reserve could hold off economic disaster, but I fear that the potential is bleak. A more rational assumption would be that the market has yet to see its lows even with stimulus.

I believe that the market has priced in a quick turn around that the COVID-19 pandemic is short-lived. However, I hate to be the bearer of bad news, flattening the curve was designed to keep our healthcare system intact and lengthen the time to overcome this virus. The following chart estimated by the CDC explains this perfectly.

Anatomy

Social distancing makes the time to recovery take longer with a prolonged shutdown. Even worse, if the economy opens too soon, the pandemic could last even longer than the CDC estimates. At this point, I believe that the market has it all wrong on multiple fronts. First, COVID-19 is here to stay until we can develop and distribute a vaccine. Second, the economic impact is already more profound than a 35% loss, which we saw in March, would support.

For this reason, I have decided to be on the defensive and not on the offensive with this rally. Our portfolios stand positioned for a recession, with long-term duration government debt balanced with low duration debt being the most attractive asset classes.

What we need to do now is look forward to the signs that the economy is entering the next phase of the business cycle, the recovery stage. These signals include a turn around in leading indicators, a steep yield curve, and a bottoming of capacity in the manufacturing sector. All of which has not happened yet, making patience the key theme here. We have a plan to re-enter the market, and that plan is when the economy offers clues that the contraction is near its end. Until then, we have to assume that the market is acting irrationally, and eventually, this rally will end with the bear market making new lows. Our technical indicators suggest that this rally could end sooner than later, but technical indicators tend to be wrong with impactful news in the opposite direction.

It is my opinion not to chase returns and enter into this rally on the fear of missing out on the upside. I have a strong conviction that there will be better opportunities in the future. So do not fear missing out on gains, because as the economy Chairman, Jerome Powel, and indirectly President Trump, can all agree there is more pain to come to this market. Now is the worst time to let FOMO (fear of missing out) force you into an irrational rally. Instead, stay the course, use wise judgment, and wash your hands.



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Aaron Soderstrom
Chief Investment Strategist
550 Reserve St Suite 190 Southlake, TX 76092
Office 817-500-0556
aaron@omega2capital.com
Omega2wealth.com
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