John P. Swift, CFA, CPA Chief Investment Officer
312-259-9595 or firstname.lastname@example.org
March 23, 2020
John P. Swift, CFA, CPA – Chief Investment Officer (312) 259-9595 email@example.com March 23, 2020
There is something different about the coronavirus when you look at the reaction to this pandemic relative to other infectious outbreaks. That reaction has been unprecedented, and, it’s fair to say, unnerving.
The last four weeks have seen huge responses from central banks which, four weeks ago, were confident in the global economic outlook and in no hurry to move on rates. The last four weeks have seen huge changes in attitude from political leaders who, four weeks ago, saw the coronavirus as China’s problem. The last four weeks have seen huge changes in the stock market which, four weeks ago, was sitting at an all-time high.
Everything seen and heard four weeks ago has been turned upside down by the spread of the coronavirus and the reaction to it.
Conditions Necessary to Reach a Durable Bottom in the Market
We cannot stress enough the degree of uncertainty surrounding any economic projections. These are truly unprecedented events with no adequate historical example with which to precisely anchor our forecast, and the evolution of the virus is also highly uncertain. Only when we receive data indicating that our containment efforts are working to slow down the spread of this virus, will we then be able to say that we have achieved the first level of recovery.
But we will not be out of the woods at that point.
Markets in a crisis bottom when you can contain “the deep tail risks.” In other words, markets often stop going down when investors can rule out the most nightmarish scenarios. The core insight is that while conditions are deteriorating rapidly, markets find it hard to be confident in the limits of the damage and so put heavy weight on deep negative tail risks. Inflection points are often, in the first instance, about the market being able to put limits on those tail risks even before true recovery is visible.
We will need to see the following five things before we can say that the market has established a durable bottom:
1. A stabilization or flattening out of the infection rate curve in the US and Europe 2. Visibility on the depth and duration of disruptions on the economy 3. Sufficiently large global stimulus
4. A mitigation of funding and liquidity stresses on the global banking systems 5. Deep undervaluation across major assets and position reduction
I would argue that we are well on our way towards satisfying #5 above, and I’m confident that the Federal Reserve stands ready to do whatever it takes to satisfy #4. Unfortunately, #3 takes acts of Congress, and as of this writing the Senate Democrats blocked a $1.8 trillion relief bill. I can only assume that they’ll come to some agreement shortly, but that leaves continuing uncertainty around items #1 & #2.
Once we can eliminate the worst possible scenarios around the infection rates will we begin to get some clarity around the price tag on the economy. Then, and only then, will we be able to see the light at the end of the tunnel of our containment efforts and its rightly purposeful and necessary degradation of our economy.
And while there’s no question that the world is set to face severe economic pain, it’s certainly possible that much of the bad news is priced into the market. Furthermore, if developments show that the outlook is less dire than what’s currently expected, then we could see the market inflect and embark on a new bull market.
R-Naught (RO) Explained
With every disease outbreak, epidemiologists try to figure out how far — and how fast — a virus is likely to spread through a population. To do that, they use the basic reproduction number, called the “R naught,” or R0. The figure refers to how many other people one sick person is likely to infect on average in a group that’s susceptible to the disease (meaning they don’t already have immunity from a vaccine or from fighting off the disease before). The R0 is super important in the context of public health because it foretells how big an outbreak will be. The higher the number, the greater likelihood a lot of people will fall sick.
Now, if the RO figure drops below 1.0 and continues to drop you know that we are on a path towards recovery since less than one person is susceptible to being infected per person infected, and the already infected are on the path towards recovery. Some will not recover. In the early days of the outbreak in China the RO figure was 2.2, and the number of infected persons was doubling every 7 days. Dramatic containment efforts in China dramatically reduced this RO figure to the point that they achieved a RO figure below 1.0 several weeks ago, and they are on their way to recovery, for now.
Improvements in RO & Clarity on Restarting our Economy
When we get some clarity on the course that this virus will take and when we might achieve its submission we will be able to get some clarity on how long our containment efforts will last and for the first time receive hard data on the price of containment. At this point we can’t see the light at the end of the tunnel which adds to the unknown cost of containment, general anxiety, and volatility in the financial markets.
The Economic Data Will Be Stunning
The second quarter GDP should be stunning. We’re talking about a double-digit percentage decline in real GDP on an annualized basis. Ed Hyman of Evercore ISI, who has been ranked for years as Institutional Investor’s top economist on Wall Street, is forecasting an annualized decline of 20%! The largest decline during the financial crisis was 8.4% in the fourth quarter of 2008, making it fair to assert that what we are all experiencing right now is far worse than the 2008-2009 financial crisis.
Hold the “V” Sign
It’s not going to be a V-shaped economic recovery in the true sense of things. Yes, when the coronavirus fog lifts, there will be an unleashing of pent-up demand, but some incredible damage has been done in just four weeks.
California, which is one of the largest economies in the world, just announced an indefinite stay-at- home order, except for essential needs. The state of New York, which also happens to house the financial capital of the world in New York City, just ordered all non-essential employers to have their employees work from home for an indefinite period.
The virus and its impact will unfortunately live longer than anyone would like to imagine. Perhaps the arrival of warmer temperatures will send it into hibernation, but even if that’s the case, it’s going to take the U.S. economy more time to wake up from this nightmare when it is over.
It took the U.S. five quarters from the depth of the fourth quarter of 2008 to reclaim the peak level of output seen in the fourth quarter of 2007. That is, it took roughly 15 months to achieve the “V” sign.
S&P 500 Price Return – July, 2008-January, 2011
The victory coming out of this episode won’t be achieved in one quarter or even two quarters in our estimation. The main reason is because of how damaging this coronavirus episode has been to consumer, business, and investor confidence — and that’s true the world over.
What It All Means
The knock-on economic effects are shaking pillars of support that fiscal stimulus plans won’t reinforce overnight:
Government spending is sure to pick up and that will help some, but it isn’t going to make everyone whole again soon.
In due course, this pandemic will subside, the economy will rebound, consumer confidence and investor confidence will rebound, and the stock market will rebound. That course of meaningful change, though, is still indeterminate.
The reaction to the coronavirus, and the fallout from it, is unlike anything we’ve ever seen before.
So, make no mistake about it. This time it is different, which is why we shouldn’t delude ourselves with the thought that it is going to be a V-shaped, quick economic recovery. However, it is important that we continue to take actions to hedge market risk and to be prepared to fully participate in the recovery in the financial markets once we have reached a durable bottom to the market. Until then, the best offense is a good defense, and we will be continuing to utilize all of the available investment tools to not only hedge volatility, but also position and rebalance portfolios into low-risk, high- quality industry leaders with strong balance sheets and a long history of not only maintaining, but increasing dividends during past recessions.
Please Contact Me with Questions
I wish you and your families good health, and I’m always available if you would like to talk. I was out here in the AZ desert on Spring break when these containment efforts were put in place and the kiddos’ school was closed. We closed our offices and are now using collaborative software tools to meet as a team via a video link-up every other day. As a result, I’m out here in the desert, but available over the phone, email, text or Zoom video link.
Warm regards, John P. Swift, CFA, CPA (312) 259-9595 firstname.lastname@example.org