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Coronavirus: Bracing for the economic shockwave

Originally published: Naked Capitalism (March 2, 2020)  

The information-aware and many in the medical industry are nervously watching the news about coronavirus spread and mortality rates. What we know so far isn’t pretty.

Why Optimism Is Unwarranted

The coronavirus appears to be highly contagious. China’s CDC, based on a comprehensive study of the data it has, said as of mid-February that the case fatality rate is 2.3%. Even though optimists have pointed out the case fatality rate in China was much lower outside Hubei, on the order of 0.7%, that appears to be significantly the result of its stringent lockdown, which greatly slowed disease spread outside Hubei. Critically, that meant a higher proportion of the severely ill could be treated.

Conversely, as we have pointed out, there is reason to think that in Hubei, at least twice as many cases as the ones reported are isolating at home. Over 150,000 people have represented themselves as being in desperate need of help on Weibo. A very high percentage likely does have the coronavirus and is also likely to suffer deaths at least at the level of the China CDC case fatality rate by virtue of not having been treated.

The WHO has also rejected the cheery line of thought, that the fatality rate may be way lower than commonly assumed because mild cases aren’t being captured. Their take is that those mild cases are so few in number as to not be meaningful. From StatNews:

Bruce Aylward, who led an international mission to China to learn about the virus and China’s response, said the specialists did not see evidence that a large number of mild cases of the novel disease called Covid-19 are evading detection….

…if there aren’t large numbers of uncounted cases, the severity seen in China is what the rest of the world should expect as the virus moves to new locations, especially if it spreads to the degree seen in Hubei province, where the outbreak began….

The case fatality rate — the percentage of known infected people who die — is between 2% and 4% in Hubei province, and 0.7% in other parts of China, he said.

The lower rate outside of Hubei is likely due to the draconian social distancing measures China has put in place to try to slow spread of the virus. Other parts of China have not had the huge explosion of cases seen in Hubei, Aylward said.

A case fatality rate of between 2% to 4% rivals and even exceeds that of the 1918 Spanish Flu pandemic, which is estimated to have killed upwards of 50 million people. Even a case fatality rate of 0.7% — which means 7 out of every 1,000 infected people would die — is sobering. It is seven times the fatality rate for seasonal flu, which is estimated to kill between 290,000 and 650,000 people a year globally.

In other words, there isn’t good reason to think the news about the coronavirus is going to get better soon, save perhaps the arrival of warmer weather slowing disease spread….but that may simply set us up for a revival in the fall. The lack of even adequate testing in the U.S. and no prospect of getting it any time soon, the Trump Administration decision to opt for spin over transparency, the prohibitively high cost (for most) of getting tested, and financial insecurity and lack of sick days making it also too costly for many to stay home if they start exhibiting coronavirus symptoms, makes the U.S. subject to more extensive propagation than might otherwise happen.

The absence of enough data for making sound risk assessments means once awareness of the disease becomes more widespread (US readers say they see a lot of complacency except in locations close to outbreaks) means those who are in an economic position to do so will take protective measures, while those who need a paycheck and can’t work remotely will keep showing up…unless and until a slowdown in their business forces hours and headcount cuts. So we see Amazon bans all “nonessential” travel and Nike temporarily shutters its headquarters campus for a “deep cleaning” while Amazon warehouse laborers are expected to keep up their punishing routines no matter how terrible they feel. Amazon seems far more concerned about coronavirus leading to Prime Day inventory shortages than to its warehouses becoming coronavirus clusters.

And to weigh heavily on the obvious, the U.S. is not well positioned to cope with a massive public health crisis. The CDC’s poor calls on the test kits calls the agency’s sense of priorities into question. As most readers know, its staffing levels were cut under the Trump administration, particularly of “disease security” programs.

But the problem with our public health system extend well beyond Trump. Even if the CDC were well funded and staffed, it could not do all that much. Public health in the U.S. is a state and local responsibility. That virtually assures that if the coronavirus were to become a large-scale problem, responses across the U.S. are likely to be uncoordinated. Consider this discuss from the National Conference of State Legislatures:

The preservation of the public health has historically been the responsibility of state and local governments.

