COVID-19’s Far-Reaching Implications Are Making Our Economy Sick
Insight from Our Chief Risk Officer
CRO X is the Chief Risk Officer for a large, well-known, “globally systemic” financial institution. That’s regulator speak for “darn big and important.” He’s requested to write under anonymity for American Consequences so he can freely speak his mind without undue retribution…
In this time of a global pandemic and many other scary monsters hiding under the bed, I find myself answering the question… What’s it like being a Chief Risk Officer of a major financial institution in times like these?
The answer ranges from scary to confusing, depending on how prepared your company was for such events.
Second-quarter 2020 U.S. GDP is down 32.9%. The S&P 500 and Nasdaq are at, or near, all-time highs (depending on the day). Tesla has a market cap approaching $400 billion off a de minimus bottom line. The Federal Reserve’s balance sheet is approaching $8 trillion. The 10-year Treasury yield is below 50 basis points. And confirmed COVID-19 cases globally approaching 30 million with deaths nearing 1 million. Excess deaths, a measure that compares actual to expected mortality, suggests that the real COVID-19 impact could be substantively larger, with figures understated by 20% to 40% in developed countries and by substantially more in emerging countries.
The economy, markets, and mortality pictures provide perhaps the most fascinating, uncertain, and volatile backdrop in recent memory for those focused on risk.
Many financial institutions and CROs spent the post-2008 decade building strength and resilience in our firms through careful analysis of risks taken and robust stress-testing regimens – perhaps even including a pandemic scenario built off the Spanish flu of 1918. For them, solvency and independence are assured, leading to a measured response with the goal of optimizing long-term economics. Each of these possible paths forward is reliant upon specific economic and policy outcomes as we move through the post-COVID decade and beyond.
Today, how do we think about the possibilities for paths forward? What are the implications for policy, for the economy, and for fiscal sustainability?
Record unemployment? A COVID-19 vaccine… Or not? Federal deficits and debt? World appetite for the U.S. dollar remaining the reserve currency? Societal evolution or revolution? The erosion of capitalism through the removal of failure as an outcome?
None of these are easy questions. And many of the potential answers can be unnerving. But ultimately, those of us who were prepared are playing from a position of strength.
On the other hand… For those who spent the years leading up to 2020 seeking to arbitrage regulatory capital constructs to effectively maximize risks taken per dollar of capital and maximize earnings, it’s a much different story…
In crises past, these unfortunate souls would have been negotiating with regulators and ratings agencies for leniency, raising capital at exorbitant costs, and exploring risk-reducing transactions that would ensure the survival of their firms but erode economics as sales were made at distressed pricing.
But today, they are visiting Washington, D.C. to plead for bailouts of industries where they are imprudently exposed… and for support of financial instruments such as collateralized loan obligations (“CLOs”). These leveraged financial instruments were known to be exposed to “tail outcomes” like, say, a pandemic… but paid well in times of plenty.
And because of unprecedented support from the government, advocating for bailout dollars is time well spent. However, the benefit may be short lived, as bailouts do not solve long-term economic issues. Instead, they frequently forestall the inevitable. So perhaps those firms with less discipline may yet find themselves reliving the past as bad industry bets and investment discipline come home to roost.
Fortunately for stakeholders, our firm belongs in the first camp. Our prospects for survival are well-measured and calibrated, and we have an unwavering focus on the medium- and longer-term outcomes. So let’s examine the drivers that will define the shape of the distribution of potential outcomes in the future.
While the number of potential drivers is virtually infinite, for the benefit of simplicity and brevity, I have attempted to confine them to four.
1. How do we assess and differentiate between risks in a world with implied or actual governmental support?
The government extending an unsteady and uncertain umbrella of protection for borrowers in times of crisis shields those borrowers and investors from managing ahead of these events.
For example, assume going forward that large airlines have implied support. The result is that they will be able to run with higher degrees of leverage, increasing business risk without appropriately considering systemic risks such as fuel or disease in their sustainability assessment. This works until the implied government support is withdrawn… at which time investors are left with catastrophic losses.
Another major economic and political shift is increasingly strident calls to replace the globalization of supply lines and labor initiatives of the last 30 years with domestically sourced materials… and foreign jobs with domestic jobs. If all we had to consider was the economic side of the picture, we could assess what percentage of supply chains must be contained domestically across a range of scenarios to protect production, and size the resultant reshaping of industry and jobs accordingly. This, however, becomes far more complex when policymakers from both the Left and Right become involved, trumpeting slogans like “Bring Jobs Home to Americans” and “America First and Forever!” in reelection campaigns and promises to reduce record unemployment levels.
