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Wednesday, March 18, 2020

On Pandemic Economic Scenario Analysis

The increased flow of information about the coronavirus means that we can think about scenario analysis. This, as well policy actions, are probably explaining the pause in the bear market for risk assets. I want to outline what I see as important about looking at potential scenarios for the economy. I will try to keep this as brief as possible, since I am not advancing any particular scenario as a forecast.

Medical Scenarios

I have been on Twitter quite a bit recently, and one common complaint I have seen is that are apparently too many people with no medical/disaster analysis training making too many forecasts. Although that is true, one needs to keep in mind is that being a generalist is exactly what anyone in macro trading has to do. For a fixed income person, you need specialised information on the peculiarities of fixed income markets. But if you want to forecast anything, you are often going widely afield. For example, you need to have a pretty good idea of what is happening in the oil markets if you are trading inflation breakevens.

The skill you need to have is to be able to read technical presentations by subject matter experts, and translate it into terms that are useful for yourself. And yes, it may mean that you end up disagreeing with the experts, although that is hopefully about the implications elsewhere, and not the specialised subject matter.

I do not want to add any disinformation myself, and so I will avoid discussing the medical outcomes too much. I just want to make the following observations, which appear highly defensible.
  • I am looking at things from a Canadian/American perspective, where cases generally have not really hit critical levels. Other countries that have been hit earlier probably have more information to work with. These countries' experiences should be taken into account when looking at the lagging countries.
  • I am taking a slightly optimistic stance that social distancing will be enough to avoid completely catastrophic outcomes. My argument is that once intensive care units are under severe pressure, quarantines are enforceable.
  • There is an extremely popular chart comparing the growth rate of cases in a country once 100 cases have been hit. (Many countries show a 33% daily growth rate trend.) This chart is probably the most useful summary for thinking for us non-specialists, but we might need to keep in mind the possibility of differing circumstances. Can other countries replicate the response of Singapore? To what extent does the age profile of the population matter? Air temperatures? These factors appear obvious, but the risk is that some market participants take charts like this too literally.

Maximum Output Scenarios

Let us look at the profile of maximum work hours, which will correspond to the theoretical maximum output.

We can see a few potential profiles.
  • The optimistic profile, where the drop in activity is one-off, and returns within a few months. We could imagine that testing, treatment, or a vaccine could eliminate the threat of the pandemic.
  • The pessimistic profile, where the measures cannot be lifted for a long time. 
  • The relapse scenario, where measures are removed, then returned. In North America, this could easily be regional in character.
From an individual standpoint, the relapse scenario might feel very bad, since it creates huge uncertainty about your plans. But from an abstract economic perspective, the later relapses will be a return to a known state, so they will be less unsettling for markets, and policymakers will hopefully have the kinks worked out with their policy response.

Financial Considerations

The reality that everyone has cash flow requirements messes up the story about production only depending upon labour availability. People and firms can go bust.

This is extremely well known, and the focus of practically everyone is on the stresses that will be faced by households and small businesses. Policymakers have been acting in Europe and Asia, and "Anglo" country politicians are following with a lag. There is no international one-size-fits-all policy, as each country has its own peculiarities.

Big corporations are easy to deal with, since there are only a few that will need help. There is no equivalent to the logistical problems of mailing a lot of cheques to individuals (for example). I have no doubt that big businesses will get bailout money from politicians, the only question is whether the politicians take some scalps this time (unlike 2008).

Central banks have the tools to keep the money centre banks solvent, which are needed as market makers if financial markets to function. The only serious risk is the Euro area, where we have to rely on moral hazard.

Most of the analytical work for scenario analysis is judging whether policies announced will keep households and small businesses functioning. 

Oil Market

The other major macro event is the situation in the oil market. Demand is cratering, and supply continues to flow. Other commodities are seeing similar weakness, and so that creates another chain of disruptions in the economy. This analysis has less fundamental uncertainty than the analysis of the pandemic, but it cannot be ignored. What happens to the U.S. energy sector will have a big impact on the credit markets.

