Economic Analysis of Covid19 – When will the Third Shoe Drop?

Today the Federal Reserve cut rates by 50 Basis Points in an attempt to blunt the economic impact of Covid19, also known as SARS II. The rate cut came sharply on the heels of bullying by the President, who tweeted yesterday that the Fed “Should ease and cut rate big. Jerome Powell led Federal Reserve has called it wrong from day one. Sad!” After the rate cut today, the President tweeted, “The Federal Reserve is cutting but must further ease and, most importantly, come into line with other countries/competitors.” Of course this kind of interaction between the President and the Federal Reserve is entirely unprecedented, as the Federal Reserve is supposed to be independent of political influence. It is has been widely reported that the President is obsessed with the stock market, and has been upset that the market suffered heavy losses last week, including the largest single day drop (measured in point totals) in history. One could interpret the President’s bullying of the Fed, and the rate cut that followed as a response to the stock market, and not to the pandemic that appears to be upon us. The stock markets gyrated wildly after the rate cut today, but by mid afternoon the DOW was down almost 900 points.

The stock market’s decline, regardless of rate cuts by the Federal Reserve should come as no surprise. Rate cuts by the Fed are an appropriate tool to stimulate aggregate demand in the economy. The concern about aggregate demand was the first economic shoe to drop in the Covid19 crisis. The measures taken by the Chinese government in response to the outbreak resulted in stores closing and the Chinese consumer all but disappearing during and since the Lunar New Year holiday. Since China is the world’s second largest economy, taking that much demand out of the global economy was sure to impact global GDP growth. The stock market had a fairly modest reaction to that demand shock about three weeks ago, but seemed to regain its footing after a couple days of volatility. Then last week the second shoe dropped, and the market began to price in the more important impact of the conditions in China, specifically the fact that Chinese factory product did not resume after the Lunar New Year, and still has not reached anything close to full capacity. It is unclear when the factories in China will come back on line. Most companies manufacture in China, so this means that firms like Apple don’t have product to sell. The cratering global supply chain is what has led to the dramatic stock market sell-off over the last 8 trading days. No rate cut will address this issue. Regardless of how much central banks act to provide liquidity and stimulate demand, there simply are no products to sell. While some technology firms may not raise prices, ultimately prices will rise across the board for a wide variety of products. Basic economics tells us that when Supply is reduced and demand is constant or rising, the result is higher prices, otherwise known as inflation. It would have been more prudent for the Fed to hold off on the rate cut until supply came back on line, and then cut rates to goose demand as supply increased.

But there remains still at least one more shoe to drop: the cash-flow shoe. Many firms finance manufacturing, and service their revolving debt through subsequent sales into their distribution channels. The constant turn-over of sales and manufacturing, and ideally growth of those volumes, sustains the firms’ business model. Invariably when growth slows, some unprepared firms drop out of the market, or are consolidated into their competitors. The global supply shock we are currently experiencing will be like a recession on steroids with regard to how it impacts cash-flow industries, like the PC business for example. The impact will be made worse by the fact that the economy was relatively healthy to begin with. With full employment and relatively low costs of capital, firms were not anticipating a global slow down so they will be even less prepared for the complete interruption in the cash-flow cycle. So we should anticipate a wider swath of firms failing than we would see in a traditional recession. I predict this will be the next shoe to drop, and we can expect it to happen within the next 3 to 6 weeks.

~~ Pete Dailey