This New Coronavirus Threatens to Expose Our Vulnerabilitiesadmin
“People tell me the Fed
shouldn’t ease because it would be nothing more than a Band-Aid. What did you
do last time you cut your finger? Right. It stopped the bleeding, didn’t it?” – Ian
Shepherdson, chief U.S. economist for Pantheon Macroeconomics”
As we don’t pretend to be anything resembling virus experts, this weekly column has refrained from commenting on the coronavirus in any detail since it began spreading a month ago. With cases now in more than 50 countries, the consequences have truly become global, and last week’s market reaction made clear that your authors could avoid it no longer, but where do we start?
The economic damage has been impossible to gauge with any sort of accuracy, with some expecting a brief slowdown in the first quarter, and others a more prolonged lull. At this point, it seems too early to say how long the economic disruption could last. The effects of the virus aren’t even showing up in the actual economic data yet!
While economic data lags, stock and bond markets are (supposed to be) a real-time indicator of future economic activity. As bond desk escapees, your authors watch interest rates and the yield curve for clues about where we are in the economic cycle, where monetary policy is likely to go and what that means for real estate.
We aren’t ones to second guess Mr. Market, but the past week’s move is a real puzzler.
The number of times we’ve said the phrase, “This move in rates is wild,” to each other is meaningful. It was, in fact, a pretty good clue that this virus was more serious than many originally thought.
You will have already seen the headlines saying that we are seeing record low interest rates. Yields on the 10-year Treasury note crashed through previous lows in the high 1.3% range and never looked back. And the drop in rates at the short end of the yield curve was even more impressive. As we write this, markets are pricing in an aggressive response from the Federal Reserve, to the tune of, count them, three rate cuts coming as soon as this summer.
This is particularly interesting as the Fed has done very little in the way of attempting to alleviate the market’s stress this past week.
“I think it would be premature, until we have more data and have an idea of what the forecast is, to think about monetary policy action,” Chicago Fed President Charles Evans said on Thursday. His counterpart in Kansas City, Loretta Mester, added, “It really depends on: What are the medium-term implications for the U.S. economy?” The St. Louis Fed’s James Bullard went as far as to suggest the low rates should be viewed as a positive. Many market participants were unhappy with this wait-and-see response. It is true that there seems to be some reticence to act aggressively, and on a certain level, that is understandable. In many ways, the impact of the coronavirus looks like a classic exogenous shock, the kind that you hit your little model with back in Econ 101 to see what would happen. And that little blackboard model would tell you that if this shock is temporary, you don’t have to do anything for to help the economy. It will recover on its own.
Clearly, the global economy is more complicated than that, and we are sympathetic to the argument made by Ian Shepherdson in the quote above. One reason for that sympathy is that there are reasons to believe that the virus is hitting an economy that is less resilient than it was a year or two ago.
Sticking with our market-driven analysis, estimates of long-term inflation have been falling quite a bit, even before the coronavirus turned up. We track consumer inflation expectations through two different consumer-based surveys from the New York Fed and University of Michigan, but we think a better measure is through trading in inflation-protected securities and inflation swaps. The five-year, five-year-forward break-even level of inflation expectations, seen in the chart below, is a measure of where market participants think inflation will stabilize in the future, ignoring any temporary fluctuations (we will save you the exact explanation, and you will trust us, because we wouldn’t lie to you).As you can see in the chart, this measure of inflation expectations has already fallen sharply. Simply put, markets have no faith in the Fed reaching its 2% inflation target anytime soon.
We’ve been writing in recent weeks about some underlying softness in U.S. economic data that belies pretty decent headlines. One such subject was the recent release of 2019 gross domestic product data for the fourth quarter. Then came the first revision of that initial release. While the headline growth figure was unchanged at 2.1% annualized growth, the underlying details that we worried about before only got worse. Both consumer spending and business investment were revised down from 1.8% to 1.7% growth and 0.1% to negative 0.5% growth, respectively. We noted an unusual boost to growth from the decline in imports, which made the trade deficit appear better … that too was revised to show an even further drop in imports. While this boosts headline GDP growth, it is not a good sign for the health of the economy.
It seems that the foundations of economic growth are being stressed, and cracks are forming in select states. The Philadelphia Fed tracks leading indicators for all 50 states in the U.S., publishing a monthly estimate of where growth will be six months from now. As of December, the fewest states were forecast to grow since the crisis.
Beyond this, the Philadelphia Fed reports that more than half of the states are growing below 1%. If the combined impact of supply disruptions and negative demand shocks from the coronavirus is even just negative 1%, that would likely push the overall economy into a contraction. Hopefully a temporary one.
In other data, we saw the University of Michigan’s consumer confidence index report a weaker present conditions index. The decline was driven by a hit to the index’s “Labor Differential” calculation, which measures those in the survey saying jobs are plentiful, less those saying jobs are hard to find. This sub index has now retraced all progress since June 2019, a sign of a weakening labor market.
The virus may be hitting growth at a particularly vulnerable time.
What could the impact be for commercial real estate? Again, we have little choice but to turn to the markets to get a hint. Publicly traded real estate investment trusts have suffered, down about 12% on average at the time of this writing. As bad as that is, it’s roughly in line with the rest of the S&P 500. In the market for commercial mortgage-backed securities, we’ve seen spreads widen across the credit stack. But so far it seems like that market has fared at least as well as corporate credit, and much better than high-yield corporate bonds. That seems like relatively thin analysis, but at this point there are more unknowns than known. We are certainly keeping our eyes and ears open.
The Week Ahead …This week has snuck up on us, heavy on data to open March. One question is how viable the information will be in light of this past week’s stock market sell-off. The February jobs report is scheduled to be released on Friday, where there is a risk of correction in some of the weather-sensitive sectors that benefited from a warm January. Additionally, as we note above, consumers seem to have experienced worse luck finding jobs in February.
Ahead of the report, the Institute of Supply Management reports the results of business activity surveys for the manufacturing and non-manufacturing sectors on Monday and Wednesday, respectively. While regional surveys have suggested businesses remained resilient so far in February, they likely understate the impact of global uncertainties seen by large, multinational firms. The schedule is light for Fed speak, with only Chicago Fed President Charles Evans slated to speak twice, but that could change should the Fed decide it needs to counteract some of the market’s panic.