COVID-19: Research Update V


Will McIntosh, Ph.D
Global Head of Research

John Kirk, CAIA, CCIM
Senior Director, Research

Mark Fitzgerald, CFA, CAIA
Executive Director, Research

Karen Martinus
Senior Associate, Research

Chenchao Zang
Senior Associate, Research

Jane Zheng
Associate, Research

May 4th, 2020

Here are our thoughts on the economy and financial markets as we reflect on the pandemic and its fallout:

Were there any critical observations from the first-quarter GDP report?

After almost 11 years, the longest economic expansion in U.S. history is officially over, replaced by what will likely be the deepest downturn since the Great Depression in 1929. The economy shrank at a 4.8% annualized pace in the first quarter, the most significant decline since 2008 and the first contraction since 2014. With roughly 85% of households sheltering-in-place, the economic slide was not surprising, but a few things stood out in the report:

  • Rapid Decline: The nation’s first shelter-in-place order occurred on March 16, and up until that point, GDP growth was arguably on pace for a flat-to-slightly positive output, albeit weaker than earlier estimates given the rising uncertainty associated with COVID-19. Over the next 15 days, however, shelter-in-place restrictions brought the economy to a standstill, resulting in the sharpest quarterly decline in a decade. Looking ahead, one could see how the severe second-quarter GDP projections, ranging from negative 20-40%, could materialize given that large swaths of the country have been under stay-at-home orders for a much more extended period. There is hope that the federal stimulus programs combined with the gradual opening of some states should begin to soften the blow.  Still, second-quarter GDP could be one of the most severe economic contractions on record.
  • Health Care Struggles: Despite having played a vital role in combatting COVID-19, the health care industry saw spending fall by 18%, subtracting 2.3% from overall GDP growth, according to Capital Economics. As mentioned during last week’s update, many health institutions generate a significant portion of their revenue from elective procedures, most of which have been discontinued as hospitals have prioritized care for Coronavirus cases. Medical facilities should normalize as the pandemic subsides, and restrictions are lifted. Still, hospital revenues will be slower to bounce back as most states are requiring hospitals to reserve a certain percentage of beds for Coronavirus cases indefinitely.
  • Deflation Risks: The headline PCE (Personal Consumption Expenditure) index, which is the Federal Reserve’s (Fed) preferred inflation measure, was up 1.3 percent for the quarter. However, when examining the month of March, which took the brunt of the impact from COVID-19, PCE was down 3.8% from a year ago – the worst decline on record since they begin tracking the data in 1960. Notably, this figure did not include the collapse in oil prices that occurred in April, which raises concerns regarding what economists refer to as the deflationary spiral. For instance, if demand remains persistently weak, prices will begin to fall, followed by production cuts to accommodate the lower demand.  In turn, companies tend to reduce their workforce, resulting in higher unemployment. Deflation risk is common during a recession, but unlike previous downturns, there is more uncertainty surrounding the current economic recovery because much will depend on how long it takes to contain the virus.

What more can the Fed do?

The Fed has arguably backstopped the U.S. economy. Their balance sheet approached $6.7 trillion last week, up more than 55% since the health crisis began.  At one point in March, the Fed’s was purchasing $75 billion in Treasuries every day to keep interest rates near zero, though the level has moderated to $10 billion per day as of last week. The central bank has established nine emergency financing facilities capable of injecting over $4 trillion (or 20% of GDP) into the economy. They are now lending to companies directly for the first time in history, buying upwards of $750 billion in corporate bonds, including high-yield bond ETFs. Just the last week, reports emerged that the Fed is considering a bailout for the oil industry, extending their lending operations to include local municipalities, and expanding the “Main Street Lending” program aimed at mid-size firms. Thus, the Fed’s balance sheet is expected to balloon to $10 trillion in the coming months, more than double the level reached in the years following the Global Financial Crisis (GFC). While policy officials certainly deserve credit for acting swiftly to support the financial system during this crisis, the unwinding of such a massive balance combined with the economy’s heavy reliance on the Fed will one day be of great concern for many market participants.

