Investors are feeling pretty good these days. The S&P is only down 10% on the year and the NASDAQ is actually up. The bull case is very simple: The Fed Won’t Fail Us! That’s it.
Sure, you can argue if we get a vaccine soon prices are justified, but that presumes nothing else changes. Namely, if the virus went away, so would the Fed stimulus. If you take away both, stocks are pretty rich given the permanent changes that will keep the economy below its potential.
So what’s the bear case? It’s pretty simple. The long term impacts on the economy are much greater than the Fed’s ammunition. I’ve broken the candidates for disappointment into direct (virus related) and indirect (structural changes).
Direct Impacts
These range from the obvious (can we get a vaccine quickly, will we have enough tests) to the less predictable (the sideswipe risk).
The Vaccine
Most people seem to believe a vaccine is just a matter of time. Polls show the expectation is for a vaccine by the spring, even though Fauci and Gates keep saying 18 months. There is a risk it is years away.
There is also a risk that it will be of limited effectiveness. Or that we won’t be able to make enough quickly enough (and who gets it first if we can only make 10M the first year?). Or God forbid, that we find out it has terrible side effects after we give it to the first 100M people. If your main bull thesis is the vaccine will be our savior, you’re not considering all of the risks.
Testing
But maybe we can get by without the vaccine? After all, we’re going to have widespread testing so people can return to work soon. Are you so sure about that?
Fauci’s tone has changed for the worse in the last week or so regarding the prospects of normalcy by the fall. He has become dismissive of returning to school, playing football, and other fall activities.
Reading between the lines, his concern seems to be we will still not have adequate testing by the fall. In addition, the tests we do have just aren’t accurate enough, particularly the seriological ones.
The hope that we can have a significant portion of the population “pass” an antibody test and resume normal activities is fading because there are too many false positives (i.e. uninfected and thus vulnerable people thinking they’re safe). Without confidence in the accuracy of the test, there is no point in even taking it. It’s Russian roulette.
Warmer Weather
Remember back to the early days of the virus when the hope was warmer weather would kill the virus. There is some truth to that, but it’s not the whole truth. African and South American countries are seeing outbreaks, so the virus can still spread in warm temperatures. The main benefit is it doesn’t survive as long.
It is no coincidence that death rates are lower in states like Florida, Georgia, and Texas. They are not inherently less susceptible. Instead, they have had better weather.
This suggests the rate of spread will slow across the country over the summer. However, it will return with a vengeance in the fall and winter. Remember, we aren’t likely to have vaccines or adequate testing by the end of the year. This brings us to the head fake…
The Second Wave
My expectation is we will see improvement in contagion through the summer. Consumer confidence will rise and businesses will start to cautiously re-open. We will get sports back and some schools will open.
Then, we take the 2X4 to the head. The “second wave” comes at the worst time – right when we let our guard down. Layoffs resume and this time businesses shut for good. The government has run out of stimulus capacity and has limited tools to respond.
I heard a good summary of the epidemic so far. First, we underreacted to the threat by not preparing in January. Then, we overreacted by shutting down the economy when it was too late to slow the spread materially. In my scenario, we continue that pattern by letting our guard down too early by misattributing diminished cases to the virus dying out rather than a temporary respite due to warmer weather.
Indirect Impacts
But let’s say I’m wrong about all of that and we don’t have a second wave and we start to return to work. Would I still be bearish? Absolutely.
The indirect impacts are related to the economic shutdown and the changes in consumer psychology and shopping patterns. The economic damage will continue longer than most people suspect. This will not be anything close to a ‘V’. The foundation of the economy was too wobbly to begin with and we don’t have the resources to solve the new problems without making painful choices.
Deficits Matter
The government response to the crisis has done permanent damage. It will be years before we get back to full employment. More importantly, the government’s balance sheet has been severely weakened.
There are only two ways to remedy that – raise taxes or create inflation. We may do some of each. Both are obviously bad for economic growth and bad for stock market valuations. However, we will be in a world with limited options and it’s hard to imagine higher taxes, higher inflation, or both not being part of the policy prescription.
Also, all these arguments obviously apply at the state and local level as well. Taxes will go up materially. States obviously can’t print money so they will have to resort to options like selling assets (airports, real estate, toll roads, etc.).
China
It’s pretty obvious the political answer to the virus is going to be to blame China. I’m not only referring to spreading the virus. All the trade war issues will bubble up again as well.
The pandemic exposed all the weaknesses in the global supply chain and outsourcing manufacturing. The result will be a global retrenchment which might be good for reducing our tail risk but reduces productivity and GDP near term.
Commercial Real Estate
The inevitable decline of store based retail has been accelerated by the virus. When activity returns, it is less likely to take place in store. Same for restaurants. Restaurants can’t survive at 50% capacity. More of them will resort to take out only at smaller, cheaper locations. Office space demand will be in decline due to more workers deciding to stay at home.
The takeaway is there will be a lot of vacant real estate. Real estate is a highly levered asset class. To make things worse, low interest rates drove capitalization rates (i.e. valuations) higher. If rental income declines too much, you can’t service the debt. If cap rates decline, you can’t sell for a valuation greater than the principal of the debt.
In other words, you are insolvent. There are likely to be massive real estate bankruptcies. This will produce a lot of losses for banks, pension funds, and other investors. As a rule of thumb, commercial real estate crashes are not good for stock market valuations.
Zombies
It’s not just CRE or retail. There are lots of overly levered zombie companies that need to restructure. There are the obvious candidates like airlines, but really anything transportation – rental cars, makers of city buses or subway cars, Uber drivers who bought a car and can’t make payments.
Colleges are going to require a major overhaul. Hospitals will need to have more excess bed capacity. Who needs to go to the dry cleaner or cater a corporate lunch?
There are so many businesses that won’t make a full recovery and most of them are highly levered and often financed by inventory that is now worth far less than the assumed residual value.
Be Cautious
To be honest, my list of things to worry about keeps going, but that ought to be enough to convey the point. There are structural changes that will remain even after the virus is gone. A brew of higher taxes, higher inflation, less globalization, and lower productivity are not conducive to profit growth or higher valuations.
In addition, I am very concerned about the sideswipe risk. It’s human nature that a temporary improvement over the summer will be viewed as the end. Instead, it will be like going outside as the eye of the hurricane passes, unaware the rest of the storm is about to hit. Investors will be fully invested in the fall just in time for the bottom to fall out.