COVID, the Economy and What’s Next
SMITH BRAIN TRUST – It’s always a useful reminder: The stock market is not the economy.
To look at the major indices on the New York Stock Exchange, you might think – depending on the day – that the economy is holding up fairly well. You’d be wrong, says Maryland Smith’s Albert “Pete” Kyle.
“Fundamentally, the economy is trying to have a severe recession,” says Kyle, the Charles E. Smith Chair in Finance and Distinguished University Professor at the University of Maryland’s Robert H. Smith School of Business. The government has been resisting that outcome with three strategies: paying people not to work, bailing out big and small businesses, and by enabling the Federal Reserve to buy private sector debt.
It’s had an effect.
“Paying people not to work has allowed personal income to rise and has supported consumer spending,” Kyle notes. Just not among higher-income earners. Those more affluent consumers are actually sitting on a bit of their money right now, with their travel and entertainment plans currently on hold. Knowing they’ll defer those expenses until later, they’re stashing their cash in the stock market for now, and that’s helping to drive up valuations. (Remember that maxim: The stock market is not the economy.)
“If it were not for bailouts, whole sectors of the economy would be bankrupt, including banking, airlines, aircraft, car manufacturers, travel, hotels, restaurants, non-online retail, and even health care,” says Kyle, rattling off a list that’s worth reading twice. “Therefore, many industries have no intrinsic fundamental economic value.”
Even their bonds, he adds, would also have reduced value because of the current high risk of default. “Current values are based on speculation about the size of government support for firms and the economy, both now and in the future,” Kyle says.
A different kind of downturn
With highly accommodative fiscal and monetary policy, the coronavirus recession looks a lot different from other recessions. The good: Many people have plenty of income, resulting in higher private saving, Kyle says. The bad: The public finances of the federal government have deteriorated more sharply than in a typical recession. “Fiscal deficits are unsustainably high. Furthermore, state and local governments are facing insolvency if they do not receive federal bailouts.”
That leaves the long-term outlook for the U.S. economy looking grim. “At some point, extra government spending will have absorbed the savings glut which has financed both the deficits and the stock market boom,” Kyle says. At that point, there will be upward pressure on real interest rates – the nominal interest rate minus inflation. “The federal government will not be able to afford paying high real interest rates, so the Fed will likely keep nominal rates low, triggering inflation.”
Policymakers, meanwhile, are facing increased demands for income and wealth redistribution. However, Kyle says, there isn’t likely to be a way to pay for it, since the fiscal slack will have already been spent on the coronavirus recession.
“In my opinion, this implies that there will be a sharp decline in stock market prices at some point during the next few years,” he says. “It will likely be impossible for retail investors to time this well.”
Impact on markets
Empirical academic finance literature suggests a buy-and-hold strategy “most of the time,” Kyle notes. Experts typically carve out an exception, however, suggesting that holdings be reduced with the market declines on high volatility from high valuations. Kyle says investors who don’t minimize their exposure to equities now are likely to rush for the exits when the market declines on high volatility.
“The outlook for investors will be worse if the government responds to the demand for income redistribution by cutting bailouts for publicly traded firms, raising income taxes on high income professionals, imposing wage and price controls, and continuing historically loose fiscal policy,” Kyle says, warning of an unfortunate deja vu. “This will take us back to a stock market atmosphere like the 1970s, when there was high inflation, high nominal interest rates, and a collapse in real stock market valuations.”
As tensions between the United States and China continue to mount, Washington may attempt to revive the manufacturing industry by bringing manufacturing – likely high-tech manufacturing – from China back to the United States, Kyle says. It’s a move with upsides, as well as downsides, however.
“While this will benefit some manufacturing industries, it will reduce real wages due to higher costs associated with income substitution, even as manufacturing wages increase,” Kyle says.
“The economics of all this is simple,” he says. “The coronavirus pandemic has a huge economic cost for the United States, similar to that of World War II both in terms of government expenditure and lives lost.”
The costs of the coronavirus pandemic won’t be paid for on average by lower-income families, he says, because there is massive political pressure to support incomes of people on the lower end of the income spectrum. Instead, he predicts they’ll be paid by higher income earners, through some combination of higher taxes on wage and investment income, increased inflation and adjustments to business-friendly policies.
The result? “All of these mechanisms will push stock market valuations down,” Kyle says, as individual investors put less money in their stock portfolios and as companies see regulations eat into quarterly profits.
It’s impossible to predict exactly when this will happen, Kyle notes, calling to mind another maxim of economics and finance – “You can’t time the market.”
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