Economic Impact of COVID-19

When the SARS (severe acute respiratory syndrome) hit southeast Asia in early 2003, I was working in the U.S. real estate organization of my company, and I was not personally affected by this virus. I do, however, remember getting a call from my good friend Joe at the height of the epidemic. Joe, who had replaced me as the head of international real estate finance, had just returned from a trip to Toronto to meet with our real estate development partner. At the same time, several cases of SARS were discovered in greater Toronto, and upon Joe’s return back to Arkansas, our company had placed him in quarantine for two weeks. I found this quite funny, and so I gave my friend a very hard time for being stuck at home for two weeks in quarantine.

Earlier this year, when the news started to come out from Wuhan, It immediately drew my attention, as I still follow events in China because on my past experience there. In addition, my wife is from China, and she lived through SARS epidemic in 2003-04. Upon hearing the news that Hubei province was being locked down, she immediately sent me to Walmart to buy face masks, latex gloves, and hand sanitizer. We also began stocking up on basic food items. I admit at the time I thought this was a little crazy, but luckily I am a good husband and purchased all of the items on her list. And I am so glad I did! The next week there were absolutely no gloves or face masks to be found anywhere.

I immediately recognized this could be a serious situation. There is no way the Chinese government would lock down an entire province unless the situation was dire. It amazed my wife and I that, early on, the U.S. mainstream media almost completely ignored the situation. The U.S. news channels had 24/7 coverage of the impeachment proceedings at the time, but I felt the outbreak of the corona virus in China was a much bigger story. My wife was in touch with her family back in China on a daily basis, and we learned that people in her home city were very cautious about getting out.

I came into the year of 2020 with a cautious outlook. In my opinion, stocks, bonds, and real estate were all overvalued. We were in the longest economic expansion in history of the U.S., breaking the previous record of 120 months that had ended with the bursting of the dot com bubble in March 2001. I had started restructuring my investment portfolio in late 2018 to be more recession-proof. I was a bit early in making this shift and could have taken advantage of some nice gains in the market had I stayed more aggressive back then, but I slept much better at night knowing I was protecting myself from downside risk. And I did o.k. on my investments, just not as good if I had been more aggressive.

So here we are in May 2020. Is it just me, or does it feel like this year has lasted about 2 1/2 years?Below is a list of the significant occurrences so far this year:

• January 3: A U.S. drone strike kills Iranian general Qasem Solemani.
• January 8: Iran launches ballistic missiles at two Iraqi military bases housing American soldiers.
• January 8: Ukraine International Airlines flight 752 is shot down by Iran’s armed forces.
• January 16: The impeachment trial of president Donald Trump begins in the U.S. Senate.
• January 30: The World Health Organization (WHO) declares the outbreak of the disease as a Public Health Emergency of International Concern.
• January 31: The United Kingdom formally withdraws from the European Union.
• February 5: The U.S. Senate acquits president Donald Trump.
• February 27: The Dow Jones Industrial Average (DJIA) drops almost 1,200 points, or 4.4%, which is the largest one-day plunge (by points) of all time, and the week ending February 28 is the largest weekly decline since 2008.
• March 8: 16 million people are placed in quarantine in Italy.  The next day the quarantine is extended to the entire country.
• March 9: The DJIA drops more than 2,000 points, once again setting the record for the largest one-day drop in history.
• March 9: Oil prices drop as much as 30% during the day after Russia and Saudi Arabia cannot agree on production cuts over the preceding weekend.
• March 11: The WHO declares COVID-19 a pandemic.
• March 12: Global markets crash again, with the DJIA dropping over 2,300 points.
• March 14: Spain goes into lockdown due to a surge in the number of cases of COVID-19.
• March 16: the DJIA drops almost 3,000 points, setting more records for the largest daily drop.
• March 17: Iran warns that millions may die as the virus spreads throughout the country.
• March 24: India goes into lockdown.
• March 24: The UK goes into lockdown.
• March 30: The price of Brent Crude falls to $23 per barrel, the lowest since November 2002.
• April 7: Japan declares a state of emergency due to COVID-19.
• April 8: China ends the lockdown in Wuhan.
• April 14: The International Monetary Fund (IMF) announces that it expects the world economy to shrink 3% in 2020.

