Cam Hui, CFA | cam@pennockideahub.com Page 1

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Quantitative & Strategy

FISCAL CLIFF = DOUBLE-DIP

August 3, 2020

EXECUTIVE SUMMARY

The pandemic has imposed both a supply and demand shock to the global economy. The

supply shock was in the form of disruption to supply chains as factories were shuttered —

this has largely been corrected.

The demand shock was in the form of a loss of demand as lockdown and stay-at-home

orders cratered demand. Governments around the world acted to cushion some of the

demand shock by way of fiscal support. In the U.S., a significant part of the fiscal cushion

is expiring, and it is sparking some dire consequences.

One puzzle of the stock market rally since the March lows is how stocks can strengthen in

the face of the worst economic slowdown since the Great Depression. Sure, central bankers

took steps to mitigate the worst of the damage. While they can print money, they cannot

print sales or customers for businesses, nor can they print equity.

While some of the risk-on tone could be attributable to central bank action, the real reason

for the market’s strength is fiscal policy. While the stock market isn’t the economy, and the

economy isn’t the stock market, the two are nevertheless connected. We pointed out last

week (see What’s the Bull Case?) that U.S. fiscal support had strengthened household incomes

to pre-pandemic levels. Retail sales were therefore recovering strongly as a consequence.

All that is about to end as the $600 per week supplemental unemployment insurance

payments expire at the end of July. Congress has failed to act to extend the benefits, and

the economy is going over a cliff. Brace for the double-dip recession.

Cam Hui, CFA cam@pennockideahub.com

Table of Contents

Brace for the Double-Dip .......................... 2

Differences in Policy Time Horizon ........... 3

Assessing the Damage ............................ 4

Other Risks .............................................. 9

A Second Demand Shock ...................... 11

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August 3, 2020

Quantitative & Strategy

Brace for the Double-Dip

One puzzle of the stock market rally since the March lows is how stocks can strengthen in the

face of the worst economic slowdown since the Great Depression. Sure, central bankers took

steps to mitigate the worst of the damage. While they can print money, they cannot print sales

or customers for businesses, nor can they print equity.

While some of the risk-on tone could be attributable to central bank action, the real reason for

the market’s strength is fiscal policy. While the stock market isn’t the economy, and the

economy isn’t the stock market, the two are nevertheless connected. We pointed out last week

(see What’s the Bull Case?) that U.S. fiscal support had strengthened household incomes to pre-

pandemic levels. Retail sales were therefore recovering strongly as a consequence.

Exhibit 1: V-Shaped Recoveries in Retail Sales and Incomes

Source: Bloomberg

All that is about to end as the $600 per week supplemental unemployment insurance payments

expire at the end of July. Congress has failed to act to extend the benefits, and the economy is

going over a cliff. Brace for the double-dip recession.

Cam Hui, CFA | cam@pennockideahub.com Page 3

August 3, 2020

Quantitative & Strategy

Differences in Policy Time Horizon

The differences in monetary and fiscal policy response to the pandemic represent a stark

contrast in time horizons. The Federal Reserve believes the effects of the COVID Crash are

medium- to long-term in nature. The most recent July FOMC statement shows the Fed believes

the pandemic will be a key driver of the medium-term growth outlook.

The path of the economy will depend significantly on the course of the virus. The ongoing public health

crisis will weigh heavily on economic activity, employment, and inflation in the near term, and poses

considerable risks to the economic outlook over the medium term.

The economic recovery will be long and drawn out. Interest rates are going to be on hold for

a very long time. When asked about the triggers to raising rates during the press conference,

Jerome Powell replied that they were not even thinking about raising rates. He also pleaded

with Congress to enact another stimulus bill to keep the economy from going off a cliff as the

Fed cannot do the heavy lifting all by itself [emphasis added].

It will take a while to get back to the levels of economic activity and employment that prevailed at the

beginning of this year, and it will take continued support from both monetary and fiscal policy

to achieve that.

By contrast, the fiscal response has been short-term in nature. Congress viewed the pandemic

as a short-term shock to the economy. A short-term shock meant a short-term response. It was

therefore no surprise that the extended $600 per week unemployment insurance benefits in the

CARES Act expired at the end of July.

The short-term view was wrong. After raging through Washington State, Northern California,

New York and New Jersey, the pandemic went on a rampage through the Sun Belt states.

Setting aside the uneven stay-at-home responses of state governors, the populace did not feel

safe enough to return to normalcy in the face of infection risks. So much for the re-opening

and the V-shaped recovery.

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August 3, 2020

Quantitative & Strategy

Assessing the Damage

The main damage of the fiscal response can be seen in the expiry of the $600 per week

supplemental unemployment insurance that expired July 31. The deadline was no surprise.

