The American people and their economy have paid a heavy tribute to the Covid-19 pandemic. Arriving in North America a little later than in Europe, and long played down by President Trump, the coronavirus has already caused the death of some 130,000 Americans, which unfortunately is only a provisional figure. As we are writing these lines, there has been an alarming surge in the virus, particularly in the southern states of Florida, Texas and California (see chart). With nearly 50,000 new cases reported daily in early July, the first wave of the epidemic is still going strong, and healthcare authorities are warning that it may be “out of control”.
Due to lockdown measures and social distancing, the US economy has entered the worst recession since 1946. According to Federal Reserve Bank of Atlanta estimates, US GDP plummeted 12% in Q2 2020 (an annualised rate of 40%), a dramatic slump comparable to what was seen in Europe. In the absence of job retention schemes, the impact on the job market was huge, with the destruction of 20 million jobs. In May, the number of companies filing for chapter 11 bankruptcy protection surged 50% compared to the previous year.
Fortunately, the stalled economy did not get any worse, thanks to combined support by the US Treasury and the Federal Reserve, which has prevented interruption in global funding, a predominant component of all major crisis.
The Fed revives the markets
GROWTH AND INFLATION (%)In the first weeks of March, risk reassessments combined with the prospects of an economic downturn triggered a widespread flight to cash. Orders to liquidate assets (equities, bonds and mutual fund shares) put pressure on players vital for the financing of the economy, including Primary Dealers and Money Market Funds. To prevent the economy from freezing up, the Fed mobilised considerable resources, most of which were unconventional. After avoiding the limits on its quantitative easing policy, the Fed purchased virtually the equivalent of a full year of French GDP in just four months’ time[1].
EPIDEMIC RECOVERYA number of ad hoc refinancing programmes were launched and the Fed became less demanding about eligible collateral. By doing so, it positioned itself as the lender of last resort in absolutely all compartments of the debt market, including the primary and secondary markets as well as in the investment grade and high yield compartments.
Since the US dollar liquidity crisis was global, the Fed’s interventions reached far beyond US borders. It concluded swap agreements with the main central banks around the globe. Altogether, the credit lines opened by the US Fed exceeded a trillion dollars, but since all of them have not been drawn on, the amount potentially available is actually much higher.
Thanks to this virtually unlimited public reassurance, the markets were able to rebound rapidly and spectacularly. The most striking example is the cost of credit default swaps (CDS). After surging as high as a 1000bp in the high yield compartment, risk premiums began to ease as of 23 March, when the Fed activated its main support measures, including unlimited quantitative easing, and primary and secondary market corporate credit facilities (see box). Today CDS have returned to nearly normal levels, even though the number of credit events has surged in the United States and is showing signs of rising in Europe (FT, 24 June)[2]. The equity markets, which are highly correlated, recovered part or all of the losses engendered by the Covid-19 crisis, and some sector indexes, for technology and healthcare stocks, for example, rose above their pre-crisis listings.
Looking beyond a Q3 rebound
MONETARY SUPPORT MEASURESSince the economic recovery depends on keeping financing channels open, the Federal Reserve has done a lot to pull economic indicators out of depression territory. The fiscal deficit has also helped: roughly USD 1 trillion allocated to the Paycheck Protection Program (state-backed loans) and the extension of unemployment benefits helped maintain household income during the worst of the recession[3]. In May, as shelter in place and other protective measures were gradually lifted, private consumption resumed and employment picked up again[4]. The business climate perked up and the rally extended into June, with the Institute for Supply Management’s purchasing managers index rising above the 50 threshold in manufacturing. After plummeting last spring, activity is bound to strengthen in Q3, partially making up some of the lost ground.
But what then? Looking beyond the fact that the epidemic has not disappeared, a number of imbalances that were already present before the crisis have worsened, making the recovery even harder. Corporate debt was already at a record high[5] and has continued to swell, raising questions about debt sustainability in the sectors where declining sales will not be transitory (such as air transport, retailing, natural gas and shale oil). Equity and bond market investors have convinced themselves that the worst is over and that monetary policy will remain permanently accommodating, but the rallies of recent weeks are hardly grounded in economic fundamentals.
Will the markets continue to rebound strongly in H2 2020, the current PE multiples of the corporate listed on the S&P 500 would still be in the area of 30, e.g. close to historical peaks. According to the valuation model of the International Monetary Fund (IMF), risky assets, whether equities or corporate bonds, are historically overvalued[6]. From a strictly business perspective, the economic situation in the United States seems to have improved, but it also seems to be very vulnerable to any snags in the recovery or shifts in expectations.