Wow. What a year, and not yet halfway over! I believe Vladimir Lenin was right when he said, “There are decades when nothing happens, and there are weeks were decades happen.”

So, if you are like me, you are wondering what will happen next?  As we begin to open the economy back up, will life get back to “normal” quickly, or will it be a long and difficult period that we must face before the world economy stabilizes?  I do have a quick, pithy answer to these questions.  No one knows.  We have never faced a situation like this.  Never. 

Sure, the Great Depression had produced a stock market crash where the drop, from the peak on October 24,1929 to the trough on July 8, 1932 was 89.2%!  Let that number sink in.  Let’s say you had $10,000 saved up and invested in the markets back in 1929. By the middle of 1932, your investment would have dropped to $1,080.  People who had invested in the stock market were almost completely wiped out.  Now, back in the 1920s and 1930s, it was the wealthy people who invested in the market.  However, in 1929 the drop in the stock market was a reflection of the weakening economy, where weakening demand drove decreases in company profitability, which drove job losses.  The unemployment rate peaked in 1933 at 24.9%, with 1 out of every four people losing their job.  I remember seeing photos of men and women standing in line to get a meal, as many families suffered during these challenging years. 

The question on many people’s minds these days is, “Will the pandemic lead to another depression?”  First, let’s define that term.  According to Investopedia (www.investopedia.com), an economic depression is “a severe and prolonged downturn in economic activity.  In economics, a depression is commonly defined as an extreme recession that lasts three or more years or which leads to a decline in real gross domestic product (GDP) of at least 10% in a given year.”  A recession is commonly defined as two or more quarters with declines in GDP.  In the first quarter of 2020, GDP declined by 4.8%, and it’s a foregone conclusion that second quarter GDP will be negative.  Remember, the economic impact of COVID-19 did not impact the U.S. economy until mid-March when quarantines began in many parts of the U.S. and Canada.  Since the second quarter ends on June 30, we only have forecasts at this point for Q2 GDP.  Here are a few estimates that I found:

• Kiplinger                       -30% to -40%
• Morgan Stanley               -38%
• PIMCO                         -30%
• The Conference Board  -45%

These unprecedented numbers are horrendous.  And I’ve seen several unemployment forecasts of greater than 20% by the end of the quarter.  Earlier in March, many forecasters were expecting a V-shaped recovery (quick decline followed by quick recovery), with GDP rebounding in Q2.  Now the recovery forecasts are being pushed out to Q3 or Q4 by the most optimistic forecasters, and I fear these may be too aggressive.

Not to belabor the point, but the economic challenges we face today are unprecedented.  Just think about it.  This virus has led to the almost complete shutdown of practically every economy in the world by at least 8-10 weeks.  While there are encouraging signs from China that a second wave of infections has not yet hit, the truth is China is far ahead of western countries in regards to volume of testing, contact tracing of infected people, and their aggressiveness in controlling the spread of the virus.  Let’s hope that other countries are prepared for this when reopening begins.

So, even though I do not believe we can accurately predict the economic damage and when we will get past this, there are certain economic indicators that I am focused on.  And no, the stock market is not one of them.  Because of the central banks injecting liquidity into the economy at unprecedented levels, the stock markets have become even more distorted than they were before, with the result being the rich get richer as the market gets inflated again.  That is a topic for another day, so let’s move on to what I am closely watching:

