The Systemic Risk of COVID-19

A U.S. recession may already have begun. Many have reached out to ask me about the economic implications of the COVID-19 crisis. Here is what we have learned. 

• The U.S. economy was already slowing before the outbreak. The yield curve had inverted in the second quarter of 2019 signaling slower growth. 
• Many initially discounted the extent of the COVID-19 risk thinking that it was temporary and could be contained.
• This week investors sharply revised their expectations of the extent of the economic damage (in addition to the human damage). 
• Stocks were punished because slower economic growth reduces future profits. In addition, heightened uncertainty also contributes to depressed prices.
• Investors derisk (sell risky assets like stocks) and buy less risky assets (10-year Treasury bond). This is known as “risk-off” trade.
• Buying pressure in the 10-year U.S. Treasury pushes bond prices upwards and long-term yields plummet.
• The yield curve quickly re-inverts. The reason for the re-inversion is consistent with my yield curve model – investors expect lower economic growth.
• Usually globalization allows countries to share risk (you might be hurt if one country you do business with goes into a recession but that might be offset by another country doing well). This episode is different for two reasons. First, China is not just another country – it is integral to world growth and world supply chains. Second, investors realize this is not just a China problem. Other countries, such as Korea and Italy are impacted and the virus could spread further. 
• The markets seem to be telling us that a recession is highly likely. Indeed, the recession may already have begun. This is not just theoretical. We can all see the videos of ghost streets and shuttered factories in China.
• Even purported “safe haven” assets like cryptocurrencies are being punished. They certainly do not look like a hedge to me.