Update 442 — A Tale of Two Economies:
Market Correction v. Employment Collapse
This week, we compare the impact of the Corona pandemic on the U.S. capital markets and on the real economy of wages and workers. The major indices — DJIA, S&P, NASDAQ — are down less than ten percent this year with gains over the past two months now. Meanwhile, each week over that period, at least three million Americans have lost jobs.
The disparity of impact mirrors a peculiar mix of fundamentals and psychology confronting investors on the one hand and workers on the other. Today, we examine the paradox of an apparent market recovery amid massive, unabated layoffs.
The New York Stock Exchange reopened its trading floor yesterday for the first time in two months. Markets rallied, with the Dow Jones closing just under 25,000 points. Looking at the recent market performance, you might think the economy is back to normal. For Wall Street, the shutdown was merely a commercial break, a good time to bargain shop.
For the over 38 million Americans who have lost their jobs since this crisis began, there is no recovery. As states begin to reopen, workers face the difficult choice of staying at home and losing benefits or going to a job and risk contracting the virus — if they have a job to go back to. An estimated 100,000 small businesses have permanently shuttered since March.
U.S. Equity Markets
S&P 500 Index – 6 Month Performance
As of today, the S&P 500 is trading above 3,000 points, a level it hasn’t reached since early March and about 37 percent higher than its low on March 23. The Dow followed strong gains last week with a 575 point climb yesterday and another 350 point increase today, though a chunk of today’s gains disappeared following news of increased tensions between the U.S. and China. NASDAQ is actually up year to date. Notably, gains have not been universally distributed, as airlines and automakers are still far from their pre-COVID levels.
The U.S. is by far the hardest-hit country in the world when it comes to the COVID-19 pandemic. So what explains recent optimism in the stock market?
After the crash in March, reverberations continued to give investors pause, and the VIX, or CBOE Volatility Index, raged during April. It has since stabilized, indicating that investors are beginning to calm. The Treasury’s $500 billion relief fund and the Federal Reserve’s forceful response have been key to equity markets’ health. The Fed has ensured credit flows and has signaled to investors that it will take singular measures to protect against financial-market collapse. Keeping interest rates near zero makes stocks more attractive to savers.
Some investors’ optimism flows from rumors of vaccine development. A mere press release from biotech firm Moderna, Inc. spurred $1.34 billion in gross proceeds. But the release revealed little to no information on their data, and the company currently sells zero products and has never produced a vaccine. The market is undeterred.
U.S. Debt Markets
Over the past decade, total corporate debt in the U.S. has risen to record levels, almost doubling from around $4.9 trillion in 2007 to nearly $9.1 trillion in 2018. In addition to its size, the quality and riskiness of the debt is concerning. With historically low interest rates, indebted companies have easily met interest payments and rolled over debt. Take collateralized loan obligations (CLOs), which are securities composed primarily of leveraged loans of varying maturities and quality. In 2019, the market for CLOs totaled $660 billion, up from $350 billion in 2014. The COVID-19 pandemic has exposed this practice of over-leveraging and borrowing.
Highly-indebted companies accustomed to cheap credit found themselves in a different situation when the economy crashed in March and lenders reassessed their risk profiles. Many indebted firms, including J. Crew and Neiman Marcus, have filed for Chapter 11 bankruptcy. Still, many over-leveraged companies are benefiting from the Fed’s activities. The Fed stepped in with aggressive facilities in the corporate bond market, even buying non-investment grade bonds from “fallen angels” who experienced recent credit downgrades. The Fed’s response has helped; investor confidence has returned and credit markets are functioning well so far.
- Treasury Debt Securities: In normal times, the Treasury securities market is deep and liquid — a good hedge against risk. But when the economy crashed in March, investors who held these securities rushed to sell them off and convert them into cash. Prices became volatile; market dysfunction ensued as sellers could not find borrowers. The Fed came to the rescue and provided cash in repo markets, resumed quantitative easing, and loosened leverage ratios on banks to allow them to hold less capital. Market liquidity has recovered; futures are pricing in line with cash deliverables.
Private equity (PE) did not escape the Q1 downturn. PE giant Apollo Global Management saw its private holdings depreciate by 21.6 percent in the first quarter. PE firms lobbied for inclusion in Fed lending facilities and Paycheck Protection Program (PPP) loans. The Small Business Administration denied PE firms access to the PPP, but the industry will have access to the Fed’s Term Asset-Backed Securities Loan Facility.
Like their public counterparts, PE is starting to feel bullish again. Earlier this month, Carlyle Group co-founder David Rubenstein predicted that private equity would outperform the public market as it did during the Great Recession. Rubenstein and other PE leaders say that their firms have plenty of “dry powder” left. Apollo, Carlyle, and the Blackstone Group alone have $250 billion in uninvested capital. As the economy recovers, many suffering businesses may fall prey to PE takeovers, making PE requests for federal relief questionable at best.
Financial Sectoral Drilldown
Below, we analyze two key sectors whose performance have broad effects on the macroeconomy.
- Banking Sector: The S&P 500’s financial stocks are up nearly 24 percent since their March low. The industry benefited from the Fed’s measures to maintain liquidity in financial markets. In a Senate Banking Committee hearing earlier this month, Fed Vice Chair Randal Quarles credited Dodd-Frank reforms for ensuring that banks had adequate capital in the lead up to this crisis. But the Fed warns that if the virus persists, more businesses may become insolvent, potentially damaging the financial sector.
- Housing: Yesterday, the Case-Shiller National Home Price Index released its figures for March, showing a 4.4 percent rise in home prices. This rosy figure largely reflects home-buying decisions from January and February. Data from April shows trouble on the horizon. Existing home sales fell 17.8 percent in April, and new home construction dropped 30.2 percent. Economists at Zillow are forecasting that home prices will likely fall 2 to 3 percent through 2020 and begin to recover in 2021.
Saving Wall Street over Main Street
Economic pain has not been equally distributed during this crisis; residents in economically depressed areas like Detroit (where nearly half of those working before the pandemic have lost their jobs) are not seeing the same relief as those employed on Wall Street. The CARES Act prioritized massive aid to big, publicly traded companies, leaving small businesses and individuals to fight over the scraps.
What’s happening on Wall Street bears only the faintest relation to the real economy, a truism never more apparent than today. On Friday, the on the ground reality that Wall Street overlooks, looking, instead, somewhere over the rainbow.