— 2020 Q1 UPDATE —

These are trying times for people on a level that goes beyond the scope of investing.  Here at K2 Financial Partners, we wish all of our clients and global community at large good health and peace of mind.  We understand our skillset is best suited to help shine a light through the cloud of uncertainty in the economy and financial markets and that is what we will be focusing on in this market update.

Some of the highlights of our market update are:

• Landmark U.S. fiscal response to Covid-19 with CARES Act
• Unprecedented steps from the Federal Reserve to reduce economic fallout
• Scenario analysis of 4 hypothetical outcomes we could face

To be clear, we are not medical professionals and we are not giving any medical advice.  This is a quarterly update written about the economy and financial markets.  Any information about Covid-19 should be confirmed with a medical professional.

Equity Markets:

Statistics:

Covid-19 & The Macroeconomy:

The first case of Covid-19 was officially reported on January 10, 2020 in Wuhan, China.  At the time of writing this sentence, on April 1st, 2020; there are 203 countries and provinces inflicted with Covid-19, totaling approximately 960,000 confirmed infections and 47,000 deaths worldwide.  This is obviously a tragic loss of human life, and there will inevitably be more human life that is lost over the course of this pandemic.  Losing human life to a quasi-invisible enemy, in which we must stay inside for an indefinite period of time, has caused an unprecedented shock to individual human behavior (social distancing) and the global economy in totality.  There is a globally uniform level of existential dread and uncertainty that has potentially not been collectively felt since the Cold War.  The main difference between the solution for this Pandemic and the Cold War is that the solution to this pandemic (quarantines/social distancing) is causing an unprecedented slowdown to the global economy which brings about an almost unlimited number of uncertainties along with it.

The uncertainty that everyone feels in their individual lives is a microcosm of the uncertainty intertwined throughout the current macroeconomic environment. The antithesis to stability in the financial markets is uncertainty and we have not seen this level of uncertainty in the economy since the 2008-2009 financial crises.  As human beings and as investors, we strive to reduce uncertainty in our lives and when we do not have the adequate ability to reduce uncertainty, panic sets in.  Therefore, the only way to evade panicking during times of market distress is to have a clear enough picture of the economic landscape that one is able to remain confident in their long-term investment strategies.  Luckily for us, the one thing we can control is our ability and effort towards fundamentally dissecting the economic landscape in order to see the underlying changes driving the financial markets. 

U.S. Fiscal Response to Covid-19:

In response to the economic fallout from widespread forced shutdown of business and mandatory quarantines, the U.S. government passed a landmark bill named the Coronavirus Aid, Relief, and Economic Security (CARES) Act.  This is the third iteration of the bill, with the first version being an $8.3 billion act to support public health and the second named the Families First Coronavirus Response Act. 

This bill looks to expand upon the first two iterations of the bill to support the health and economic wellbeing of the country.  According to Tax Foundation, these are some of the highlights of the new bill.

1. Expanded Unemployment Insurance(UI) for Workers: Includes a $600 per week increase in benefits for up to four months and federal funding of UI benefits provided to those not usually eligible for UI, such as the self-employed, independent contractors, and those with limited work history.
2. $350 billion allocated for the Paycheck Protection Program: Aimed at helping small businesses (fewer than 500 employees) impacted by Covid-19.  Gives loan forgiveness incentives for employers to keep employees retained with their firm.
3. Recovery Rebate for Individual Taxpayers: Provides a $1,200 refundable tax credit for individuals ($2,400 for joint taxpayers). Taxpayers will receive $500 per child.  The rebate phases out at $75,000 for singles, $112,500 for heads of household, and $150,000 for joint taxpayers.
4. Tax Incentive: Creates a $300 partial above-the-line charitable contribution for filers taking the standard deduction and expands the limit on charitable contributions for itemizers.
5. Retirement Account Distributions: Waives the 10% early withdrawal penalty for taxpayers facing virus-related challenges. Withdrawn amounts are taxable over three years, but taxpayers can recontribute the withdrawn funds into their retirement accounts without affecting retirement account caps.
6. Student Loans: Certain employer payments of student loans on behalf of employees are excluded from taxable income. Employers may contribute up to $5,250 annually toward student loans, and the payments would be excluded from an employee’s income.
7. Variety of Business Tax Provisions: Employers are eligible for a 50% refundable payroll tax credit on wages paid up to $10,000 during the crisis. Employer-side Social Security payroll tax payments may be delayed until January 1, 2021, with 50% owed on December 31^st, 2021 and the other half owed on December 31^st, 2022.  Firms may take net operating losses earned in 2018, 2019, or 2020 and carry back those losses five years.  There are more provisions that become highly technical in nature.
8. $454 billion in emergency lending to businesses, states, and cities: Includes $25 billion in lending for airlines, $4 billion in lending for air cargo firms, and $17 billion in lending for firms deemed critical to U.S. national security.
9. $150 billion in a Coronavirus Relief Fund: Provided for the state and city government expenditures incurred during the treatment of the pandemic.

