Over the past month, equity markets and financial assets broadly, have been attempting to price in the dual shock of a pandemic and the sudden collapse in oil prices, the latter a huge negative for the energy sector. The roughly 30% drop in the U.S. equities is pricing in >100% probability of a recession.
Stocks have responded to the growing liquidity stresses across financial markets. The 100% basis point Federal Reserve cut Sunday has been ignored by investors, arguably worsened fragile sentiment, and likely contributed to the further selling we saw Monday. At one point, the VIX, or “fear index” posted an all-time closing high, around 83, which is higher even that during the Great Financial Crisis of 2008-09.
History is often a useful tool, and since 1900, there have been 22 equity drawdowns of 20% or more and, painful as it has been, the current 30% slide would rank only number 14 overall. Notably, the typical bear market during a recession period is 30%, so the S&P 500 index has already discounted a recession. But this has been a particularly disorderly liquidation, with investors not attempting to discount the pandemic’s fundamental outcome. Has the stock market become uninvestible?
The relentless selling has made it virtually impossible to distinguish winners from losers, exemplified by the broad-based selling across all companies, even high-quality companies. Yet, in a business cycle downturn, stronger companies should be able to gain market share and actually improve market position, with the inverse for weaker industries, with poor fundamentals and higher leverage. The market is making clear that the “cure” for the pandemic is as bad as the disease.
There are potential reasons for this:
– if markets are seeing broad-based liquidation via passive vehicles ETFs, etc., then there is no “winners vs losers,” just selling.
– or perhaps the sell-off is exposing the risk of an asset light economy. The problem with this argument, is the industries that should be hurt the most are those negatively impacted by slowing human interaction (travel, restaurants, hotels, entertainment, etc.).
– But once position squaring has taken place, I expect there to be significant recovery of the “winners.” My colleague Tom Block observes the conditions in Washington, D.C. are supportive of Washington to bring on “Mother of all fiscal plans.” See page 11.
Social distancing is creating enormous ripple effects that we initially failed to appreciate. And this has created a growing sense of hopelessness among our clients. Several even suggested that equity markets should be shuttered until COVID-19 peaks. To me, it is incredible to see the change in character stemming from a pandemic shock. Understandably, stocks are discounting “long term outcomes” but the path of economy and the world is made uncertain by the coronavirus. The key question, therefore, is whether markets can gain confidence without the end of the crisis visible.
Again, look at history. In the 2008-09 crisis markets were able to begin to stabilize long before fundamental visibility improved. In fact, 2009 was still characterized by contracting GDP and negative EPS revisions but equity markets managed to bottom before those took place.
More importantly today is that unlike 2008-2009, Washington is more likely to provide substantial fiscal relief, perhaps even larger than what was seen during the Great Financial Crisis, because the circumstances today do not have the “bad actors” seen in GFC (blaming banks). According to Tom Block, the process is more likely to be based on “asks” and “what do you need?”– and Washington might be willing to give. We could ultimately see a comprehensive plan emerge soon, encompassing many industries and addressing the suffering seen by U.S. workers and households.
This, of course, would be a big step in containing the fear and perhaps break this cycle, enabling stocks to bottom before pandemic cases peak in US. Meanwhile, the coronavirus infection cases and mortality continues to rise, but what’s important is the rate of change, the second derivative. Once that flattens, investors could breathe a sigh of relief and some normalcy could return to markets.
Flatter infection and mortality curves are seen with South Korea and China. Europe is a high trajectory region and most of it seems to be following the awful path in Italy. If the US tracks Italy, in approximately 2-3 weeks, we could see peak 115,000 cases across the US, implying 8,000 deaths from over 200 recently, a big concern for the market. If the US tracks Korea, the cases would peak at ~50,000 with around 500 deaths.
A few weeks ago, we thought markets were setting up for a V-shaped bounce, but financial conditions broadly have deteriorated instead. We’ve experienced the fastest move from a new high to a bear market in history. Stocks are attempting to price in an uncertain outcome (COVID19 path), but at the moment it is choosing not to decide.
Among the “good things” starting to develop in the financial markets is a pronounced steepening of the long-term yield curve (U.S. Treasury 30-yr-10-yr). The steepening argues for economic resilience. The risk is that a pandemic short-circuits these signals, creating a recession as a self-fulfilling prophecy. Investors should ask themselves if that is possible: Is the US lurching into a recession without the typical high leverage and diminishing cost of capital?
What could go wrong? COVID-19 could indeed morph into a more dangerous disease, changing the risk profile and the required response of markets.
BOTTOM LINE: I think certain factors will break the downward feedback loop: (i) fiscal policy, (ii) pandemic curve flattening and/or (iii) Saudi/Russia peace.
Figure: Comparative matrix of risk/reward drivers in 2020
Per FS Insight
Figure: FS Insight Portfolio Strategy Summary – Relative to S&P 500
** Performance is calculated since strategy introduction, 1/10/2019
