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Brace for the second waves

Summary:
As we progressed through the pandemic induced recession, there have been much discussion about a second wave. Second waves appear in many forms, and they can threaten the current consensus expectation of a V-shaped rebound.  Here are some of the second wave risks the market faces. A second wave of COVID-19 infections A second wave of layoffs and wave cuts A second wave of bankruptcies Finally, investors have to face the risk of permanent economic scarring that impair long-term growth potential. Under that scenario, slower growth rates will persist even after any recovery, and affect asset prices in ways that the market hasn’t fully discounted.  A second wave of infections In all likelihood, there will be a second wave of COVID-19 infections. The Center for Infectious Disease

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As we progressed through the pandemic induced recession, there have been much discussion about a second wave. Second waves appear in many forms, and they can threaten the current consensus expectation of a V-shaped rebound.
 

Brace for the second waves

Here are some of the second wave risks the market faces.

  • A second wave of COVID-19 infections
  • A second wave of layoffs and wave cuts
  • A second wave of bankruptcies

Finally, investors have to face the risk of permanent economic scarring that impair long-term growth potential. Under that scenario, slower growth rates will persist even after any recovery, and affect asset prices in ways that the market hasn’t fully discounted.
 

A second wave of infections

In all likelihood, there will be a second wave of COVID-19 infections. The Center for Infectious Disease Research and Policy (CIDRAP) conducted a study and believes the latest pandemic most resembles influenza pandemics in infectious characteristics. CIDRAP went on to examine eight major influenza outbreaks and found that there was always a second wave. The more disturbing finding was that pandemics since 1918 had larger second waves.

Of eight major pandemics that have occurred since the early 1700s, no clear seasonal pattern emerged for most. Two started in winter in the Northern Hemisphere, three in the spring, one in the summer, and two in the fall (Saunders-Hastings 2016).

Seven had an early peak that disappeared over the course of a few months without significant human intervention. Subsequently, each of those seven had a second substantial peak approximately 6 months after first peak. Some pandemics showed smaller waves of cases over the course of 2 years after the initial wave. The only pandemic that followed a more traditional influenza-like seasonal pattern was the 1968 pandemic, which began with a late fall/winter wave in the Northern Hemisphere followed by a second wave the next winter (Viboud 2005). In some areas, particularly in Europe, pandemic-associated mortality was higher the second year.

The current pandemic will likely last 18-24 months.

Key points from observing the epidemiology of past influenza pandemics that may provide insight into the COVID-19 pandemic include the following. First, the length of the pandemic will likely be 18 to 24 months, as herd immunity gradually develops in the human population. This will take time, since limited serosurveillance data available to date suggest that a relatively small fraction of the population has been infected and infection rates likely vary substantially by geographic area. Given the transmissibility of SARS-CoV-2, 60% to 70% of the population may need to be immune to reach a critical threshold of herd immunity to halt the pandemic (Kwok 2020).

CIDRAP postulated three separate scenarios for COVID-19.
 

Brace for the second waves

Here is the most worrisome development. Different US states are reopening their economies at different paces. The worst hit states like New York and New Jersey have constructively bent their new case curves downward. Many other states, like California, have only flattened their curves instead of bending them down.
 

Brace for the second waves

What if a vaccine were to appear? CBS reported that a poll revealed that only half of Americans would get a COVID-19 vaccine, which is not enough to achieve herd immunity.

Only about half of Americans say they would get a COVID-19 vaccine if the scientists working furiously to create one succeed, according to a new poll from The Associated Press-NORC Center for Public Affairs Research.

That’s surprisingly low considering the being put into the global race for a vaccine against the coronavirus that’s sparked a pandemic since first emerging from China late last year. But more people might eventually roll up their sleeves: The poll, released Wednesday, found 31% simply weren’t sure if they’d get vaccinated. One-in-five said they’d refuse.

Here are some of the reasons cited.

