By Robert Phelan, CFA, GARP
(www.riskdirector.com , 973-2727-3603, bphelan@riskdirector.com)
April 13, 2020
The US Economy is too diverse to have one U-shaped, L-shaped, W-shaped, or V-shaped economic recovery. Each metropolitan area, each industry, and each firm will have a unique curve because of the strength of its business ecosystem. For example, we see that New York is experiencing a flattening of the Coronavirus infection curve, but how will New York differ in economic recovery from other areas?
An assessment of the economic recovery trajectory will lead to the development of appropriate risk strategies. Surprisingly, most business leaders are in concurrence with Wall Street commentators’ view that the economy has reached the low point of business activity, and the only remaining question is how long before we return to the full strength of pre-Covid-19 economic activity. However, when a priori assessments of sustainable economic activity are too optimistic, maintaining prior risk strategies could worsen business outcomes. I would caution that the economic effects have not bottomed out and that risk controls should be targeted to the geographies, industries, and firm idiosyncratic risks that will be magnified by millions of layoffs, small business closures, and tight credit conditions. From a most pessimistic viewpoint, “the J.P.Morgan economists estimate that the US gross domestic product is collapsing at a 40% annual rate” (Barron’s – Forsyth). It is unrealistic to assume the same consumer and business spend and debt capacity levels that we experienced in the 2019 economy because consumer behaviors will have changed.
Data Elements for Predicting Geographic, Industry, and Firm-Specific Economic Activity:
Because the economic activity will be uneven, it is important to adjust risk models with economic data to balance the control actions for high-risk accounts, while continuing to capture growth opportunities with prospects or customers that are on a faster recovery slope. Risk managers will need to be more agile with risk management decisions, given the uncertainty of the recovery. Risk monitoring will play a more critical role in the risk appetite framework for management and Boards. The Risk Appetite Framework at most banks will need to be updated for: criteria for mortgage and loan forbearance; the extent of workout and settlement programs given the speed of economic recovery; and the risk of a moral hazard if customers triage their debt.
The existing risk policies need to allow discrimination using a broader set of data, even if that data only modifies risk model estimates. Many of the rating agency models, e.g., Moody’s RiskCalc, are less predictive today, given the rapid change in demand and the deterioration in balance sheets of small and medium enterprises. Therefore, risk managers must rely more heavily on recent data. The following data elements may improve the risk assessment of consumers and business risk:
- Number of Metro Area Businesses shutdown and for how long: The length of time that non-essential businesses were closed by government restrictions or by lack of business demand should be correlated to the economic damage that the region sustained. The more damage and more Covid-19 cases, the more likely the economic recovery would be a U-shaped recovery rather than a V-shaped recovery. “On April 13, the governors of New York, New Jersey, Connecticut, Pennsylvania, Rhode Island, Massachusetts, and Delaware said on Monday that they would work together to plan for re-opening the region’s economies, schools and other important elements” (NY Times: Live Updates). Since these states have different economic ecosystems, monitoring the level of economic recovery and the infection relapse rate will be valuable data from these seven states.
- Weekly Unemployment US and by State: Company layoffs announced in the press or reported weekly by the Department of Labor should be monitored as an important coincident indicator of risk. “The seasonally adjusted insured unemployment during the week ending March 28 was 7,455,000, an increase of 4,396,000 from the previous week’s revised level. This marks the highest level of seasonally adjusted insured unemployment in the history of the seasonally adjusted series. The previous high was 6,635,000 in May of 2009” (DOL Blog). The level of unemployment claims has exceeded the Great Recession of 2009. “The largest increases in initial claims for the week ending March 28 were in California (+871,992), New York (+286,596), Michigan (+176,329), Florida (+154,171), Georgia (+121,680), Texas (+120,759), and New Jersey (+90,438)” (DOL Blog). The weekly unemployment rate and change in claims are available weekly as data for risk managers from the Department of Labor Blog. In all recessions, unemployment and changes in unemployment have proven to be the most consistent predictors of default risk and economic recovery.
- Corporate debt downgrades: Rating Agencies downgrades are a leading predictor of company layoffs and a lagging indicator of company risk. “US corporate bonds are being downgraded at breakneck speeds, highlighting the threat posed to companies’ balance sheets by the coronavirus crisis. The ICE BofAMLU.S. Corporate Index, has suffered $569 billion in downgrades since March 16, according to Bank of America” (Pelleiero).