How has the crisis affected U.S. debt levels?

The Congressional Budget Office, or CBO, projects that the deficit will top $3.7 trillion this year, equivalent to 18% of GDP – up from 4.6% in 2019 – and the most significant gap since WWII. As a result, federal debt as a share of GDP will top 100% in 2020 before approaching the record high of 108% of GDP in 2021. While it is hard to argue against the use of public debt in battling COVID-19, there will inevitably be consequences for carrying such a heavy debt burden. Fitch Ratings recently announced that they expect 2020 to be a record year for sovereign downgrades, given that government debt levels are expected surge as a result of COVID-19’s impact on the global economy. In March, before realizing the full extent of pandemic’s effect on the economy, Fitch affirmed the U.S’s investment grade (AAA) credit status but warned that rising deficits and debt levels were starting to erode its credit strength. Given the recent CBO forecast, the U.S. credit rating might be at risk of being downgraded over the next year.

Can the government save the single-family housing market?

The U.S. government is attempting to prevent a single-family housing crisis like the one that occurred during the GFC. Government officials are expected to provide forbearance for nearly 15 million loans to keep foreclosures to a minimum. The government agencies (e.g., FHA, Fannie Mae, and Freddie Mac) account for about 70% of outstanding mortgages and are allowing upwards of 12 months forbearance for homeowners. While the remaining 30% of lenders will not be as forgiving, the government’s approach should prevent a collapse in homeownership, such as that seen after the GFC. Consequently, the homeownership rate will likely hold steady at around 65% over the next year. However, even after the health crisis has passed, it will take some time for households’ savings and income to bounce back. When combined with tighter credit conditions, the single-family housing market will not recover to its pre-crisis levels until mid-2022 at the earliest, according to Moody’s. This outlook bodes well for multifamily demand over the next several years.

The federal restrictions are lifted, and now what?

The federal government’s social distancing orders expired last week, and states have begun to implement rules for opening their respective economies, with some parts of the country being less stringent than others. States with more relaxed guidelines may serve a testing ground for the broader economy. First and foremost, there will be a keen focus on the number of new Coronavirus cases, given the serious concern regarding the possibility of a second wave of infections. From an economic perspective, investors may gain insight from high-frequency data sources such as box office receipts, restaurant reservations from apps like OpenTable, and retail foot traffic in newly opened malls. The resulting output could be an indication of both the financial and psychological state of the U.S. consumer, which is vital given that consumer spending accounts for two-thirds of GDP.

Where are we with a vaccine?

There are at least 70 different vaccines in development by various groups, according to the World Health Organization. Most experts warn that the earliest delivery of a vaccine is at least 12-18 months away. However, last week the Trump administration announced an effort to drastically cut the time required to develop a vaccine by aggregating the efforts of private pharmaceutical companies, government agencies, and the military. The program called “Operation Warp Speed” would attempt to reduce the development time by as much as eight months.  This initiative and others like it provide hope for a speedy resolution capable of saving lives and jump-starting the economy. Still, history suggests that even the 12-to-18 month timeline is optimistic. The mumps vaccine – considered one of the fastest ever approved – took four years to complete during the 1960s, and more recently, it took scientists five years to gain approval for the Ebola vaccination in 2019. While it will probably take at least a year to complete clinical testing for COVID-19, the good news is that the trials should provide valuable information about how the immune system can fight the virus, helping doctors combat any new outbreaks.

Concluding Thoughts

The federal government’s social distancing guidelines expired last week. Some regions of the country are open for business, while others have delayed reopening their economies. Only time will tell if the success in containing the virus thus far will be reversed as states begin to open. In either case, what has become evident is that the economy has undergone a structural change regarding its reliance on the Fed and a rapidly increasing debt burden. While it is too soon to know the ramifications of these issues, we suspect the impact will be widespread, affecting commercial real estate and other financial markets for many years to come



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