An update on the financial markets and the Coronavirus
An External Shock Turned Recession at Light Speed
In February, when the Coronavirus epidemic appeared to be under control in China, we interpreted the situation as a transitory external shock. Such circumstances usually represent buying opportunities in equity markets, like in 2016 after the Brexit referendum.
Obviously, things aren’t under control and we are now facing a global pandemic that threatens to overload the healthcare system in many countries. Most Western governments continue to play catch-up and have lost considerable time as opposed to getting out in front of the curve like China and some other Asian countries did.
We don’t know how long this crisis will last and how bad it will be. However, we can be pretty sure the world will not be the same again. The reality is that we are already in a deep recession and it is likely to get worse in the short term.
First Ever U.S. Recession Caused by an Outbreak
The coronavirus outbreak is the first time where a U.S. recession is caused by an external shock rather than an internal economic imbalance. The decline in equity markets has occurred at an unprecedented speed. In three weeks, from an all-time high of nearly 3,400 points on the S&P 500 index, the U.S. market has discounted a severe recession.
Intra-sector valuation spreads have moved by 3.5 standard deviations in three weeks. In 2008 it took four-and-a-half months to achieve similar market movements. The measures taken by governments to contain the spread of the coronavirus have plunged developed economies into recession at the speed of light.
Markets are now influenced by three factors: central banks’ measures to ensure stability in the banking sector and the functioning of markets are safeguarded, income supporting measures from governments for individuals and businesses most affected, and the evolution of the pandemic.
Our View of a Possible Depression
Some recent articles in the media are speculating that this could lead to a 1930s style economic depression. We think this is highly unlikely. The main difference with the 1930s is that the Fed was not an effective central bank back then and did not provide liquidity support to the markets, while governments only started economic stimulus plans in 1932, three years after the stock market crash.
In equity markets, the bearish intensity is showing signs of a slowdown, even if it is still early. At 2,200 the S&P 500 index, for example, is discounting earnings to fall by more than 20% in 2020 and then to remain unchanged until 2025. Given all the monetary and fiscal stimulus this seems an unlikely scenario to us.
Unfortunately, visibility remains very low on the economy and whether the measures of government support will be adequate or not. Nevertheless, the fall in equity and credit markets is already implying an economic contraction of several percentage points of gross domestic product (GDP) in the U.S. and in Europe.
As we don’t know how this pandemic will evolve, there are still short-term risks, however the outlook for stocks is improving. We highlight some positive catalysts that should underpin the equity market as the pandemic progresses:
- We are already in recession. Markets normally find their bottom during a recession and historically offer attractive risk-reward return profiles.
- China’s manufacturing Purchasing Managers’ Index (PMI) and other economic data fell below the Global Financial Crisis (GFC) lows. As a rule of thumb, investors should buy stocks when the global PMI is well below 50.
- Consumers will benefit from the oil market sell-off and the super low mortgage refinancing rates.
- Market sentiment indicators are at negative extremes
Corporate and emerging market bonds are facing a major liquidity crisis. It is virtually impossible to trade at a decent price in these bond segments. The Federal Reserve’s latest measures extending intervention to investment-grade bonds and exchange-traded funds will ease the stress in investment grade credit segments.
Central Banks Strategies
Central banks have fully leveraged their 2008 experience. In regard to the central banks’ interventions to stabilize financial markets or at least ensure that they function properly, the picture is encouraging. In record time, they have deployed the entire arsenal of measures needed to prevent the crisis in the real economy from triggering a financial crisis, which in turn would further damage the real sphere.
The markets clearly benefited in recent days from the experience painfully gained in 2008. In contrast to the financial crisis, ironically, commercial banks are not the cause but the solution. Measures to ensure their ability to provide relief to the non-financial sector, by relaxing regulatory requirements, were quickly taken. This is intended to enable them to extend lines of credit to private companies who have seen their incomes fall overnight due to the strict containment measures imposed by governments.
Problems in the Market
One of the problems in the past two weeks was the lack of liquidity in the markets. Gold’s weakness last week was very concerning because it happened while risk aversion and volatility spiked. Along with the weakness in the yen, it was the clearest symptom of the incapacity of the Fed to supply enough liquidity into the market.
The Fed – ”Whatever It Takes”
Last Monday, the Fed announced an incredible package of programs that include what amounts to unlimited asset purchases and direct lending to the private sector via the U.S. Treasury Department. In the context of the build-up of measures announced over the past two weeks, this is the clearest indication the Fed is ready to do “whatever it takes” to provide liquidity to the market. The rebound in gold confirms that market participants finally feel like the Fed is getting ahead of the demand for liquidity.
Lastly, why we think this is not going to lead to a 1930s style depression is the fact that governments are falling over themselves to announce stimulus and bailout packages. The U.S. has agreed on a USD 2 trillion package, which is equivalent to 10% of GDP and that is enormous. Germany is talking of fiscal stimulus of 650 billion Euros. Smaller countries like Singapore yesterday announced a stimulus package equivalent to 11% of GDP. We don’t know if these amounts will be enough, but it looks like that governments around the world have committed to the “whatever it takes” mentality.
This is will have a mitigating effect on the global economy and that is the main reason equity markets started to recover this week. We don’t know if we have seen the bottom yet but at least an intermediate term rebound is likely until we have more clarity on the economic impact in the coming months. For now, we would definitely recommend investors to remain invested and stick to their long-term strategy.
As always if you have questions or would like to review your portfolio, your plan or goals, please contact me directly.
We shall be sending further updates this week as we monitor market conditions and news.
Sources: Alpine Macro 2020
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Disclosures & Definitions: Indices are unmanaged and investors cannot invest directly in an index. Unless otherwise noted, performance of indices do not account for any fees, commissions or other expenses that would be incurred. Returns do not include reinvested dividends.
The Standard & Poor’s 500 (S&P 500) is an unmanaged group of securities considered to be representative of the stock market in general. It is a market value weighted index with each stock’s weight in the index proportionate to its market value.
The ISM Purchasing Managers Index (PMI) is an indicator of the economic health of the manufacturing sector. The PMI index is based on five major indicators: new orders, inventory levels, production, supplier deliveries and the employment environment.
The VIX is a trademarked ticker symbol for the Chicago Board Options Exchange Market Volatility Index, a popular measure of the implied volatility of S&P 500 index options. Often referred to as the fear index or the fear gauge, it represents one measure of the market’s expectation of stock market volatility over the next 30-day period.