These drastic measures might temporarily stabilize some American workers in the short run, with potentially dire consequences for the global economy. It’s yet another opportunity for us to recall the words of George Santayana: “Those who cannot remember the past are condemned to repeat it.”
Perhaps it is too much to ask that our politicians revisit the Great Depression saga and the role that the Smoot-Hawley tariffs played in contracting the global economy.
2. How do we weigh the possibility of a no-vaccine world where COVID-19 becomes something we live with versus a world where a cure or sustainable vaccine is developed?
There are again profound consequences to these bifurcated outcomes… While we all might like to consider a vaccine as a virtual certainty by the first quarter of 2021, with enough doses to largely immunize populations globally made available, we are a long way removed from that certainty.
Historically, it has been notoriously difficult to develop sustainable vaccines for coronaviruses. While a number of promising vaccine candidates exist and untold amounts are being spent on research, handicapping the prospects for sustainable societal immunization with any mathematical rigor is virtually impossible.
A world with a vaccine by the first quarter of 2021 leads to a sharp rebound of economic activity globally, with GDP recovering substantively by the end of 2022. Disruptions in work and lifestyle patterns, while already meaningful, might be reduced to a point where the way we use commercial real estate and transportation may yet be preserved. The role of center city hubs as epicenters of human activity and workplace will be shaken, but preserved.
A world where we learn to “live with” COVID will look dramatically different. Center city hubs might become abandoned shells. A city’s fiscal sustainability will be in question thanks to fading tax bases and unsupportable infrastructures requiring constant federal bailouts or a wave of defaults – first of municipalities, then states. Disruption in work and lifestyle patterns will move toward permanently reshaped tendencies with long-standing consequences for infrastructure, not to mention the ongoing reality of the humanitarian tragedy that COVID leaves in its path.
The foundation of the American economy is built upon capitalism… a world where unfettered competition sparks relentless innovation, expertise, and constant evolution for companies that are successful, and failure where companies miss the mark.
3. What happens when capitalism is eroded through the removal of failure as an outcome?
The foundation of the American economy is built upon capitalism… a world where unfettered competition sparks relentless innovation, expertise, and constant evolution for companies that are successful, and failure where companies miss the mark. This foundation drove both America’s emergence as the economic superpower of the world and the remarkable advances of the human condition over the last 200 years.
As an example, let’s look to the evolution of the auto industry. In the 40 years after engines were put to use for transport in the 1880s, more than 1,000 automobile manufacturers were initiated. By 1920, more than 1,000 had failed… a remarkable picture of the brutal world that is capitalism. How many fortunes were made and lost in these 40 years? How many jobs were gained, lost… and then gained again?
Failure took many forms, ranging from outright bankruptcy to mergers with more successful companies. But those who triumphed truly earned their positions through excellence in design, manufacturing, supply-chain management, and constant innovation to ensure that competitors were held at bay. And the employees of the dominant U.S. automobile manufacturers by the 1930s were driving the emergence of the American middle class. During World War II, American expertise in manufacturing and automobiles contributed immeasurably to the success of Allied armed forces through the ubiquitous Jeep and the Sherman tank. It’s a remarkable success story built upon myriad failures and driven by unfettered competition.
As we look to our current predicament, politicians have turned on capitalism.
Jobs and job security are a remarkable vote-generator, and politicians want above all to stay in office. The bailouts of companies started with Chrysler in 1979, principally to preserve 360,000 jobs. How did that work… Chrysler was bailed out again in 2008, filed for bankruptcy in 2009, and is now a division of Fiat. Would bankruptcy have eliminated 360,000 jobs? No, it would have enabled the company to restructure and reinvent itself in 1979 and perhaps driven Ford and GM to improve quality much earlier, preserving the status of the U.S. auto industry globally.
But unfortunately, today’s bailout is practically the first page of the playbook for politicians with hundreds of billions, even trillions, of dollars flowing from government to businesses.
Equity ownership used to come with the rewards from prosperity along with the risk of losing everything if the venture was unsuccessful. Bankruptcy allowed for the orderly repositioning of the company, debt holders became equity holders, equity holders lost all, businesses with positive cash flow were reinvigorated and given a new capital structure… a new lease on life, with employees remaining.
Who has benefited from the bailouts? I would argue almost no one.
