The Road to Recovery
Our forecast from last May outlined the four stages of economic distress that we anticipated would develop as a result of the COVID 19 pandemic. Those four phases were:
1. The Great Pause
2. Cashflow Deterioration
3. Cascade across markets
4. The New Normal
That forecast was based on the history of previous recessions and failed to account for never before seen levels of government financial and regulatory relief. Regulatory relief was extended to 2022, EDIL grants and SBA loan levels were increased, the eviction moratorium is set to expire in mid-summer 2021, the second round of PPP loans are being distributed, and enhanced unemployment along with a third stimulus check is working its way through the economy. Many companies that were initially hit hard have learned to adapt and survive the pandemic.
This has had two major impacts on the economy which we didn’t forecast. First, the massive government interventions have done wonders for those experiencing growth as a result of the pandemic. They’ve enjoyed stable demand from customers who might otherwise have been in deep distress and many have been able to consolidate their growth into a new normal already. And many or even most of the sectors hurt by the pandemic have used the help to avoid entering a death spiral, but they continue to teeter on the brink of disaster. In short, the US economy has bifurcated into two realities: the boom and the bust, depending on how one was affected by the pandemic.
With the vaccine now available to everyone who wants it, cities are expected to reach herd immunity levels by the end of summer. People are returning to work, and the economy is projected to grow at 6.5% GDP for the year. Much like in the years following the flu pandemic of 1918, as normalcy returns, there is $2.6 Trillion in pent-up consumer savings that will be released with a vengeance. Additionally, government policy is considering additional spending packages focused on returning the United States to full employment as soon as possible.
This is a recipe for boom times.
Massive and ongoing government intervention has dramatically slowed the economic disasters facing many sectors. So, instead of a deep and ongoing recession, we foresee a series of waves approaching.
Wave One: PPP Round 2 Rejections
The first wave of distress is beginning to emerge. Over the past year, Small and Medium Size Businesses (SMBs), in large part, got frozen out of the bankruptcy courts as companies rapidly cut expenses, received PPP and EDIL funds to fill holes, and obtained regulatory relief from the banks. That trend is starting to reverse as funds run dry, and companies haven’t been able to obtain round 2 of PPP as easily as round 1. Those companies who got rejected from round 2 for one reason or another are now filing for bankruptcy.
Wave Two: PPP Round 2 Runs Out
By Fall, Round 2 of PPP funds will start to run out, and another wave of distress will emerge. While plenty of companies should be buoyed by the economic recovery, plenty of others were struggling before the pandemic and only survived due to direct government support and indirect regulatory relief.
Wave Three: Regulatory Relief Expires and Zombie Companies
By Q4 of this year, banks will have a quarter of ‘post-pandemic’ financial results. This will allow them to start triaging their portfolios of who will recover and who will be left behind. At the stroke of midnight on December 31st, 2021, the regulatory relief provided to the banks will expire. They will be forced to take action on their troubled credits. However, it’s likely that banks won’t wait until the stroke of midnight to start moving their most troubled borrowers off of their rolls in order to maintain capacity as they go into the new year.
According to researcher Edward Altman, who famously developed the Altman Z-Score for predicting bankruptcy, 20% of American companies are considered “zombies”, meaning they are only able to make interest payments but cannot reinvest in their business. In addition, 8% of American companies are considered both zombies and have a 0 on the Altman Z scale, meaning they have an extraordinarily high likelihood of default in the near future.
Wave Four: Inflation and Interest Rates
In a typical recession, inflationary government spending is used to counteract the deflationary forces of reduced consumer spending and the destruction of consumer credit. Yet this time around, many of those deflationary forces are accumulating behind dams. Savings and debts have swelled without the relief of bankruptcies, which have barely budged. This delayed deflation, in addition to countless supply chain issues, is a recipe for higher than anticipated inflation.
Some inflation will be transitory as government loans made during the pandemic will roll off and minor supply chain issues get resolved. Still, many other inflationary drivers will likely be around for the next 18-24 months.
The global supply chains have not recovered from the capacity losses, end product demand changes, and inventory imbalances created during the pandemic. Supply chains that could previously handle minor shocks are now fragile. They unravel when faced with historic weather events, trouble in the Suez, ransomware attacks, and crumbling bridges. Adding salt to the wound, consumer panic buying behavior then depletes what remaining stock is left.
Higher than anticipated price increases are the result of supply chains struggling to recover their balance against this tidal wave of demand. April 2021’s CPI increased 4x over expectations.
Deflationary pressures will have to return to keep inflation in check. This may be in the form of bankruptcies or rising interest rates that bring about defaults to reduce demand and destroy credit.
In 2020, corporate bankruptcies increased only 29%, versus the 2-3x typically seen during a recession. At the same time, personal bankruptcies are at a 35 year low. Personal debts, including rental debts, have soared, with nearly 12 million Americans owing around $6k in back rent. By summer, that sum will likely grow into the five-figure range. In addition, the actual unemployment rate is believed to be over 11% when you factor in people who have stopped looking for work because no equivalent job exists during the pandemic.
Even if the Fed holds off raising rates as long as possible, by my estimate late 2022, the markets must respond to near-term pressures to keep their portfolios above water. The cost of capital will begin to increase, and zombie companies will struggle to refinance going forward.
This is a recipe for bust times.