House Democrats had passed a $3-trillion relief bill in May. No one expected the Republican-

controlled Senate would pass the bill in its entirety. The bill represented the Democrats’

opening gambit in bargaining and it was a signal of its priorities, which were especially important

in an election year. The Republican-controlled White House and Senate did not take up the

relief issue until mid to late July. When it did, it was unclear whether the resulting $1-trillion bill

could muster sufficient Republican support in the Senate to pass.

While all sides are continuing to negotiate, there will be a discontinuous break in disaster relief,

which could be catastrophic for some of the population. If we were to continue the cliff and

precipice metaphor, it's easier to limit the damage by preventing people from going off the cliff,

than to try and rescue them after they've fallen.

For some perspective of the economic cliff, over 30-million Americans will see a sudden

income cut of 50–75% if the $600 weekly benefits disappear. The Republican bill proposed a

temporary supplement of $200 per week, to be replaced by two-thirds of the worker’s previous

wages, which would be implemented later so that state governments could re-program their

computer systems. George Pearkes of Bespoke Investment Group estimated that the

Republican proposal represents a -3.2% reduction in GDP.

The economic damage is not just limited to household incomes. Depending on the jurisdiction,

hastily enacted eviction moratoriums are either expiring or have expired. The Intelligencer

reported:

At midnight on Friday [July 31], a federal moratorium on evictions will end. Similar bans by state

and local governments have already passed or will soon expire. With tens of millions of Americans

seeking jobless benefits, and the federal unemployment-insurance bonus set to expire, many American

renters will soon be at risk of losing their homes...

[The CARE Act] protected people from eviction if they live in homes or apartments with a federally

backed mortgage. According to one estimate, that amounted to roughly 12.3 million units, home to

just over a quarter of the country’s renters. There were problems with the law, though. Apart from

leaving three-quarters of the country’s renters exposed to evictions, there was also no enforcement

mechanism or penalty for landlords who attempt illegal evictions.

Even if Congress were to agree to a rescue package later in August, the discontinuous loss of

unemployment benefits has the potential to become a homelessness crisis with dire

consequences. Over 40% of renters are at risk of eviction.

Cam Hui, CFA | cam@pennockideahub.com Page 5

August 3, 2020

Quantitative & Strategy

Exhibit 2: Eviction Vulnerability by State

Source: CNBC

The lack of a rescue package has other repercussions. One glaring problem is the hole that the

pandemic has blown in state and local budgets.

Exhibit 3: Comparing State Budget Shortfalls During Recent Recessions

Source: RSM US

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Quantitative & Strategy

Without federal aid, state and local governments will have no choice but to cut employment.

Despite the improvement in Nonfarm Payroll (NFP) for the past few months, government

employment has not recovered. Expect it to drop in the coming weeks and months.

Exhibit 4: State and Local Government Job Growth Stagnant

Source: FRED, Federal Reserve Bank of St. Louis

If you thought that employment rebound was a bright spot in the recovery, be prepared for a

negative surprise. Former Treasury official Ernie Tedeschi observed that high-frequency

Census data shows a softening in the jobs market. The market consensus for the July NFP to

be released this coming Friday is a gain of about 2.3-million jobs. Tedeschi estimated that, after

adjusting for definition differences, timing and seasonality effects, July NFP is likely to come

in at a loss of -2.2 to -4.7-million jobs. Prepare for a jobs report shocker.

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August 3, 2020

Quantitative & Strategy

Exhibit 5: High Frequency Census Data Pointing to Negative Jobs Growth in July

Source: Ernie Tedeschi

Economic data reports are turning sour. Initial jobless claims rose last week for a second consecutive week, indicating a stall in the recovery. The preliminary Q2 GDP fell -9.5% quarter-over-quarter, or at an annualized rate of -32.9%, which was ahead of expectations but still deeply negative.

The stock market had been rallying on positive economic surprises. The Citigroup Economic Surprise Index, which measures whether top-down data is beating or missing expectations, appears to be peaking and turning down. To be sure, there is some good news on the horizon, as it appears that the new infection counts are topping out in the Sun Belt. Fatality rates will stop rising and begin to decline in about a week.

Nevertheless, the economic damage is becoming apparent. How will the market behave in the face of the economic cliff and disappointing macro releases?

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August 3, 2020

Quantitative & Strategy

Exhibit 6: Reversals from High Economic Surprise Readings Are Not Equity Friendly

Source: Refinitive Datastream, StockCharts

Cam Hui, CFA | cam@pennockideahub.com Page 9

August 3, 2020

Quantitative & Strategy

Other Risks

In addition to the economic risks that have been mentioned, there are also other risks the

markets could interpret to be unfriendly.