Among Americans who say they wouldn’t get vaccinated, seven-in-ten worry about safety…about four-in-ten say they’re concerned about catching COVID-19 from the shot. But most of the leading vaccine candidates don’t contain the coronavirus itself, meaning they can’t cause infection.

And three-in-ten who don’t want a vaccine don’t fear getting seriously ill from the coronavirus.

While some of the issues cited could be addressed to raise the vaccination rate, this is nevertheless a disturbing development from a public health policy viewpoint. For investors, any hint of a second wave of infection will evoke a reaction from the health authorities to re-impose tighter stay-at-home policies, which would elongate the economic slowdown.
 

Layoffs and wage cuts ahead

In addition to the more obvious COVID-19 public health issues, investors have to be concerned about a second wave of economic damage. The effects of the first wave of layoffs are well-known. So far, most of the job losses have been concentrated among the low paying workers. Now reports are piling up that white-collar layoffs are ahead. The NY Times reported that Boeing is cutting 16,000 jobs. Bloomberg reported that Deloittes is preparing to lay off 2,500 employees. The list goes on, but you get the idea.

As well as layoffs, we now to worry about a new second wave, namely wage cuts. The Fed’s Beige Book reported a “second wave” of wage cuts is hitting the economy.

Wages and other benefits were lower than in our previous report; a payroll company reported a “second wave” of wage cuts, and reports across industries have mentioned cuts to benefits, including employer 401k matching. Some companies, especially those in competitive fields, have promised to repay lost wages at the end of the crisis; and others have increased wages to maintain morale and lure back hesitant workers.

The NY Times reported that some companies are considering wage cuts in lieu of layoffs.

Even as American employers let tens of millions of workers go, some companies are choosing a different path. By instituting across-the-board salary reductions, especially at senior levels, they have avoided layoffs.

The ranks of those forgoing job cuts and furloughs include major employers like HCA Healthcare, the hospital chain, and Aon, a London-based global professional services firm with a regional headquarters in Chicago. Chemours, a specialty chemical maker in Wilmington, Del., cut pay by 30 percent for senior management and preserved jobs. Others that managed to avoid layoffs include smaller companies like KVH, a maker of mobile connectivity and navigation systems that employs 600 globally and is based in Middletown, R.I.

None of these developments are conducive to a V-shaped recovery.
 

A second bankruptcy wave

In addition, we have barely seen the start of a bankruptcy wave in this recession. The combination of temporary fiscal rescue measures and Fed policy has served to put in a temporary cushion on the wave of bankruptcies that is likely to hit the economy. Unless Congress acts to extend PPP, the payments expire in July.

Already, credit quality is deteriorating.
 

Brace for the second waves

A second wave of bankruptcy is almost impossible to avoid.
 

Brace for the second waves

As the damage of these business failures hit the economy, the effect of this second bankruptcy wave is likely to be persistent.
 

The risk of permanent economic scarring

The persistence of economic damage is especially a worrisome problem for economists. A new IMF Working Paper addressed this issue of “hysteresis”.  For the uninitiated, hysteresis in economics is the persistence of effect after the initial shock of the effect is gone.

The IMF paper is mainly a survey of past research, and there were many papers cited. In particular, the authors referenced the well-known Reinhart and Rogoff study of past financial crises:

Reinhart and Rogoff (2014) examine the evolution of real per capita GDP around 100 systemic banking crises and found that a significant part of the costs of these crises lies in the protracted and halting nature of the recovery. On average it takes about eight years to reach the pre-crisis level of income; the median is about 6.5 years. In a sample that covers 63 crises in advanced economies and 37 in larger emerging markets, more than 40 percent of the postcrisis episodes experienced double dips.