Clarity in leadership is crucial in a joint federal, state, and local response to any event which could cause harm to the public’s health. The public health authority of the states derive from the police powers granted by their constitutions and reserved to them by the 10th Amendment to the U.S. Constitution. The basis for the federal governments’ authority to prescribe a quarantine and other health measures is based on the Commerce Clause, which gives Congress exclusive authority to regulate interstate and foreign commerce.

To be specific, a comprehensive public health response to avert the spread of highly contagious diseases may call for the isolation of people, the quarantining of a community exposed to the infectious disease or both. Quarantine typically refers to the “separation of individuals who have been exposed to an infection but are not yet ill from others who have not been exposed to the transmissible infection.”[i] In contrast, isolation refers to the “(s)eperation of infected individuals from those who are not infected.”[ii] Primary quarantine authority typically resides with state health departments and health officials; however, the federal government has jurisdiction over interstate and foreign quarantine.

The article notes that the federal government can take charge if a state asks or of the Feds deem the state response inadequate. However, my impression is that for decades, the Feds have always been invited in; disaster areas are typically desperate for help. However, one can imagine the Trump team imposing its will on parts of California just for the hell of it.

In addition, neoliberalism and the precautionary principle do not co-exist happily. The public is already being conditioned to expect that any coronavirus vaccine won’t be free, but at least unlike being tested for the disease, will be “affordable”. So many won’t seek care unless and until they become desperately ill. The failure to get a diagnosis and isolate early will increase coronavirus spread.

Real Economy and Market Exposures

I don’t want to minimize the seriousness of the coronavirus health risks. But on top of that, people who do not become sick or come down with only a mild case may wind up suffering economically due to cuts in hours or job loss or for those who have them, damage to their pensions.

The markets are finally taking coronavirus very seriously, with the long bond trading at record highs and stock markets doing synchronized swan dives last week.

But unlike the financial crisis, where it was possible to identify the main drivers, housing debt and highly leveraged resecuritizations (CDOs) where the risks wound up concentrated at undercapitalized, systemically important financial institutions, here, many real economy sectors are seriously exposed: energy, travel and hospitality, aircraft manufacturers, automakers, restaurants, casinos.

Even though the business press is geared to covering stocks, it is high levels of downgrades and defaults that make for financial crises. Remember that the the dot-bomb era, despite a massive wipeout of equity values, didn’t result in a crisis due to limits on margin lending.

But as a result of the measures to move risks out of the banking sector, it may be harder to anticipate where ruptures will occur. The current leading edge conventional wisdom is that we’ll see a massive credit crunch as many companies start looking wobbly as their revenues shrink and investors get nervous about taking lending risk until they see a bottom to the disease and the economic damage.

The fact that the Telegraph’s Ambrose Evans-Pritchard is in top form is a bearish sign. In his latest article, he starts by describing Standard & Poors and Moody’s issuing broad-based warnings. Note that S&P and Moody’s are known for not downgrading until bonds are already trading as if they’d been notched down:

There are mounting risks of a credit crunch in vulnerable sectors of the corporate bond market, potentially rocking an unstable financial edifice with record levels of debt and set off a dangerous chain reaction….

Moody’s has issued a global recession alert should the coronavirus turn into a global pandemic, deemed inevitable by many of the world’s top virologists after exponential outbreaks in Korea, Iran, Italy, and now France. “The economy was already fragile before the outbreak and vulnerable to anything that did not stick to script. COVID-19 is way off script,” said the rating agency.

S&P’s [head of credit research for Europe and the Middle East] Mr [Paul] Watters said sectors with a toxic mix of high leverage and poor cash flow are coming under the microscope. Health care borrowers in the high-yield league are the most stretched with a debt-to-earnings ratio of six times, followed by media on 5.5 times.

Yves here. Bet you didn’t know there was lots of credit risk in the health care sector. I have to confess I found that out only recently due to some deep-dive research by a colleague that is being circulated privately. Upon reflection, it makes sense since private equity firms have long been buying in the medical space, both due to the perceived safety of cash flows and when they find a choke hold, their ability to jack up prices.

