Efforts to stem the spread of the coronavirus are disrupting economies across the globe. Financial markets are responding to the expected impact on earnings and asset values. The stock market dominates the headlines, especially Monday’s 13% plunge in the S&P 500, the biggest one-day drop since 1987.
Yet the stock market is not the main area of concern, as it largely reflects adverse developments elsewhere. The pain points one should be alert to in the months ahead are in cash flows and liquidity shocks; in the resiliency of the financial system under a time of stress; and in the economic fundamentals, both prior to the spread of the coronavirus and, especially, as partial or complete shutdown of sectors in the economy take their toll:
- Impact of the shock on cash flows. This is the primary driver of the economic ramifications of the crisis. As retailers, restaurants, hotels and airlines—the list goes on—lose customers who are following the advice of health officials to pursue “social distancing”, their revenue shortfalls make it difficult to meet their obligations to employees, suppliers, lenders and landlords. Certain REIT sectors, including Lodging and Resorts and Regional Malls, have exposures to these shocks. If the revenue shortfalls are large enough, this can cause a cascade of financial strains throughout the economy. Which brings us to,
- Resiliency of the financial system. The cash shortfalls mentioned above mean that businesses are likely to make unprecedented demands on the banking system in the weeks ahead. For example, REITs alone have $118 billion in untapped lines of credit, and some REITs have already tapped these credit lines to maintain liquidity in the face of uncertain tenant behavior. The ability of the banks to meet these needs is a critical linchpin that may determine how widely the crisis spreads through the economy, and how deep is the resulting damage.
The distinction between the cash flow shocks and a systemic crisis is important. The mortgage defaults that began in 2007 did not reach their most virulent phase until the financial system froze up following the failure of Lehman Brothers in September 2008. Prior to then, banks and other intermediaries had been able to meet the needs of businesses and consumers, and the worst of the problems were largely contained in the MBS market and certain lenders with high exposures to mortgages. Once the banks stopped providing credit the crisis exploded.
The Fed’s actions on Sunday March 15 were largely aimed at bolstering the stability of the financial system. By buying $700 billion of Treasury securities and $200 billion of Agency MBS, lowering the Discount rate for banks borrowing at the Fed’s Discount Window and arranging U.S. Dollar swap agreements with foreign central banks to ensure smooth functioning of dollar-denominated credit flows across the world, the Fed hopes to help banks maintain the smooth functioning of credit markets upon which businesses and consumers rely. The Fed continues to provide additional support to the banking system, for example, with the establishment of the Primary Dealer Credit Facility (PDCF) announced Tuesday to help the banking system support the credit needs of businesses and households.
The resiliency of the financial system has an advantage today that it did not have in 2008. The banking system is much better capitalized and regulators have scrutinized bank risk positions much more carefully. One hopes that this will help ward off a systemic failure like occurred in 2008.
- Economic fundamentals are what ultimately matter. Both the “before” and “after” are important here. The U.S. economy started the year with low unemployment, good job growth and wage growth, and a household sector that was living mostly within its means. Both business and household sectors are in a better position to face this crisis than they had been in many years. The magnitude of the cash flow shocks described above, however, will test this resiliency.
It will be the presence or absence of second-round and third-round effects of the business shutdown that will ultimately determine how deep and long-lasting will be the economic damage from the crisis. Do firms lay off workers temporarily when businesses shut down or will there be permanent job losses? Do households react cautiously to the uncertain economic environment, or do they hunker down and cut back as sharply as they can? Does the financial sector continue to function for businesses struggling to deal with the cash flow shocks or freeze up as in 2008?
It is too soon to know the outcome for the issues raised above, and much of it will depend on how long it takes to bring the spread of the virus under control. For those keeping score, though, the size and breadth of the shocks to cash flow are a clear negative in this situation, and the response of businesses and consumers and whether they generate second-round effects is simply unknowable today. Some of the policies being discussed in Washington today, including fiscal support for the sectors hardest hit by the shutdown of travel and retail and business activity, may help avert the worst-case scenarios. But the robust fundamentals of the U.S. economy at the start of this episode and the strength of the financial system compared to in 2008 give us some hope about the eventual outcome.