1. Industries directly impacted by COVID-19 – I include on this list airlines, hotels, resorts, cruise lines, car rentals, taxis, Air Bnb owners, etc.  Will these industries get bailed out?  If so, what does that look like?  The travel industry has been absolutely slammed, beginning with the early travel restrictions in February.  And then, of course, we had the Diamond Princess saga, where all 3.700 people on board were held in quarantine on the ship for 14 days.  Can you imagine being an executive for a cruise line and watching in horror as these events unfolded?  Late last year, my wife and I had discussed taking a cruise sometime in the next year or two.  Now?  There is no way we are getting on a ship!
2. Second-order impacted industries – I define these as the businesses that were not directly impacted by COVID-19 but are now suffering due to the quarantines/lockdowns.  And as I begin to think of these impacted industries, the list very quickly got really long.  In fact, a list of industries not impacted would probably be much shorter!  At the top of my list, however, would be the following: restaurants, clothing retailers, convenience stores, real estate agents, cinemas, sports leagues, musicians (i.e. concerts), automobile dealerships, etc.  You get the idea.  Almost every industry has been impacted to some degree.
3. Bankruptcies – This is one area I will watch closely.  As I monitor the companies declaring bankruptcy, I also think about who else gets impacted.  For example, when a retailer files for bankruptcy, the other companies, entities, or individuals impacted are banks (loans are assets on the balance sheet), bondholders (i.e. pension funds, banks, individual investors, etc.), landlords (the retailer typically can reject any leases for locations where it longer wants to operate), employees (layoffs), etc.  So as bankruptcies occur, their impact on the overall economy is multiplied as other entities down the line get impacted financially.

So let’s see who has filed bankruptcy so far this year.  This is not a complete, all-inclusive list, but it is a good representation of the industries that are being impacted so far.

Restaurants: FoodFirst Global Restaurants (71 of 92 restaurants temporarily closed do to virus); Garden Fresh Restaurants (Souplantation, Sweet Tomatoes; liquidation); Krystal; Village Inn.

Retailers: JC Penny; J. Crew; Neiman Marcus; Papyrus (luxury greeting cards); Lucky’s Market (supermarkets; filed one month after Kroger divested of its interest in the company); Earth Fare (organic grocer; some of the 50 stores will stay open after being acquired by a new owner); Pier 1 Imports (seeking buyers after announcing closure of all 450 stores); Art Van Furniture; Modell’s Sporting Goods (will liquidate all stores after failing to find a buyer); True Religion (previously filed for bankruptcy in 2017); Stage Stores (Goody’s, Palais Royale, Bealls, Gordman’s; will start winding down operations while trying to find a buyer).

Oil & Gas: Diamond Offshore Drilling; Whiting Petroleum Corporation.

Other: XFL; Noah’s Event Venue (offers spaces for various gatherings); Gold’s Gym.

As you can see, so far retail has been the hardest hit industry when considering the number of bankruptcies.  So it’s no wonder that there is speculation about shopping center owners that are highly leveraged and whether they can avoid bankruptcy. And there are quite a few more retailers that have not yet filed but are at risk of filing for bankruptcy. 

As most of my career was spent in the retail industry, I continue to monitor retailers rather closely.  Below is a list of retailers that have been severely impacted by the economic shut-downs that, in my opinion, are at risk of making it through this challenging environment, especially if re-openings do not happen soon:

Gap: Moody’s downgraded their bond rating to Ba1 (junk) on March 26.  On April 1, the company announced they had suspended rent payments under the leases for their stores that are temporarily closed, and they are negotiating to defer or abate their rent in these locations.

Tailored Brands: Moody’s downgraded the company to B3 (speculative and subject to high credit risk) on March 26.

Game Stop: Announced on April 21 that it did not make a portion of lease payments where stores were closed due to governmental regulations and properties closed due to landlord decisions.  They remain in discussions with landlords regarding ongoing rent payments, including potential abatement, deferral, or restructuring of future rents.

Bed Bath & Beyond: On April 3, Moody’s affirmed its rating of Ba2 (speculative and subject to substantial credit risk) but changed its outlook to negative due to uncertainty of duration of the store closures, impact on liquidity and credit metrics as well as the pace of rebound in consumer demand once the pandemic begins to subside.

Well, this note ended up being a lot longer than I anticipated, so if you made it through and are still reading, thank you! I have been considering starting a blog for a couple of years, but I always found an excuse not to do it. Luckily, it was a holiday today here in Canada, so I had the time to finish this note. The next few years will likely have many ups and downs, but I know we will come out of this stronger. I hope you have a great rest of the week!

Best Regards,

Brent

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