The IMF study concluded:

In the last 25 years we have seen the development of an alternative model of business cycle that emphasizes the effects that business cycles can have on the drivers of long-term economic growth. In these models GDP is history dependent and all shocks can have permanent effects on output, what we refer to as hysteresis. This represents a change from the traditional cycle-trend decomposition that defined cycles as deviations from a trend that was independent of any of the traditional demand shocks that could be responsible for economic fluctuations…

In the presence of hysteresis, the costs of cyclical shocks or the lack of action of policy makers are much larger because of the permanent scars they can leave on GDP through their interactions with the endogenous forces that drive long-term growth or the dynamics of labor markets. Aggressive and fast action during recessions becomes optimal policy. And during expansions, the cost of acting too early on fears of inflationary pressure can also be very costly as it can either reduce the potential growth of the economy or hinder positive developments in the labor market. In this new framework, policy makers should understand the likely large supply costs of not being as close as possible to potential output by running a “high-pressure” economy.

In practical terms, here is what hysteresis, or the persistence of economic shock, means in real life. A recent Goldman Sachs survey of small business participants by Babson College and David Binder Research reveals small firms have already suffered considerable damage from COVID-19. 9% are permanently closed, and only about half are fully open. Looking out over the next six months, respondents believe that 71% of customers will return, at a rate of only 63% of revenues.
 

Brace for the second waves

What was not asked was how many and how long can small businesses survive at 63% of previous revenue levels.
 

The burden of reopening

Some clues to that question came from a survey done in late April by the Chicago Fed in association with the local chambers of commerce. Even though the survey was restricted only to the Chicago Fed’s Seventh District states, the survey does provide a window into the outlook for small business in the US. Survey respondents were predominantly small businesses: “About 60% of the respondents were from firms with fewer than ten employees and another 25% were from firms with ten to 49 workers.”

One of the biggest concern expressed in the survey was the extra costs involved in reopening after the lockdowns are lifted. As we move into Q2 and Q3, watch the narrative from companies start to change to “we are burdened with an extra layer of costs in reopening, along with reluctant customers”. The Chicago Fed survey found companies that would experience financial distress under “moderate” social distance measures and gatherings of 50 people or less if the operate at 75% capacity range from 38% for manufacturing to 88% for restaurants.
 

Brace for the second waves

The survey also asked whether companies were concerned about different metrics of financial health over the next three months. Cutting to the chase, about 30% to 40% of most companies were concerned about their own financial solvency over this period. Companies in finance were in the best shape, while restaurants were in the worst.
 

Brace for the second waves

In short, expect at least one-third of small businesses to fail in the next three months, even with massive fiscal and monetary support, and assuming that there is no second wave of infection. This is a level of business failure that does not appear to have been fully discounted by the financial markets.

Lastly, the recent wave of protests springing up around the US will hamper the prospect for a V-shaped rebound. Depending on how long the protests last, can anyone really believe that business will return to normal with rioters in the streets? Here are some reactions from analysts of the effects of the riots, as reported by Bloomberg.

“I think people are coming to the realization that their jobs may not be coming back or coming back quickly. This is all conflating with the racial tensions and completely boiling over,” said Mark Zandi, chief economist at Moody’s Analytics. “This highlights the depth of despair in America,” he added, citing 20% unemployment and 50 million workers who’ve lost their jobs or had pay cuts…

“The impact of the riots may be greater on the daily and weekly measures of consumer confidence, which were trending slightly upward since mid-April, but which may now post a pull-back into early June,” said Mike Englund, chief economist at Action Economics, which provides financial-market commentary.

In conclusion, even though market analysts have discussed “second waves”, I do not believe they fully appreciate the multi-factor nature of the second waves that threaten the growth outlook. While all of these risks may not fully materialize, the current consensus market narrative does not seem to have fully discounted many of these risks.
 

About Cam Hui
Cam Hui
Cam Hui has been professionally involved in the financial markets since 1985 in a variety of roles, both as an equity portfolio manager and as a sell-side analyst. He graduated with a degree in Computer Science from the University of British Columbia in 1980 and obtained his CFA Charter in 1989. He is left & right brained modeler of quantitative investment systems. Blogs at Humble Student of the Markets.

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