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.

Positive Progress

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:

1. We are already in recession. Markets normally find their bottom during a recession and historically offer attractive risk-reward return profiles.
2. 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.
3. Consumers will benefit from the oil market sell-off and the super low mortgage refinancing rates.
4. 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.

Conclusion

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.

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Sources: Alpine Macro 2020

Disclaimer: This newsletter contains general information that may not be suitable for everyone. The information contained herein should not be construed as personalized investment advice. Past performance is no guarantee of future results. There is no guarantee that the views and opinions expressed in this newsletter will come to pass. Investing in the stock market involves gains and losses and may not be suitable for all investors. Information presented herein is subject to change without notice and should not be considered as a solicitation to buy or sell any security.

The views expressed in this economic update are those of the author and do not necessarily reflect those of BFT.  This update contains “forward-looking statements” that relate to future events, including future economic performance and plans. These forward-looking statements can be identified by the use of such words as “believe,” “think,” “intend,” “may,” “will,” “should,” ”expect,” ”anticipate,” “estimate,” or “could,” or variations of these terms or the use of other comparable terms. There are certain risks and uncertainties that could cause actual results to differ from those predicted in the forward-looking statements. Readers are cautioned not to place undue reliance on these forward-looking statements, which speak only as of the date of this update.

Securities offered through BFT Financial Group, LLC Member FINRA/SIPC.  Investment advisory services offered through BFT Financial Group LLC, a registered investment adviser. BFT Financial is not an affiliated company

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.

An update on the financial markets and the Coronavirus

An Atypical Global Recession

Bear markets typically happen when we experience a global recession. Looking back in history global recessions typically cause equity Markets to fall 30% from peak to trough. The 2008 global financial crisis was a special one as the whole banking system was falling apart under too much leverage and the global equity market dropped 55% from the peak in November 2007 to the low in February 2009, a 16-month period. In the last 4 weeks the Morgan Stanley Capital International (MSCI) World¹ has dropped 32%, with certain emerging markets dropping by 50% or more. The speed of stock price declines suggests the global economy most likely is already contracting quickly.

Therefore a global recession is now a certainty. The only question is whether there will be a technical recession lasting a couple of quarters, or a more prolonged downturn that produces a sizeable increase in unemployment rates.

This will be a unique recession because in postwar history, all recessions are typically caused by financial crises or bursting asset bubbles as a result of Fed monetary tightening.

In this COVID-19-led recession, however, the sequence seems to be precisely the opposite: output contraction may come first, as the fear of contagion has begun to scare off consumers, triggering a fall in their spending. This fall could lead to spreading bankruptcies, a rising unemployment rate and potentially, escalating financial stress or even a crisis.

Different Sectors Will Have Different Effects 

While it is possible that spending will remain broadly depressed even after the panic subsides, this seems unlikely. Private-sector finances were reasonably strong going into the crisis, while ultra-low government bond yields will incentivize increased fiscal outlays. Spending on leisure travel and public entertainment will remain subdued well into 2021, but much of this demand will be redirected to other categories of discretionary consumer purchases, particularly in the e-commerce space. Health care expenditures will also increase.

Central Banks Quantitative Easing

What is also unique in this recession is that already at the very start of the economic contraction Central banks have loosened monetary policy tremendously by cutting interest rates and/or injecting huge amounts of liquidity into the system through Quantitative Easing (QE). While at the same time governments are not wasting time announcing huge fiscal stimulus packages.

In a virus-led downturn, it is the authorities’ job to act quickly and with overwhelming force to provide businesses and consumers with the necessary financial relief such as tax breaks, loan guarantees, subsidized credit, etc. These measures are aimed at removing solvency risk, allowing companies and people to prepare for economic recovery once the public health crisis is over. In other words, policy support is not designed to stop the economy from falling into a recession, but to help businesses and consumers through this difficult period.

This is the only way to prevent a liquidity crunch from becoming a solvency crisis that leads to rising bankruptcies and unemployment. This secondary damage is more difficult to heal than a temporary fall in spending. In this vein, the Fed’s aggressive rate cuts and massive liquidity injections via repo operations and a resumption of QE are absolutely needed to ensure ample liquidity as demand for credit lines increases quickly.

The list of large spending packages proposed by governments around the world is only growing longer. Some countries, like France and Spain, have already announced guarantees and allocations measured in hundreds of billions of euros. The German state bank KfW has half a trillion euro available to support small businesses. The White House is talking about a $1.2 trillion support package. This week China cut rates again and is ready to open the fiscal and credit taps in a fashion similar to 2008.

These measures are designed to avoid a freeze up of the credit market and make sure small businesses and individuals are not bankrupted for no reason of their own making. This increases the odds that economies will be able to rebound once the worst of the pandemic is behind us. While in the short-run, those announcements are positive, in the long-run, they greatly increase the risk that inflation will comeback.