But it’s not just PE plays:

Europe’s car industry is also in the sights. Moody’s downgraded Renault to junk last month. S&P has placed the company on creditwatch negative at BBB-, just one rung short of junk status and alongside GKN, IHO Verwaltungs, and ZF Friedrichshafen. The world’s number one car-maker VW is at BBB+ and no longer has much buffer….

The U.S. Treasury, the International Monetary Fund, and G20 Basel regulators have all warned that the underlying quality of high-yield debt and leveraged loans has deteriorated badly and is now more extreme than before the Lehman crisis.

But what they are even more worried about is a fat tranche of BBB rated securities that has mushroom fivefold since 2008 to $3.4 trillion and is precariously perched on the cliff-edge. The slightest shock could lead to a cascade of downgrades.

The U.S. Treasury’s watchdog (OFR) said in its Stability Report that investment funds with strict mandates would be forced to sell these derated fallen angels, setting off firesales into a frozen market.

Among the companies sitting on the lowest investment rung of BBB- and also on negative watch are Samsonite, Vale, Suedzucker, Xerox, Western Digital, EQT, BlackRock TCP Capital, ArcelorMittal, Marks & Spencers, Abertis, and the state of Romania. Nokia and Macy’s have just been downgraded to junk. So has Kraft-Heinz with $32bn of debt.

A similar red alert comes from Anthony Rowley in the South China Morning Post:

Even before the coronavirus scare, it had already begun to look like a question of when, rather than if, such a debt crisis would erupt. All that was missing was the “trigger”. There always has to be a precipitating event for a crisis and the coronavirus could well be it.

International Monetary Fund managing director Kristalina Georgieva told the recent G20 finance ministers’ meeting in Riyadh that “high debt levels in countries and corporates could be affected by a rise in risk premia or an unanticipated tightening in financial conditions”.

She was being diplomatic, of course, but her comments could be interpreted in plain English to mean: countries and companies are up to their necks in debt and if lenders decide at this time of great uncertainty to raise lending rates or to call in loans, then we could be in trouble.

Some Asian economies are heavily debt-laden:

China itself has a steep corporate-debt-to-GDP ratio of 157 per cent, and after that come places like Singapore, South Korea, Japan and the euro area. At 74 per cent, the U.S. corporate sector is less debt-addicted but that is partly a reflection of that country’s huge GDP.

When it comes to household debt, South Korea is well in the lead with borrowing equal to 95 per cent of GDP (and rising) while Hong Kong ranks second in Asia with a ratio of 77 per cent and Malaysia third at 68 per cent. Elsewhere, British households are debt addicted to a degree of 84 per cent.

State-owned enterprises represent 35% of China’s corporate borrowing, so they could be readily backstopped. The others would be messier. The first step is apparently already underway, the zombification of debt by having banks pretend that bad loans aren’t bad. We saw that playbook in Japan. It was such a failure that the Japanese took the uncharacteristic step in the early phases of the crisis of telling the West that their biggest mistake was not forcing banks to recognize loan losses and dealing with fallout. Even with the banks pretending the losses don’t exist, they still wind up being chary of extending more credit. From Bloomberg:

China’s financial regulators will allow the nation’s lenders to delay recognizing bad loans from smaller businesses reeling from the deadly coronavirus outbreak, giving temporary reprieve to trillions of yuan of debt.

Qualified small- and medium-sized businesses nationwide with principal or interest due between Jan 25 and June 30 can apply for a delay to the end of the second quarter, the China Banking and Insurance Regulatory said in a joint statement with the central bank on Sunday (March 1). In Hubei province, the centre of the outbreak, the waiver applies to all companies, including large firms, according to the statement.

Chinese banks are taking extraordinary steps to avoid recognising bad loans, seeking to protect themselves and cash-strapped borrowers from the economic fallout of the epidemic. Regulators told lenders not to downgrade loans with missed payments or report delinquencies to the country’s centralized credit-scoring system before the end of June, according to the statement.