These are simply the highlights of the CARES Act, with there being many more details that can be gone over with your financial advisor or accountant.  Ultimately, this act is the largest spending bill ever passed and it is meant to provide stimulus to the overall economy during this unprecedented shutdown.  This is also the third iteration of support for the economy since the pandemic began, which means that the government seems to be fully willing to use whatever tools they have available to them to keep the economy afloat.  These tools work beautifully during normal times, the question is whether they will work similarly well during a pandemic where citizens cannot go to work. 

Federal Reserve Response to Covid-19:

The United States government has taken unprecedented steps to relieve the economic fallout from the coronavirus, as the previous section alludes to.  However, fiscal policy is only one side of the coin when it comes to governmental response to combat the economic fallout from the coronavirus.  Monetary authorities have acted to provide liquidity to financial institutions and non-financial institutions during this point in time in order to increase the probability of solvency until recovery. 

The Fed has taken many steps, and it would take more space than available to describe it all in detail.  Therefore, we will focus on the more pertinent actions that affect us as investors. According to The Brookings Institution, here are just three of the many steps the Federal Reserve has taken in response to the coronavirus. 

1. Federal Funds Rate: According to the Brookings Institute, “The Fed cut its target for the federal funds rate, the rate banks pay to borrow from each other overnight, by a total of 1.5%, bringing the rate to a range of 0%-0.25%.  The federal funds rate is a benchmark for other short-term rates, and also affects longer-term rates.”  The lowering of the federal funds rate provides cheaper credit throughout the economy, in the hopes that it will increase aggregate demand for credit which will in turn spur investment and increase general liquidity levels in the economy.  This is the main tool the Fed normally uses in order to guide the direction of inflation, employment, and price levels in the economy.

As you can see in the graph below, all tenors of the yield curve have shifted down over the course of the first quarter.  This is a combination of the federal funds rate being cut, investors shifting their portfolios from risky assets to non-risky assets, and general liquidity being provided throughout the economy in the form of Quantitative Easing. 

Data Source: Treasury.gov     
Graphical Source: Made by Author

2. Securities Purchases (QE): Quantitative Easing was a tool that was used by the Federal Reserve to keep financial firms afloat during the 2008-2009 financial crises.  The Fed would purchase treasury securities and other financial assets (such as mortgage backed securities) from banks which would provide banks with liquidity.  This liquidity normally comes from the interbank lending markets, where banks lend to each other.  However, during times of financial stress, firms tend to reduce their lending to each other at the exact moment when it is most needed.  Therefore, the Federal Reserve interjects into this market and lends from the top down.  This liquidity helped banks remain solvent during the financial crises and potentially saved the entire system from collapsing.  The Fed is taking the same actions during this pandemic in order to ensure adequate liquidity for financial firms, and as you can see in the graph below, they are buying securities at a rapid rate.  

According to The Brookings Institute, The Federal Reserve said they will, “purchase Treasury securities and agency mortgage-backed securities in the amounts needed to support smooth market functioning and effective transmission of monetary policy to broader financial conditions and the economy.”  This seems like a move designed to instill confidence in the economy that the Federal Reserve will do everything in its power to combat the negative effects of Covid-19.

