Want to Slow the Pain of Covid-19? Here's How

It has been a wild week in all markets, bond land included. Everything has been made all the harder by how opaque the outlook is, as well as how impotent traditional economic stimulus will be to fight this slowdown. Here's what to watch as new policies roll out -- and what could make for better action -- as well as some buying options: Expect Recession Leisure plus restaurant spending accounts for just under 16% of gross domestic product. Nominal GDP (not adjusted for duration) grew by 4% in 2019. It was probably already slowing before the spread of the newly discovered coronavirus, but we'll hold that aside. This means that if this leisure spending declines by 20%, that alone would be enough to put us in a recession. But the knock-on effects will be even larger. Not only will the leisure and hospitality industry see a precipitous decline, but so will physical retail, transportation, and so on. Those industries will have to cut hours or do layoffs. Hence even if the virus' effects only last a few months, that's probably enough to cause a short recession. Monetary Policy Is Less Effective The Federal Reserve is likely to cut 50 basis points to 75bps at next week's meeting and will probably take rates to zero at the April meeting. If it were me, I'd just cut to zero now, but I don't know if the Fed is there yet. This will not do a lot to help alleviate the economic pain from Covid-19. It is more about not allowing Fed policy to become restrictive. As economic activity declines, the neutral rate also declines. Therefore if the Fed did noting, policy would become too tight. Cutting now is about avoiding further damage. In other words, cutting is definitely the right thing to do, but there will be very limited positive effects. Fiscal Policy Must Be Targeted, Help Workers One unique element of this economic slowdown is that we know the root cause is temporary. The virus won't continue to be a problem forever, either because it runs its course or we develop a vaccine. China appears to be seeing a reduction in new cases already. Hence, the only way this becomes a lasting recession is if a temporary shock to spending causes waves of small business defaults. I think most large businesses will survive or are in industries where creditors can take over without too much trouble. Examples include cruise lines or shale oil producers. But small restaurants, retailers, hotels, and other businesses could get caught up in this through no fault of their own. The Fed is already providing some regulatory relief if banks allow borrowers to go a little delinquent. The Federal government could take it a step further and provide some kind of tax holiday to businesses that keep worker hours at the same pace as before the Covid-19 outbreak. We don't need bailouts in the way we tried in 2008. Stimulus aimed at businesses needs to focus on temporary debt forbearance and maintaining payrolls. Payroll tax cuts allow currently employed people to keep more of what they earn. But it won't help anyone who gets laid off or sees their hours slashed. Speaking of hourly workers, I expect this group to be a key part of the coming slowdown. If we can keep this cohort employed or at least keep their income stable, then this could be a recession that comes and goes extremely quickly. Unfortunately, the policies proposed so far don't help. Payroll tax cuts allow currently employed people to keep more of what they earn. But it won't help anyone who gets laid off or sees their hours slashed. Furthermore, if you earn more of your paycheck, but don't go out and spend it, that provides no stimulus. Measures that will be effective have to include income maintenance. Expect policy proposals to come fast and furious in the coming weeks. I will be ascertaining whether these proposals will help risk assets based on the above criteria. But Bond Buyers Fear Missing Out Bonds are experiencing a version of FOMO -- fear of missing out. There are many fixed income investors for whom suffering through zero income for an extended period is a huge problem. So they are getting in while the getting is good. Basically, bonds are going to melt up -- in price, but melt down in yield! -- as long as people think the Fed is headed to zero -- which the Fed is. That said, watch the yield gap between 5-year and 30-year Treasury. A tighter gap indicates slower longer-term growth, or in other words, zero-rate policy for a long time. When we see that gap steepen, that suggests that while Fed policy is very low now, it will eventually rebound. Airline Debt Drags on Junk Munis The AAA-rated municipals currently yield about 30bps, more than Treasury bonds, which comes to around 140%. That isn't sustainable. Municipals are suffering right this moment from a liquidity crunch, as it looks like some muni funds are seeing redemptions. But this will pass, and eventually these munis will look extremely cheap. This is probably the cleanest trade you can do in bonds right now. Junk-rated munis are much trickier. The sector has a lot of airline debt, which could have some pain. This isn't airport debt, which ultimately will be mostly fine, but debt that is supported by Delta or American Airlines or what have you. It is also an extremely illiquid sector. The number of players in this market are very thin, and they all tend to get outflows or inflows at the same time. If you buy now and hold, you'll probably ultimately be fine, but I don't think it is the no-brainer than high-grade munis are. Corporate Bonds Suffering, too Corporate bond market volatility rivals 2008. This is a consequence of the decline in Wall Street market making that's been going on for a decade now. Real money investors have to set prices now. Wall Street isn't acting as a go-between. That will result in more volatility to be sure, but ultimately it is also more opportunities for active managers. Now, just because the volatility is like 2008 doesn't mean that we should take that comparison any further. When Lehman Brothers failed in 2008, economic conditions went from already weak to a crisis. Today we are going from an economy that is booming to one that is probably going into a short recession. The volatility in both cases stems from a high degree of uncertainty, but the downside in 2008 was far worse than the downside today.

Want to Slow the Pain of Covid-19? Here's How

Here's my take on bonds and the economy amid the coronavirus outbreak, which policies would work -- and what to considering buying now.

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