February 2020

We’re going to start this monthly update by focusing on the positive because there is so little of it in the media lately.  The most notable news was the February employment report which astounded investors with a gain of 273,000 net new workers joining the workforce, 100,000 more than had been forecast.  Moreover, the previous month was revised from 225,000 net new workers to 273,000.  The unemployment rate again fell to the all-time low of 3.5%, and while the year-on-year wage gains ticked 0.1% lower from the following month, they were still a quite respectable 3.0%.  Similarly, the housing market appears to have kicked into high gear, benefitting from the drop in mortgage rates that has corresponded with the Fed rate cuts last year.

From that initial backdrop, one could be excused for assuming that the economy would be happily cruising along.  However, that’s before the Coronavirus outbreak gained momentum around the world.  The virus began in the City of Wuhan, China where government officials implemented a lock-down quarantine of the city.  Since the initial outbreak the total number of reported cases in China has fallen, according to reports, but not before causing a sharp economic slowdown in that country. 

Since late February when the various equity indices touched all-time highs, investors have been decidedly better sellers of stocks, and in a matter of days the S&P 500 had fallen nearly 15%.  Despite the economy running at full speed, the Fed On March 3rd, surprised investors by lowering the Fed Funds rate by 50 basis points.  The surprise cut assuaged fears temporarily, but that was before Saudi Arabia dramatically cut the price of oil to punish Russia for not joining them in a production cut.

A byproduct of the slowdown in China has been a sharp drop in oil consumption in the region which has pressured oil prices.  In an attempt to force prices higher, OPEC decided that they would cut production and invited Russia, the unofficial OPEC member, to join them.  Russia demurred, prompting OPEC to take the offensive and cut the price of oil they sell.  Given that oil is a fungible commodity, the price cut reduced the revenue for all producers, including Russia and the United States.  While the cost of production varies for each producer, it’s estimated that U.S. oil production becomes unprofitable below approximately $45 per barrel.  Therefore, in cutting the price to $30 a barrel, the Saudi’s punish Russia and the United Sates. 

That further panicked equity investors, with the fear being that the strong economic growth witnessed in February was going to very soon turn into an economic downturn.  The concern is that with oil prices at unprofitable levels, U.S. drillers would be forced into bankruptcy and that would, in turn, weigh on the profit of the banks that had loan exposure to them.

Similarly, with the virus materially slowing business activity, it’s likely that the longer the problem lasts, the greater the hit to profitability of American business. 

In response to that prospect, the Federal Reserve has taken the unexpected step of lowering the overnight Fed Funds range to 0.00% to 0.25% and has committed to buying an additional $700 billion of Treasury securities in the open market.  We fail to see how that will do anything to persuade anyone to take a cruise, fly on a jet or attend large gatherings.  It seems likely that the volatility in capital markets will continue until the virus is brought under control.

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