Source: Federal Reserve Bank of St. Louis

3. Repo Operations: Example of how the transaction works: One party (firm A) needs a certain amount of money on a short term basis, let's say they need $100 in cash but all they have is a roughly equivalent amount of treasuries.  They can trade $100 worth of treasury securities with another firm (firm B) and get the $100 they need in cash.  Normally, these are very short term loans, so typically the next day Firm A will buy back the treasury securities from Firm B for a slightly higher price, say $101, and then the transaction is over.  Therefore, the Firm A got the liquidity they needed, and Firm B made an extra dollar.  That extra dollar is the implied interest rate in the repo markets.

According to The Brooking’s Institute, “The Fed has vastly expanded the scope of its repurchase agreement (repo) operations to funnel cash to money markets and is now essentially offering an unlimited amount of money.  Before coronavirus turmoil hit the market, the Fed was offering $100 billion in overnight repo and $20 billion in two-week repo. It has greatly expanded the program – both in the amounts offered and the length of the loans. It is offering $1 trillion in daily overnight repo, and $500 billion in one month and $500 billion in three month repo.”  These markets are generally dominated by banks and corporate businesses.  This is an unprecedented move.

Embedded Uncertainty Moving Forward with Covid-19:

There are currently two main sources of uncertainty moving forward with this pandemic in the United States. 

• How long will the quarantine last?
• How well will the fiscal and monetary stimulus actually work to keep the economy afloat during the quarantine?

These are the two most important economic questions at this moment because the initial shut down of the economy, the panic of the virus, and the shut down of the broader world economy is already priced in.  What is not currently priced in are the answers to these two questions because nobody truly has an answer yet and that is why it is important to analyze what different outcomes to those two questions might look like.

Scenario Analysis:

There is a clear inflection point that will come at an unknown time in the current economic environment where the government will not be able to support shut down businesses any longer and that will lead to situation where people are unable to find work after the pandemic is over. 

Here are 4 hypothetical scenarios that have different outcomes based on the interaction between whether the United States goes past the inflection point and the government’s response to the situation.  They go in order from worst case scenario to best case scenario and each event has an assigned probability attached to it which then creates a conditional probability for each of the 4 hypothetical scenarios.

These assigned probabilities were estimated based on internal research.  Assigned probabilities are multiplied in order to create conditional probabilities for the scenarios.  Projections or other information regarding the likelihood of various outcomes are hypothetical in nature, do not reflect actual results and are not guarantees of future results.  Additionally, it is important to note that information in this report is based upon financial figures input on the date above; results provided may vary.

Scenario #1:  Past Inflection Point & No Long-Term Government Help - Worst Case Scenario

Conditional Probability (2.5% Chance)

In the case where the pandemic goes past the inflection point of the government being able to support businesses, there might be a major deficit in the demand for labor even when the pandemic is over.  In this case, United States will be forced into a situation where they either continue to support the private sector with unprecedented government spending or the government does not support the private sector which would cause severe economic hardship for people who lost their jobs.  In this worst case scenario, the government decides to let people who lost their jobs suffer severe economic hardship in the name of not continuing to increase the government deficit even further.  Therefore, they decide not to extend extra benefits past the length of the pandemic, even though we went past the inflection point (which means the government was not able to adequately support businesses from going bankrupt during the length of the quarantine).

This scenario would have persistent unemployment until the aggregate demand for jobs returned.  However, it would be difficult to increase aggregate demand for new jobs (employers looking to hire)  because there would be a severe shortage of discretionary income because of high unemployment.  This lack of discretionary income would shrink profit margins in the economy which would reduce capital investment and hiring.  This negative feedback loop of lack of aggregate demand for goods & services from massive unemployment has the potential to have a spiral effect until deflationary concerns would be at the forefront.  In this worst-case scenario, it would take the economy a long time to correct towards the right direction because we would be coming out of the quarantine with two factors working against us.  The first would be that the economy did not recover in time and plenty of businesses went bankrupt.  The second would be that the government decided not to continue abnormally large unemployment benefits and other spending programs to increase discretionary income and support the businesses still afloat post-pandemic. 

Luckily, we believe this scenario is extremely unlikely.  In the event that we do not get out of quarantine until after the inflection point, it is almost a certainty that the government would continue and even expand spending in order to resurrect the economy.

Scenario #2: Past Inflection Point & Long-Term Government Support - Second Worst Case Scenario

Conditional Probability (22.5% chance)

In this scenario, the government is unable to support businesses long enough and the inflection point is passed.  However, since inducing severe economic hardship on citizens who were forced into a quarantine by their own government is not a tenable political position, it is most likely that the government would continue to support the private sector.