Dollar Funding

Another market event that has historical parallels is the increase in the value of the U.S. dollar. To what extent foreign entities were borrowing in U.S. dollars, this is disastrous. Some central bank swap lines were implemented, but I do not believe that the developing countries were adequately covered.

From a developed economy perspective (e.g., Canadian dollar), this is a market event, but of limited importance for the domestic economy. This is less true for developing countries.

Known and Unknown Unknowns

What I have covered is relatively well known, or at least a known unknown. However, once we look at longer forecast horizons, there are some very big questions. Some things I am wondering about (which might not be the most important).

From a traditional macro policy standpoint, the big issue is that we have the conjunction of governments attempting to keep nominal incomes stable while productive capacity is being deliberately shut down. One could easily tell an inflationary story about this. However, I think one will need to dis-aggregate the price index, as there is a simultaneous demand collapse, and some prices are under severe downward pressure (e.g., oil).
  • The future of globalisation is unclear. Having populations locked down for months as a result of a disease that spread internationally is going raise question marks about the value of globalisation. The risks associated with allowing medical supply chains to migrate overseas were also uncovered. One could see efforts made to reclaim manufacturing capabilities.
  • Housing markets are likely to be frozen, and the prospects do not look entirely promising. From the Canadian perspective, the housing market was the main source of macro vulnerability, and this is not a helpful situation.
  • We are likely to see a further shift towards larger versus smaller firms.
  • The way in which health care is managed in the United States is likely to come under extreme scrutiny.
  • Universal basic income schemes will be of increased interest. However, governments have done one-off payments in the past, without it becoming a full-time policy.
  • Conventional macro indicators that are based on inference from historical time series (output gap, NAIRU, r*), will be even more useless than usual in the coming quarters.

Fixed Income Markets

In the United States, with the cut to zero, it seems that the rate forecasting business will get quiet again, once the initial turbulence dies down. Right now, we are presumably seeing fund liquidations, and so price action is extremely volatile.

Although I am a firm believer in rate expectations being the dominant factor in bond pricing, this breaks down if nobody has the capacity to hold positions based on valuation consideration. In particular, breakeven inflation is likely to be unhinged from inflation forecasts, much as in 2008. Although some people have a rather desperate desire to dunk on rate expectation theory, the reality is that pricing right now is being driven by fund liquidations. Nobody can seriously posit that as a valuation tool anything outside of a crisis, and it tells us nothing about valuations (since we do not know global investor positioning, all it does is offer a back story about price changes that have happened).

The only question is the next move. 
  • Will the Fed go negative?
  • When will the first rate hike come?
The real excitement in fixed income markets will be credit markets, funding markets (e.g., cross-currency basis), and inflation-linked markets.

Risk Assets

Stock picking may be at a premium. Normally just buying the index near the bottom of a crisis based on macro considerations has paid off, but we are likely to see an extremely wide variance in outcomes for firms. The most obvious examples are the problems faced by the airline and cruise industries. Beyond pointing that out, I leave this to the reader.

(Note. This \wraps up a wave of free form comments on market developments. I will probably revert to writing about other topics that are aimed for publication in a book.)

(c) Brian Romanchuk 2020


  1. As I read your post, I extract quite a sense of confusion. 'Confusion' underlays my own post found at

    I am observing a failure of 'reference points'.

    The most recent reference point to fail is interest rates. A zero rate is no rate.

    Earlier, increasing oil supply in the face of declining demand is a failure of reference points.

    The work stoppage related to the coronovirus is the biggest reference point failure of all. It destroys cash flow, demand and supply.

    Having lost these three reference points, we (as decision makers) are forced to reexamine our economic roles as we respond to titanic forces. Who owns what?

    The first owner of any business is government; able to extract taxes and control conditions. The second owner is the lender (if any); able extract interest and take control to enforce conditions. The third owner is the 'owner'; able to extract profit and exercise normal management control. The forth owner is the worker; able to enter into mutually beneficial arrangements with the third owner but lacking business control.

    The reaction by government to the coronovirus has disrupted not only only reference points but also the cash flows binding the ownership chain together. Agreed upon conditions have become impossible to fulfill.

    To be decided: Who will take the financial hit and end up with future control?

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