First, assuming that Congress does cobble a rescue deal together at some point in the future,

the economy will need fiscal support after the November election. If the support period of the

new package does not last until late January, it may be virtually impossible to pass any legislation

between Election Day and Inauguration Day. This raises the risk of another fiscal cliff and

sudden stop in economic growth.

In addition, the effects of this economic cliff could affect the election. CNBC reported that

62% of swing state voters support the extension of the $600 per week unemployment insurance.

Since this is contrary to the Republican position, it could degrade the Republicans’ electoral

odds. As well, the Washington Post reported that Wall Street is showering the Democrats with

campaign contributions. Such a level of defection is unusual considering how the Democratic

agenda is unfriendly to financiers. A Biden and Democrat victory is likely to translate into higher

corporate taxes and a reduced earnings outlook for 2021 and beyond.

Exhibit 7: Swing-State Voters Support More Stimulus

Source: CNBC

The risk of electoral chaos is also rising. Remember the Florida hanging chad controversy? The

U.S. could see a similar episode, but at a higher order of magnitude. President Trump has

already questioned the possible legitimacy of the election and raised the possibility of a delay,

which is legally questionable and rejected by his Republican allies.

Cam Hui, CFA | cam@pennockideahub.com Page 10

August 3, 2020

Quantitative & Strategy

Exhibit 8: A Call for Delay, or Pre-emptively Questioning the Election’s Legitimacy?

Source: Twitter

Trump can’t legally delay the election, but he can take steps to question the legitimacy of the

results. Business Insider reported that cybersecurity experts believe it could take weeks to

determine the winner after November 3.

Election cybersecurity experts said Tuesday that “the electorate may not be prepared

for how long it’s going to take” for winners to be declared after the general election

on November 3.

A panel that included two cybersecurity experts who served in the White House agreed

that simply counting ballots may take a week or two.

Any litigation that follows that counting could postpone results for much longer in a

scene reminiscent of the 2000 election, when results were delayed until January.

The experts also said voters’ loss of trust in the system may be the biggest risk in the

upcoming election.

Despite fears of foreign interference, hacked voting machines and disinformation

campaigns, there is some optimism that the country is better prepared than in 2016.

Max Boot wrote in the Washington Post that he participated in a “war game” that postulated

different electoral scenarios. Most of the time, it resulted in chaos and “near civil war in the

streets”.

The danger of an undemocratic outcome only grows in other scenarios that were “war gamed” by other

participants. For instance, what if there is no clear-cut winner on election night, with Biden narrowly

ahead in the Electoral College but with Michigan, North Carolina and Florida still too close to call?

The participants in that war game concluded the result would be “near civil war in the streets.” Far-

fetched rumors are enough to bring out armed right-wing militias today; imagine how they would

respond if they imagined that there was an actual plot afoot to steal the election from their hero.

Such an outcome would create uncertainty, both politically and in the financial markets. Risk

premiums would rise substantially under such a scenario and markets would tank.

Cam Hui, CFA | cam@pennockideahub.com Page 11

August 3, 2020

Quantitative & Strategy

A Second Demand Shock

In conclusion, the pandemic has imposed both a supply and demand shock to the global

economy. The supply shock was in the form of disruption to supply chains as factories were

shuttered — this has largely been corrected.

The demand shock was in the form of a loss of demand as lockdown and stay-at-home orders

cratered demand. Governments around the world acted to cushion some of the demand shock

by way of fiscal support. In the U.S., a significant part of the fiscal cushion is expiring, which

is sparking dire consequences in the following forms:

Over 30-million Americans will see an immediate 50–75% loss of income. A moderate

scenario, based on the Republican proposal of a reduction of the $600 per week

unemployment insurance to $200 per week, would result in a -3.2% fall in GDP. Even

if Congress were to come to an agreement on a rescue package at a later date, the fiscal

cliff damage will be difficult to undo.

The expiry of eviction moratoriums has the potential to spark a homelessness crisis.

Without federal aid, state and local governments are poised to start mass layoffs.

Even without the fiscal cliff, what re-opening recovery was already flattening out, and the July

Employment Report has the potential to see a large negative surprise. In addition, the economy

is likely to need further support between Election Day and Inauguration Day, which will be

virtually impossible to achieve.

Say goodbye to the V-shaped recovery. Wall Street has penciled in a steep earnings recovery

for the rest of 2020. Get ready for downward estimate revisions as the prospect of a double-

dip recession gets factored into analysts’ models.

Exhibit 9: Consensus S&P 500 Quarterly EPS Estimates

Source: FactSet Information Systems

Cam Hui, CFA | cam@pennockideahub.com Page 12

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Quantitative & Strategy

Disclaimer

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