Take United Airlines. It could have reorganized in bankruptcy – with debt holders taking equity, plane leases getting renegotiated or walked away from, and the workforce getting restructured to an appropriate size for the future of travel. Instead, United Airlines workers are still likely to be unemployed, with more than 36,000 being furloughed or laid off this fall without additional billions from the government… Bond holders are looking at 20%-plus yields and market values approaching 50% of face value. Interestingly, in a world where bonds are trading at 50 cents on the dollar, equity values typically are trading at option value. United Airlines’ shares have only lost 50% of their value, with a market cap exceeding $10 billion for a firm with almost no hope to survive the next year without additional billions from the government. Additionally, we will have a firm ill-equipped to survive against more efficient nimble carriers. It will have to be subsidized forever, another postal-service debacle for taxpayers, or Chrysler part two.
Without failure, you can’t have competition… Competition drives innovation, excellence, long-term economic prosperity, and job security. Bailouts preserve jobs in the short run, but at what cost to our ecosystem and long-term prosperity?
4. Can the U.S. dollar remain the global reserve currency?
I have discussed in previous articles the precarious state of the U.S. fiscal situation. In the past, we were looking at annual deficits above 5% of GDP, growing to almost 8% by 2030 with the unwinding of social security and Medicare trust funds. That level of deficit through the decade would lead to the U.S. debt-to-GDP ratio exceeding 150% by 2030, even with robust assumptions (3%) for GDP growth. While this track was troublesome in and of itself, with real concerns about the long-term fiscal solvency and stability for the U.S., the policy reactions to the COVID crisis have sped up the timing of this conversation.
The deficit this year will exceed $4 trillion, or more than 20% of pre-COVID-19 GDP, with all indications that this number will continue to grow in 2020 as states and municipalities put their hands out for subsidies. Now we are looking at a debt-to-GDP ratio approaching 200% by 2030, with substantial reliance upon foreign investors to fund our debt.
This leaves us with two potential paths to regaining our footing…
Raise taxes substantially, which is politically unsustainable, damaging to the economy, and a drag on GDP growth.
Inflate our troubles away by reducing the value of the dollar and the debt.
It looks like this second path will be more likely… In fact, the growth in M2 (a commonly used metric for money supply) since 2000 has been astounding. From less than $5 trillion prior to 2000 to an excess of $18 trillion today… wow, talk about rearranging a historical perspective! As a result of this heroic growth, the ratio of M2 to GDP has risen from 48% to an excess of 90%.
Since WWI, the dollar has served as a bastion of safety when troubles brewed around the globe. But since the start of the COVID crisis, the dollar has lost 10% of its value and gold has reached record heights.
The world is paying attention… Since WWI, the dollar has served as a bastion of safety when troubles brewed around the globe. But since the start of the COVID crisis, the dollar has lost 10% of its value and gold has reached record heights. Is gold regaining its status as the only real reserve currency? What are the implications for exchange and interest rates, for the shape of the interest-rate curve, and the implied volatility embedded in an ocean of derivatives across the system?
In short, there is a lot to consider for a CRO today as we guide our firms through this crisis. The good news is that none of us have to predict all the uncertainties in the world. Instead, we try to ensure that our firms will survive no matter which path in the scenario we end up traveling down.
Change is opportunity and risk, and times like these are where strong risk management goes from being a necessary evil to a competitive advantage.
Read More From Our CRO X
This isn’t the first time we’ve talked to our Chief Risk Officer X. Read his exceptional contributions to American Consequences… because none of these risks are going away anytime soon.
The current understanding of the preponderance of experts seems to be that the U.S. is in a much stronger position than China to continue to grow and prosper – and to meet future challenges as we move towards new technologies, a digital economy, and a world without work.
The growth and levels of respective debt and the aging and shrinking of respective populations are the two main pillars for this position. On the surface, these arguments are compelling – and certainly problematic for China. But on a relative basis, one can argue that the U.S. is every bit as challenged, if not more.
Investors are truly in a damned-if-they-do and damned-if-they-don’t world. Betting against the central banks’ ability to print money continuously without reducing its value has been a fool’s errand for 30 years. And those who made that bet are now no longer managing money.
At the forefront of investors’ minds is the very real fear that at some point the 30-year lowering of rates must end. Then the effects of central bank market participation will create a rapid change in the supply and demand equation for government debt and drive rates higher and asset values lower. Investors hold stocks and bonds but are ready to react at the first whiff of a back-up in rates. This is a recipe for heightened volatility that will, absent a severe market correction, continue unabated.