June 2020 — The Recovery of the Economy?

I saw an article in the Atlantic Monthly that was very doom and gloom and indicated that the pandemic is going to cause an economic collapse.  It basically says that the banks have gone back to the off-balance-sheet investments like they did with mortgages in the past, except this time it is with packaged up business loans.  The author indicates that like the financial crisis of 2008, these loans are packaged up with high-risk and low-risk loans and stamped as "good" with little risk.  The author's key is that this rating system works if only some of the loans go bad, but doesn't work if all the loans in the fund go bad at the same time, such as from say a pandemic.

Image of arrow going upwardThe bottom line was that businesses with loans (particularly ones on shaky financial footing to start) are going to default as they close en-masse.  That will result in these bank loans (Collateralized Loan Obligations, or CLOs) defaulting, resulting in another need to bail out banks in an environment where 1) the public and congress is less likely to want to do this and 2) that even doing it might not stabilize things like it did in 2009.

My own perspective isn't this negative.  I also asked two other people who are investment advisors and they also were not as bearish as this author.

But I do see something interesting.  The market is at new highs right now even though the worst news from businesses won't be released until the July time frame when businesses report Q2 results.  The market has priced in the idea that these numbers are going to be in the -30% range, but then improve quickly in Q3 and Q4 with 2021 being back to same as prior to the pandemic.

Is the market correct?  It's track record isn't the best.  As the late MIT economist Paul Samuelson famously said, "Big drops of the stock market have predicted nine out of the last five recessions."

My problem is that I don't see that level of optimism in society unless we get a positive major breakthrough.  That is, some vaccine comes out; a drug is found that keeps people from having to be hospitalized/ventilated; or something else happens that causes COVID-19 to disappear or become much less deadly.  Instead, what I see is a continued high level of unemployment, a lower level of spending by consumers, and perhaps even changes in spending and debt habits.

I see a continued high level of unemployment because when businesses open, they won't need everyone to come back because they cannot serve as many customers in a given time period.  That is going to affect retail as well as casual and fast casual dining.

I see lower level of spending by consumers because we've learned to not need as many services and found workarounds.  We are also going to see a lot of businesses not reopen.  I do see this offset somewhat by new business startups that are more efficient than ones that have to retrofit.

The market likes to watch the cash flow numbers of businesses, both income and earnings.  With less money flow, public companies are going to report dismal numbers and the return is going to be slow.

I think that we're going to see a much slower economic recovery than the market is forecasting right now.  So my positioning right now would be to watch carefully for any chinks in the armor of the market's optimism as a sign things might be changing.

Posted in Finance.