Our last commentary, Perspective-Moving Beyond COVID-19 (3/25/20), focused on consumers’ “psyche” as one key to the ultimate speed of an economic recovery. Improved consumers’ “psyche” will likely require more than mediation policies to reduce their virus-induced caution. The same concerns affect investors’ “psyche.”
Initially, moderating the virus impact will hopefully come from therapeutics currently in development and tests. Therapeutics would reduce lengthy treatments for COVID-19, substantially reducing capacity pressure on hospitals. Such therapeutics include antibody cocktails, convalescent plasma, and anti-virals (see Figure 1). Effectiveness depends on their use in the early stages of infection. Therefore, timely testing will prove the key to their success. These therapies could partially reduce consumers’ caution by knowing a virus treatment exists.
Potential success for these treatments would likely push recovery forward from the current economic valley. That valley will likely last through at least the third quarter of this year—if not beyond. Because of their importance, financial markets will immediately react to development reports for these therapeutics.
The recovery timeline will require careful planning to determine the steps needed to open the economy. With no vaccine at present, opening the economy will require rigorous testing and tracing strategies to avoid serious recurrence of the virus. So far, publicly, neither the White House nor Congressional leaders seem focused on developing this strategy. Without a historical basis for judgment, investor caution seems the best approach during the gap period between opening the economy and, hopefully, successful completion of vaccine trials.
The key to next year’s growth will be a successful vaccine that prevents COVID-19 from reoccurring. To reach that goal early in 2021, the Federal government and other non-profit sources will underwrite the risks of starting to build production facilities before final vaccine trials prove their efficacy.
A vaccine broadly available in the first part of 2021 will produce higher overall consumer and business confidence leading to more rapid economic growth in the second half of the year. Once again, investors will quickly respond to headlines reporting the vaccines’ critical development results.
In the meantime, while the country now waits for therapeutics and vaccines, both the Federal Reserve and Congress have made massive commitments to the economy. Most observers look at these commitments as stabilizing efforts, not a stimulus. In its phase 3 package, Congress added over $2 trillion of fiscal spending. At the same time, the Fed will boost its balance sheet from about $4 billion to initially $8 billion and probably higher in supplying liquidity to the credit markets. In effect, the Fed nationalized our credit markets. To paraphrase a senator of yore, a trillion here, a trillion there, and pretty soon you’re talking about real money.
Early in the last decade, when the Fed’s balance sheet first ballooned, many economists expected higher inflation rates would eventually show up. The reverse proved to be the case. With the doubling of already ballooned debt levels in the Fed’s balance sheet, most observers seem quiescent about potentially higher rates of inflation. At the same time, the rapid increase in debt levels over the last decade reduced the marginal impact on GDP growth from each dollar of increased debt. That trend will likely continue and reduce the benefits of such incremental debt longer-term.
Economists estimate that closing the economy for some period will cost roughly $3 trillion. The gap between that estimate and the $2 trillion phase 3 fiscal package will likely lead to a phase 4 fiscal spending package totaling over one trillion dollars. This additional spending will likely consist of many similar provisions in phase 3 — unemployment supplement, small business loans, and hospital funding. As presidential politics moves closer, proposed new controversial spending programs will likely result, and delay passage. Depending on the bumps in the road, once the economy opens, additional fiscal packages seem likely. This spending eventually leads to higher taxes marking the end of the lowered tax rate era. Milton Friedman once said, “nothing is so permanent as a temporary government program.”
As America gradually opens up, significant changes will make prior economic, business, social, and political assumptions less valid. Our commentary outlines a few obvious changes for business, finance, politics, and our society that the virus may bring. Readers will be adding many more changes to our very limited list.
The combination of the trade war and COVID-19 will lead some American firms to reconsider single-sourced finished products and components from Asia. Further encouraging that change, growing 24-hour delivery times could also lead to shifting supply chains to North America. This shift would reduce both growing inventory requirements and associated working capital to finance that growth. This pandemic also demonstrated the thinness and inflexibility of current supply lines that depend on roughly thirty-day ocean shipping times from Asia.
For these reasons, more global supply chains will likely move to North America — including Mexico. This shift will not occur overnight but gradually, when businesses invest in new products and manufacturing facilities. Importantly, economists cite the contribution of globalization to lower inflation — might that change as the trend to North America develops. Bringing production back to North America could result in greater use of robotics to moderate higher labor cost pressures. Moving supply chains to North America would work to the benefit of ground transportation — both truck and rail. If this shift occurs, overtime, US ports, and container shipping would likely see slower growth.
Dependency on medical imports during the pandemic crisis raised a red flag. This red flag brings biosecurity to the forefront for sourcing of medical and pharmaceutical manufacturing and supplies. According to an article in Politico, 80% of the US supply of antibiotics come from China. That represents just one example. India, another drug source for this country, imports a substantial amount of its active pharmaceutical ingredients from China. So does the United States.
With biosecurity a critical national security issue, the US will likely create incentives for moving pharmaceutical manufacturing back to North America. At the same time, investment in biosciences — both corporate and venture capital — will likely escalate. Similar issues apply to medical equipment supply chains for hospitals.
With this biosecurity emphasis, selected stocks in biosciences should benefit. This should prove to be the case with the two most prominent critics of the drug industry out of the Democratic presidential primary race. Both trade and biosecurity changes suggest a further pullback from global to national interests.
Before 1982, stock buybacks rarely existed under SEC regulations due to the threat of a manipulation charge. In that year, the SEC issued a “safe harbor” rule that protects companies from liability for stock manipulation when buying their own stock. In the current political environment, generally hostile to stock buybacks, some may call on the SEC to reverse its “safe harbor” ruling. If not, Congress may take action to do so.
Banning stock buybacks would reduce earnings per share growth (EPS). Over the last fifteen years, Goldman Sachs estimates that earnings per share for corporations grew roughly 2.5% faster than their reported net income from the benefits of stock buybacks. In addition, higher stock volatility could result without the support of stock repurchases. Even if stock buybacks can continue, it seems unlikely in the current political environment that companies will borrow to buy their stock. At the same time, those companies with substantial liquidity will likely return to purchasing their stock once this difficult period passes.
Two generations will feel the effects of deep recessions. The first generation came into adulthood during the great financial crisis (GFC). The slow recovery delayed normal life events such as jobs, marriage, children, and owning their shelter. As a result, many members of that generation saw Senator Sanders as answering their frustrations.
Now we see a second generation moving forward into adulthood through a life-affecting experience and economic downturn. Depending on the nature of the changes that the pandemic brings and the speed of economic recovery, they will likely face the same life delaying events as the previous generation. If they follow that generation’s political tendencies, merging these two generations will bring significant political change to this country.
The road to economic recovery may initially prove bumpy — but recover it will. Development of therapeutics may come with both hope and disappointments — but medical science will succeed. With that Ying and Yang, a potential retesting of the stock market lows should not surprise investors but then followed by a strong rebound (see our March 25th commentary).
In the past, we recommended an asset mix of 40% equities, 35% alternatives, and 25% fixed income. Despite the economic and financial hurricane, we remain very comfortable with that asset mix recommendation. Reaching that recommended equity asset mix leads to rebuilding equity positions in high-quality companies with strong balance sheets selling at what will likely prove attractive prices. How fast each investor rebuilds depends on their own comfort to do so. In the case of fixed income, we recommended short-term credits to preserve capital, and that continues to be our recommendation.
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