Recessions and Rebounds

Many COVID-19-ravaged economies in the world are going through economic recessions. They include China, Korea and Italy. It is too early to draw any generalizations of these virus-led recessions, but China’s experience is that the economic contraction is sharp but can be followed by a quick rebound as indicated by some early economic data.

The unfortunate reality is that the U.S. economy, the largest in the world, is dealing with an early outbreak, and the number of infections will escalate rapidly – especially as official testing numbers begin to increase. The actual numbers of infections could be a multiple of the reported. There is no way to estimate how long the recession will last for the U.S. economy. It will largely depend on how quickly the outbreak can blow over. It could be anywhere between two to three months, according most experts on pandemics.

COVID-19 Can Be Stopped

Recent experience suggests that COVID-19 can be stopped, even after community contagion has set in. The number of new Chinese cases has fallen from 3,892 on the 5th of February to 6 cases on the 17th March. South Korea seems to be getting the virus under control. Japan and Singapore also appear to be succeeding in preventing the virus from spreading rapidly.

Why Is It Different From the 2008 Global Financial Crisis? 

This virus-induced recession is most likely a transitory shock. It is different from the 2008 Global Financial Crisis (GFC), when banks were collapsing, depositors ran for cover and over-leveraged consumers were facing foreclosures. It has taken more than a decade to repair the damaged balance sheets of consumers and lending institutions as the result of the 2008 crisis.

This is not the case today, with much-reduced consumer debt and well-capitalized banks. The corporate sector capital structure is much more leveraged than before due to share buybacks, but the very subdued capital investment over the past few years suggests that most companies are not dealing with over-extended balance sheets or mounting bad investment. Besides, borrowing cost is falling fast and the Fed is vigilant on financial stress. Therefore, there is nothing blocking the economy from potentially recovering quickly once the spread of the disease is contained.

The violent sell-off in the last 3 weeks means that the equity market is already pricing in a lot of bad news. The so-called Stock-to-Bond ratio is now at the same level after the 2001 bear market and is approaching the lows of 2009.

 

We do not know how far equity markets can fall before we see a more sustained recovery, and although painful, we should keep in mind that there WILL be an end to the COVID-19 outbreak. At that point, the world economy will be left with plenty of policy stimulus, much reduced interest rates and bond yields, very low energy costs and large amounts of pent-up demand of consumers wanting to buy.

The recent fall in bond yields and collapsed oil prices, lowers costs for households and companies and has historically always led to a rise in economic activity. Asset prices usually rally before an economic recovery.

Furthermore, the speed of a stock market rally could mirror how prices have fallen. This is the key reason investors should neither try to time the market bottom, nor sell into the panic.

As always if you have questions or would like to review your portfolio, your plan or goals, please contact us directly.

We shall be sending further updates this week as we monitor market conditions and news.

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This newsletter contains general information that may not be suitable for everyone. The information contained herein should not be construed as personalized investment advice. Past performance is no guarantee of future results. There is no guarantee that the views and opinions expressed in this newsletter will come to pass. Investing in the stock market involves gains and losses and may not be suitable for all investors. Information presented herein is subject to change without notice and should not be considered as a solicitation to buy or sell any security.

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.

¹The MSCI World Index is a free float-adjusted market capitalization weighted index that is designed to measure the equity market performance of developed markets.

Sources: BCA Research

We started to experience the impact of the Coronavirus (COVID-19) firsthand in the last week with the announcement of social distancing policies, and closures of businesses and public events. Understandably, there is much concern as this is certainly an unusual event. I hope that you and your family are practicing an abundance of caution.  

Likewise, we are being overly cautious and have decided to close our office until March 27th. Several factors prompted our decision. First, we intend to do our part and to adhere to the recommendations from the Center for Disease Control and the Federal Government. Our contribution may be insignificant, but ultimately, we deem it the right thing. Second, we have staff with children who are affected by school closures. Under normal circumstances, like summer break, it wouldn’t be a disruption to family life. But these aren’t normal circumstances, and we place a premium on our employees and their families.  

Please know there won’t be any disruption of service. We have disaster recovery plans in place in the event of an emergency. These plans allow for a continuation of services for situations ranging from a plumbing leak to the destruction of our physical building. While this is not a disaster in the traditional sense, the plans we have in place ensure we will operate business as usual. 

We have rerouted our main phone lines and will be working remotely. Hopefully, you won’t experience any delays as messages are forwarded. We can also conduct meetings using web-based software with both video and screen sharing capabilities as needed. There are no requirements for camera capability on your end; you need only internet connectivity.  

The partners in our Bedford home office, our Hong Kong office, and our London office are reviewing tremendous amounts of information around the clock, to help us navigate through this difficult time. Trust that we’re taking our role as stewards most seriously. Equally as important, we’re concerned for your safety and the health of your family.