We've just witnessed a major event in the stock market today. The S&P 500 hit a milestone of falling 20% from its high a month ago. Headline flashes bear market. A bear market is scary mainly because we haven't had many bear markets in the past 60 years -- that's roughly the memory span of the oldest investor alive today [1].
A bear market has arrived because a recession is either already here or closing in on the US eceonomy. Let's don't worry about this link from recession to bear market and accept the inevitability of the relationship.
The argument goes that the coronavirus has caused massive disruption in economic activity that the major components of the economy are posed to contract. Even a lazy student of economics remembers this equation [2],
GDP = C + I + G + (X - M)
It says GDP is the sum of consumption (C), investment(I), govt spending (G), and external trade (imports M and exports X). I'll keep this piece free of math, so this' the only equation.
The coronavirus will hit C for sure. Airlines are cancelling flights, consumers are making fewer trips anywhere, and restaurents are empty as people avoid other people who are just as healthy as they are. Investment will suffer because general activity is down. Corporations can't invest when nobody shows up at the office. Trade with other nations will fall for the same reason.
This leaves us with G. And we have Donald Trump. And it's an election year.
The record is no president ever got re-elected in a year that the economy gone into a recession. Trump knows that. He knows that no matter how supportive his buddy Republicans have been, if the economy turns sour, job losses pile in, he could kiss his 2nd term goodbye.
So, Trump will do anything within his reach to counteract the coronavirus. But what can he do?
Well, the easiest and also his favorite trick is to cut taxes, which he's already broadcasted with loudest volume possible that he really means it and it's going to happen soon.
Then there is that good old Keynesian thing[3]. Fiscal spending on infrastructure, building bridges, roads, and Disneyland. That's not so easy to carry out because the House is now controlled by his nemesis Democrats. And rumor is they don't like more Disneylands.
Then we have the Fed. Powell has already blinked. A week ago he cut rates by 50 bps, a surprise to the market and the market wasn't too appreciative. Bond folks are "pricing" in another 25 bps. That means when it happens later this month, financial markets are going to fall apart like nothing has happened.
So, what could save us from the apocalypse? My answer is nothing. Because there wouldn't be an apocalypse.
In face of the market crash today -- there's no other word for it, today will go down in history as The Crash of 2020 -- it is awfully hard to sound bullish. But here is the fundamental case against the end-of-world view.
It may seem weak and unconvincing when asset prices are bleeding like today, but experience shows that the long view always wins out.
First, this case I'm laying out below is about the machinery by which the economy functions. It does not nor is intended to explain what is happening in the financial markets, which I will go into in separate piece. Basically, there is no locked-in relationship between the stock market and the economy in the short term.
While the financial markets have crashed, the question is will the real economy crash as well. I'd like to argue it will not.
First, the virus won't change the US consumers. This country has experienced much greater and more damaging shock than a pandemic, yet the consumers quickly recovered. The terrorist attack on 9/11 hit at the heart of the american psyche, yet consumer spending barely budge in 2001-02. Worry about the virus makes people cut certain expenditures, such as restaurant and travel, but the net effect is they save more during this period. More saving in the consumer's hands means a sharp rebound in the economy when it's over.
Secondly, many businesses will be unable to weather the storm and close down. So there will be job losses, and some consumers will suffer income reduction. However, don't forget just a month ago, we had the lowest unemployment on record. The current economy has more than enough capacity to absorb the unemployment resulted from the pandemic shock.
Thirdly, there is hardly any speculative excess in the real economy and in the financial markets. One component that contributed to the financial crisis in 2008 was the speculation in real estate, which created the demand for mortgages which created the market for subprimes which sowed the seed of its undoing. None of that exists today.
When a black swan descents, it goes after the weakest link in the system. Some points to the elevated corporate borrowing as a weakness in the current economy. That's certainly an area of concern. However, as long as the borrowers have enough cash flow to service its debts, it doesn't present a problem. It's certainly possible that a vicious cycle develops where lower consumer spending leads to lower sales and lower cash flow for certain debt-laden corporations which are then forced into default.
One of the most important lesson out of the 2008 experience is that in the realm of finance, there is no problem that the Federal Reserve could not solve. When subprime defaults went rampant in late 2008, Ben Bernanke took the incredibly bold step of going into the market and buying up subprime mortgages, basically taking them off the hands of investors[4]. That act had worked magic. And in no small part, it solved the basic problem in 2008.
If corporate debt defaults get out of hand, there is nothing that would stop the current Fed from buying up low grade corporate papers and removing them from the system. Thus, I think this issue wouldn't break the camel's back.
Lastly, Trump will act. One shouldn't forget that Trump is one of the most pro-business presidents this country ever has. He's going to do whatever it takes to rid the pandemic of its impact on the economy, perhaps creating new excesses that lead to the next economic crisis. But that's something to worry about later.
To end this piece, I want to make one observation. The coronavirus began in China, infected the most people in China, and caused the most economic damage in China. Yet, if you look at its stock markets, they're holding up quite well. This raises the question of what caused the crash today. I'll try answer this in my next writeup.
To install and run anti-coronavirus software, follow these steps closely, and don't try to be clever about it,
sudo apt-get update
sudo apt-get install six_pack_of_your_favorite_beers (no corona please)
for i in {1..Inf}
do
./drink --beer=your_favorite_beer
done
To ask questions or report issues, please open an issue on the issues tracker.
[1] https://en.wikipedia.org/wiki/List_of_stock_market_crashes_and_bear_markets
[2] https://www.dummies.com/education/economics/10-equations-to-expand-your-macroeconomics-expertise/
[3] https://en.wikipedia.org/wiki/Keynesian_economics#Keynesian_economic_policies
[4] That's the Troubled Asset Relief Program (TARP). According to this wiki entry, Fed spent a total of $21.0 billion on these toxic assets.