In this scenario, the government realizes this is a necessity to extend fiscal and monetary benefits in order to support aggregate demand in order to avoid the worst case scenario.  In this scenario, there are still widespread bankruptcies of businesses because we passed the inflection point of the government being able to keep closed businesses from bankruptcy.  However, the government extends the benefits which allows aggregate demand to stay intact for the businesses that remained solvent.  This could lead to a lot of situations like we’re currently experiencing with Amazon.com, which recently promised to hire 100,000 new workers in order to keep up with demand for their services.  In short, this scenario could lead to a lot more corporate concentration (I.e. Costco, Walmart and Amazon becoming even larger) where the businesses that were not big enough to survive past the inflection point had to declare bankruptcy, and the large (well capitalized) businesses are able to thrive once the pandemic is over.

This type of recovery could eventually lead to a full recovery of the American economy (after some real economic hardship), but the American economy will be different than before the pandemic.  This scenario can lead to the rich getting richer and the poor getting poorer, further increasing the economic stabilization from income/wealth inequality.

The main problem with this scenario will be the same problem as the main problem with scenario #3, and it will be addressed in scenario #3.

Scenario #3: Before Inflection Point & Long-Term Government Support - Second Best Case Scenario

Conditional Probability (67.5% chance)

If the United States is able to adequately support businesses through the course of the pandemic then when the pandemic is over there will be demand for labor which will give us a relatively sharp recovery.  This would be absolutely great news and it means that there would not be high levels of bankruptcy or sustained unemployment.  In this scenario, the government continues to extend its reaches by continuing massive spending bills because the precedent has already been set.  This can lead to a situation where the economy has an extremely sharp recovery, too sharp of a recovery.  This will lead to inflationary pressures and create the potential for bubbles.  The bottom line is, this would be similar to someone getting sick and taking medicine while they are healing.  It is critical for survival to take the medicine during that time period but it starts to become a problem when the medicine is taken simply to feel good after the person has healed.  That scenario may be fun for the person for awhile but in the end it is simply dangerous because the body was not made to be on that medicine long term.

In our opinion, this is the most likely scenario because once government sets a precedent on spending, they have a tough time reversing it.  It is a difficult political position to actively take benefits away, even when it might be the best long-term move for the economy.  Unfortunately, long-term government support of this magnitude leads to massive deficits that will need to be addressed later down the road through inflation, higher taxes, or higher growth. 

Scenario #4: Before Inflection Point & No Long Term Government support – Best Case Scenario

Conditional Probability (7.5% chance)

We believe this would be the absolute best-case scenario for the long term health of the American economy.  This would result in a steady return to stabilization, a relatively small amount of bankruptcies (before inflection point), and a slow unwinding of the private sector relying on the public sector for support.  We would be able to avoid increasing the government deficit at unprecedented levels which means there would be reduced risk of sovereign default risk or having to inflate our way out of the situation.  Ultimately, this would be ideal.  However, I have it as unlikely because of the same reason listed in scenario #3.  It is a difficult political position to take benefits away that have already been given.  Therefore, we find this scenario unlikely but we are hopeful for it.

Conclusion:

The clear dichotomy between a positive and negative long run economic outlook for the United States is dependent on the government’s ability to adequately support businesses through the pandemic and to the degree which the government stays involved in the private sector after the pandemic is over.  If the majority of businesses are able to survive the pandemic then the underlying profit generator of the economy will be able to function again once their labor supply is able to return to work.  This will allow individuals to receive paychecks again, allowing them to pay their rent which allows building owners to pay their mortgages.  If the ability of the government to keep businesses afloat does not last as long as the pandemic forces us into quarantine, then the recovery of the economy will be an order of magnitude longer than in the former scenario.  The clear distinction between these two scenarios is the inflection point.  Not knowing when this clear inflection point will arise is what is currently causing such massive uncertainty in the markets as of today.    

Here at K2 Financial Partners, our number one focus is making sure our clients are in the right position to reach their financial goals.  This is why it important during times like this that you stay in contact with your financial advisor to make sure you are properly allocated to potentially capitalize on the positive times in the market and feel confident during the more difficult times.

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