Rosemary Pugh: Hello, this is Rosemary Pugh, head of global marketing at Research Affiliates. I am here to interview Professor Cam Harvey, a partner and senior advisor of the firm. Research Affiliates is committed to providing you ongoing communication in the face of this global health pandemic and market dislocation. Our aim is to help investors better understand and manage the potential risks and opportunities that emerge. Cam will speak on the Fed’s latest interest rate cut and market drop, how this crisis differs from the global financial crisis and others, and the specific steps needed by policymakers. Please send us your questions, and we will do our best to follow up with answers from our team of experts.
So, Cam, here’s the first question: Why did the Fed interest rate cut not calm the markets?
Cam Harvey: Haven’t we seen this before? On March 3, the Fed cut interest rates by 50 basis points. The reaction of the market was a drop of over 1,000 points. So, March 15, on a Sunday at 5:00 pm, the Fed drops rates to 0%, a 100-basis-point cut. Very, very aggressive. And what happens? The market plummets 2,000 points [at the time of this recording, ending the day at 3,000 points]. What’s going on? Basically, rates are already near zero. To go from 1.5% to 1.0% to 0% brings us to basically negative interest rates after we take inflation into account. This crisis is way different from 2008 when rates were 5.25% before the first cut in September 2007. Aggressive actions like this seemed to be okay for the 2008 crisis, which was a banking crisis; this is much broader.
Aggressive actions such as this are also confusing in that they cause uncertainty and panic. Investors are thinking we’re headed toward the Japan liquidity trap, which means rates are just permanently near zero. The only buyer of Japanese government bonds is the Bank of Japan—that’s a bad equilibrium. We’ve avoided it for a long time, but the Fed believes this is the first choice.
I have written on this extensively. This very low interest rate policy leads to distortions in our economy, and indeed, potentially leads to slower growth in the future. We’ve seen this play out in Europe and Japan. I wasn’t surprised, because this is just a replay of what we’ve seen. The Fed also announced a very aggressive $500 billion in Treasury purchases and $200 billion agency mortgage-backed security purchases. Again, what does that do? It essentially decreases interest rates even more. That’s not what we need right now. We need a different playbook.
Rosemary: And why did the market drop by so much?
Cam: Usually, it’s really difficult to explain why the market goes up or down. Pundits are telling us why the market went up 100 points or 200 points with this and that explanation. This time around, it’s really easy to understand why the market went down. Obviously, stock prices are a function of two very important things. Number one is expected future profitability. And that has taken a haircut. And number two is risk, or uncertainty. We can think of stock price movements as the confidence we’ve got in a firm’s expected profitability and how the profitability of the firm correlates with the economy. Uncertainty has increased dramatically. When uncertainty increases, prices come down. When expected profitability decreases, prices come down. So it’s very easy to explain why the markets have fallen.
But the more important question is, why has the market gone down so much? To answer that I looked back at 2003, which was the year of the SARS scare. Obviously, SARS wasn’t nearly the threat that COVID-19 is today, but in then, in real time, people weren’t traveling, and it was a significant scare. If we look at the reaction of the market, we can barely see anything. The reason is that the market was already in a bear market, in a drawdown of over 40% after the tech bubble had burst. Given that valuation levels were already low, there wasn’t much room for the market to go down further, so we didn’t see a big reaction.
This is in contrast to the recent crisis, where we were at an all-time high, leaving plenty of room for the market to correct. This is part of the reason we see such a large increase in uncertainty. There is consensus that growth has taken a major hit and there will be a recession in 2020, hopefully short. The severity of the drawdown is linked to the fact that we were already at all-time highs and the stock market was a bit overvalued to begin with.
Rosemary: How is this crisis different from the global financial crisis?
Cam: It’s a serious mistake to think the same toolbox can be used for the global financial crisis and the current crisis. Let me explain why. The global financial crisis that began in 2007, and really got bad in 2008, was a financial event causing a financial crisis, and the target of mitigation was to bail out the banks. The banks had taken very large amounts of risk. Then when something happened in the market, that didn’t really seem that big, because they were highly levered, many banks were put at risk, and the government had to come in and do a very unpopular bailout. Since the global financial crisis, banks’ balance sheets are in much better shape, and the regulators have made sure to do stress testing. So the global financial crisis was a financial crisis basically caused by a financial event, whereas the crisis today is a financial crisis and a health crisis caused by a biological event.
The banks were the most vulnerable part of the economy in 2008. They’re a lot stronger today. The most vulnerable today are small- and medium-sized businesses that are integral to our supply chain. It’s very important to realize that the banks are stronger today. Indeed, the Fed cut the required reserves that banks must hold with the Fed to zero. But this is just symbolic. The banks have $1.5 trillion of excess reserves at the Fed.
At the beginning of the global financial crisis, banks had only $2 billion of excess reserves at the Fed. Today there’s a huge amount of reserves parked at the Fed collecting interest. I worry about these banks deciding maybe they should just keep the excess reserves at the Fed and not provide much-needed lending to small- and medium-sized businesses as well as other businesses that are at great risk, like the airlines.
Rosemary: What can we learn from other crises?