For the West, two places to watch are junk bond positions and collateralized loan obligations. Banks would likely be holding some inventories of each. Collateralized loan obligation losses in the crisis weren’t terrible (banks also played games so as to underreport them), but they were generally believed to have taken ~15% losses, and they bounced back thanks to the liberal liquidity application by the Fed. The early thinking is CLOs could take worse hits this time around because so many different industry sectors could sink at the same time. And more of the underlying loans are “cov lite” which means junkier, so they’ll also have less value in times of stress.

We and others have warned of another possible point of failure: derivative central counterparties. From a 2018 post, which I hope you will read in full, Post Crisis Measures Have Failed to Tame Derivatives Risks:

The post crisis remedy settled on in 2009 was to require trades to be cleared through central counterparties who would be the ones to assume the credit risk of buyers and sellers. But as [derivatives expert Satyajit] Das and others (including your humble blogger) pointed out then, all this did was to move that risk out of banks and big leveraged financial players like hedge funds, and into the counterparties, which themselves are too big to fail entities.2 And even though it is true that a central counterparty will reduce overall credit exposures, as Das has explained numerous times, there is a big gap between theory and practice….

So the high-level conclusion is that CCPs in theory are an improvement over the old status quo, but they need to be implemented well to achieve their promise. Most important, they need to have strong enough capital buffers. Even then, they are not a magic bullet.

Now aside from [the Financial Times’ John] Dizard’s warning, there was reason to be concerned about the motivation for creating central counterparties, in that it was to reduce the “too big to fail” problem. In other words, given the limited, conditional risk reduction that would result, the idea of moving more credit risk to central counterparties was more than anything else to solve a political problem: to get the government out of the liquidity provider of last resort game…

But an inadequately capitalized CCP is just another “too big to fail” entity. And since the CCPs are private, there would be motivation for the participants to have the CCP be underresourced, since higher margins mean higher transaction costs and therefore lower trading volumes. And although no one would admit to this, bankers know full well that no financial regulator is willing to let markets seize up in our brave new world of market-based credit, as opposed to bank-loan-based credit.

Another effect of the officialdom’s post crisis to move credit out of risk was to move even more into the hands of investors. Those leveraged loans used to finance private equity deals, which are often bundled into those afore-mentioned collateralized loan obligations, often wind up in credit funds managed by private equity firms. Just as with private equity, investors in those credit funds are public pension funds, sovereign wealth funds, endowments and foundations, private pension funds, and life insurers. Fund managers like BlackRock, Fidelity and Vanguard also purchase them for their funds. The Financial Times reports that these investment managers are already reeling from withdrawals from their funds. By contrast, investors in private equity credit funds can’t liquidate, so they will have to take their lumps.

A big issue that astute commentators like Nouriel Roubini and Ambrose Evans-Pritchard have discussed is the Fed can’t fix a real economy crisis. Pray tell what can a central bank do to compensate for widespread business travel bans, which hit the particularly lucrative premium class international flights? Or the fact that restaurants in cities like New York are largely deserted? When hours and jobs for restaurant and hotel employees fall (for starters), you’ll see knock-ons to credit card, auto loan and student debt delinquencies. Only fiscal spending can compensate for the loss of business income and the U.S. is allergic to that, save in the form of tax cuts to the rich.

Italy is on the right track although tax relief is less than idea than direct subsidies to workers and the amount looks too small. But it’s constrained by EU budget rules. From the Financial Times:

Roberto Gualtieri, Italy’s economy minister, said on Sunday the government would introduce tax credits for companies that reported a 25 per cent drop in revenues, as well as tax cuts and extra cash for the health system.

The package will amount to 0.2 per cent of GDP, he told La Repubblica, and would come in addition to €900m worth of measures unveiled on Friday for the most severely hit regions.

Rome will simultaneously seek authorisation from Brussels to increase the budget deficit for this year, the Treasury said over the weekend.

Italy does deserve credit for moving quickly on the health and real economy fronts. The U.S. is likely to pay for its dilatory attitude in lives and in treasure.

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