- Supply Chain issues: Companies experiencing supply chain issues or mandatory plant-closings due to government mandates or loss of demand should be monitored for higher risk. For example, “Pace Industries LLC, which makes die-cast parts for Toyota Motor Corp., Fiat Chrysler Automobiles, Caterpillar, Inc., Harley-Davidson, Inc. and Whirlpool Corp. has filed for bankruptcy, saying the novel coronavirus has disrupted its supply chain and forced it to close plants and lay off 70% of employees” (Yerak).
- Demand Impacts: The shutdown of the airline industry and social distancing has reduced the demand for travel, hospitality, and the oil & gas industries. A reduction in the demand for real estate and automobiles points to increased risk for companies that sell high-ticket items.
- Government actions: The recent agreement with 23 countries to remove 9.7 million barrels of oil from production (13% of world production) is a leading indicator of accelerated defaults for energy companies with poor liquidity or weaker balance sheets. (Faucon).
- Monthly Balance Sheet Monitoring: For small and medium business lending, monitoring companies’ balance sheets and cash flows provide a pulse on businesses’ economic activity levels. VISA has a product in Plaid that can provide such data to lenders.
- Space Economic Activity Data: Many of my followers know that I was a senior software engineer on the Hubble Space Telescope. Consequently, I never miss an opportunity to inject a topic on Space data. “The Broad Activity Index, captured by SpaceKnow, monitors economic activity from the infrared spectrum. Satellite data above China indicates that 80% -90% of firms have re-opened based on the breadth of light captured. However, China’s economic activity index is still slowing based on the intensity of the light” (Barron’s – Beilfuss). Incorporating oil, coal, commodity, and manufacturing shipping activity to and from China is another useful data element for determining the shape of China’s recovery curve. A similar analysis of economic activity could be applied to the US.
References
Beilfuss, Lisa. “The View from Space: China isn’t Rebounding.” Barron’s, Dow Jones & Company, 13 Apr. 2020
https://www.barrons.com/articles/the-view-from-space-china-hasnt-started-to-rebound-51586551202
Forsyth, Randall W. “Could GDP Fall 40%? Gauging an Historic Economic Collapse.” Barron’s, Dow Jones & Company, 13 Apr. 2020
https://www.barrons.com/articles/is-the-economy-going-to-crash-because-of-coronavirus-how-quickly-will-the-economy-revive-51586560301
DOL Blog, “News Release: Unemployment Insurance Weekly Claims.” Department of Labor, 9 Apr. 2020
https://blog.dol.gov
Statista via Borodovsky, Lev. “The Daily Shot: Americans Familiarize Themselves with the Word ‘Forbearance.” The Wall Street Journal, Dow Jones & Company, 13 Apr. 2020
https://blogs.wsj.com/dailyshot/2020/04/13/the-daily-shot-americans-familiarize-themselves-with-the-word-forbearance/?guid=BL-278B-2097
Faucon, Benoit; Said, Summer; Puko, Timothy. “US, Saudi Arabia, Russia Lead Pact for Record Cuts in Oil Output.” The Wall Street Journal, Dow Jones & Company, 12 Apr. 2020
https://www.wsj.com/articles/opec-allies-look-to-resolve-saudi-mexico-standoff-and-seal-broader-oil-deal-11586695794/
Pelleiero, Sebastian. “Corporate Bond Downgrades Grow as Coronavirus Spreads.” The Wall Street Journal, Dow Jones & Company, 2 Apr. 2020
https://www.wsj.com/articles/die-cast-manufacturer-pace-industries-says-coronavirus-contributed-to-bankruptcy-11586801946/
Yerak, Becky. “Die-Cast Manufacturer Pace Industries Says Coronavirus Contributed to Bankruptcy.” The Wall Street Journal, Dow Jones & Company, 13 Apr. 2020
https://www.wsj.com/articles/die-cast-manufacturer-pace-industries-says-coronavirus-contributed-to-bankruptcy-11586801946/
The NY Times: Live Updates. “’Worst Is Over,’ Cuomo Says as 7 States Ally to Re-open Economy: Live Updates.” The New York Times, 13 Apr. 2020
https://www.nytimes.com/2020/04/13/nyregion/coronavirus-new-york-update.html