Cam: The problem with learning from other crises is that they’re all different, so we need to be really careful. For example, I think our policymakers are making a mistake by using the same playbook they used in 2008. 2020 is a different crisis. I’ve looked at the history and there are some comparisons, but we need to be very careful.
In 1918, the Spanish flu pandemic was incredibly deadly. Six times more Americans died from the Spanish flu than were lost in World War I. We see very little evidence that the stock market was going down because there was a countervailing force: in 1918 World War I had just ended and there was a peace dividend; people saw that growth prospects were increasing. The Spanish flu pandemic was a confounding event and it is really hard to read anything into the data of 1918 that we can learn from in 2020. One comparison that is kind of similar—it’s not a pandemic, but it was a crisis of confidence and had a very large amount of uncertainty—was 9/11.
At the time, the market closed down, and people didn’t know if it was the beginning of a larger threat. We could see economic growth slow. We could see negative movements in the market. But, of course, that was resolved over many years. I think it’s probably the closest comparable to what we are experiencing today. Again, the difference is where the market started at the onset of the crisis. 9/11 was somewhat similar to the SARS scare when the market was already in a drawdown. The tech bubble had burst and prices had already come down. Our situation is much different today in that the market was at the peak, at an all-time high, when the crisis started, so it seems very dramatic to end up today where the market was in June 2017, which is a huge loss. But if you have a very long investment horizon, it looks a lot more painful than it actually is.
The key thing in terms of what we can learn here is the turning points. The turning point in this particular crisis will be when the number of new COVID-19 cases starts to decrease. This is very clear, and hopefully that happens fairly quickly. This also contrasts with the global financial crisis, which was a very long recession. In real-time in the global financial crisis, we weren’t sure if it was serious, maybe a problem with a few banks, no big deal. And then it became a slow-moving train wreck. It just got worse and worse and worse.
In this particular crisis I think there is a time line for it. Other countries have gone through what the United States is going through, so we can actually see the future. A good comparable, in my opinion, is South Korea. I think we’ll see that this crisis is short lived in terms of the maximum pain. The real question is, can we mitigate the damage to the economy so that we can snap back with a V-shaped recovery rather than a U-shaped or, even worse, an L-shaped recovery? It is incumbent upon our policymakers to make sure that we’re in the best possible shape in terms of our economic recovery. And, of course, all of this is secondary to the issue of health.
Rosemary: What specific steps should be taken by policy makers given the challenges we face?
Cam: The key thing is not to make the same mistakes we made in the global financial crisis. In 2008, many of our large banks were at great risk of failing. The government made, at the time, a controversial decision to bail out these banks, even though these banks essentially were failing because of the massive risk they were taking and the lack of risk management. The focus was on the banks.
Given that the banks were very stressed, the banks essentially focused on their largest customers and ignored the small- and medium-sized businesses. This time around, it’s different. It’s different because the banks are a lot healthier. This was not a crisis caused by excessive risk-taking by the banks. The banks have been stress-tested. And they will be stressed, perhaps beyond the stress tests that the Fed has already conducted multiple times. They will be stressed, but the focus should not be on the banks, but making sure that the banks provide the necessary liquidity to the corporations.
By that I mean not just the large corporations, but the small- and medium-sized businesses. We don’t want to repeat the mistake of the global financial crisis, where small- and medium-sized businesses were essentially ignored. This crisis is different on many different dimensions. One is that many companies were doing a great job. They were profitable, providing perhaps an important link in the supply chain. Yet this exogenous event, like a natural disaster, hit and put them at risk. Thus, to let them fail would be a huge mistake. If these firms, many of which are integral to the supply chain, fail, there will be very considerable unemployment.
On top of that, it will take a very long time to recover from this economic shock. Our policy makers should insist that the banks make at least an equal amount available for both small and large businesses. That is essential. Some of the things the Fed has already done, for example, the repo facility being increased, is useful in terms of liquidity. Again, that’s a page of the playbook from 2008. But what I’m most concerned about is that the small businesses have to get bridge financing from the banks. That needs to be made a priority. This is a crisis that’s hitting everybody, a different aspect than the global financial crisis. Therefore, we need to focus on making sure the supply chains are resurrected.
Rosemary: And why are small businesses so important?
Cam: Often the large businesses are the ones in the news; Apple and Google and very large firms get all the profiles. However, 49% of the employment in the United States is from small- and medium-sized businesses and 51% is from large businesses. Thus, they are a very important part of our economy. But, more importantly, 61% of employment growth comes from small- or medium-sized businesses. Often these businesses are cloaked in the supply chains. We know as consumers what company is producing a good and we know the final seller of the good, but the supply chain for parts of that good critically depend upon smaller businesses that we are largely unaware of. So this crisis could be made much worse if we do not focus on that supply chain, which means we need to focus on small- and medium-sized businesses. This is why I’ve been aggressively advocating that our banks need to provide the same type of bridge financing extensions of credit lines they’re giving their largest customers to their smallest customers.
Rosemary: Thank you, Cam. And thank you all for joining us today. We are here to provide you regular updates to help you cut through the noise and get an informed, long-term perspective on the investment landscape. Please don’t hesitate to reach out. We appreciate your support and are available to answer any questions. Thanks again.