In this article, we review what we believe the market will be watching regarding the COVID-19 crisis, including:
- Expectations of upcoming second quarter gross domestic product (GDP) contraction, which could prove to be the worst single quarter since World War II
- Unique characteristics of this COVID-19-induced economic slowdown, which could be relatively short lived
- Important trends to watch in COVID-19 infection and recovery rates during the next few months
- Potential impact of lower interest rates and recent monetary policy actions by the Fed
- Potential magnitude of pending fiscal policy legislation currently being negotiated within Congress
Extreme times call for extreme measures, and during these final weeks of March, life as most people know it has been turned upside down. In a nationwide effort to fight COVID-19, newly established guidelines such as sheltering in place, self-isolation, quarantines, and social distancing have created a new normal in daily life unimaginable just weeks ago.
Office buildings are empty, city streets are barren, the sports world has been benched, and college students are back at home with their parents. In many homes, only the most urgent of needs necessitate trips outside the neighborhood. Few events in history, perhaps with the exception of maybe a world war or two, have led to so much upheaval in such a short time.
This new world will have direct and negative impacts on the U.S. and global economies for at least the next three to six months. Since so much of the widespread shutdowns and cancellations occurred during recent weeks and at such a rapid pace, the magnitude of these negative effects are only just now being fully estimated, and they are turning out to look far worse than expected even just a few weeks ago.
Specifically, second quarter U.S. GDP now appears to be on the verge of the worst single quarter of economic contraction since GDP first began to be measured on a quarterly basis in 1948. In a flurry of downward revisions over just a few days-time, the latest round of forecasts for second quarter economic growth now range from about negative 8% to negative 15%. Should reality between now and June reflect the midpoint of that range, only those who personally experienced the Great Depression of the 1930s will be able to say they have lived through a steeper three-month decline in the economy.
Amid this backdrop, the equity and credit markets have taken a major hit. The S&P 500® has declined more than 30% from its record high on February 19, and credit spreads on corporate bonds have blown out to levels versus comparable maturity Treasurys unseen since the financial crisis of 2008. With little visibility on what third quarter GDP or corporate earnings growth might look like in the upcoming summer months, the markets continue to trade somewhat emotionally and generally based on COVID-19 infection and fatality rates, which continue to worsen globally.
However, while this economic air pocket is to a large extent stunning and sobering, there are several unique circumstances investors should take into account regarding this first medically related economic recession in more than a century. These would include:
The markets and the world are watching infection, fatality, and recovery rates on a country by country basis. We believe a vital statistic to be watching is total recoveries/total cases, and ironically China, where the virus began in late 2019, is currently the only nation where recoveries constitute a majority of the reported cases. While sadly about 3,000 people have died in China of the coronavirus, approximately 72,000 have fully recovered, accounting for close to 90% of total cases. No other nation is anywhere close to this ratio and many, including the U.S., are close to zero as the virus has only recently crossed through its borders.
To improve this ratio, countries will need to reduce the rate of infections, or what is being referred to as “flattening the curve,” and also have enough medical testing and treatment equipment to remedy those diagnosed with COVID-19. While this is currently a major challenge globally, if in the months ahead the U.S. and other highly impacted nations such as Italy, South Korea, Iran, France, Germany, and Spain can reach a recovery profile close to China’s, it could go a long way toward not only reducing the overall fatality rates of the virus but also alleviating fears throughout the world community.
The markets have to some degree already discounted the second quarter contraction and are likely now more focused on the duration of the slowdown rather than the depth. Should we see more of a “U-shaped” economic recovery driven perhaps by containment or successful treatment options for COVID-19, we could potentially see positive growth in 2H20, which we believe, given the recent dramatic decline in asset prices, could result in a sharp reversal for stocks and the credit markets.
The Federal Reserve has stepped up in historic fashion by reducing short-term rates to zero and reinstituting large-scale asset purchases in an open-ended manner. The Fed has taken unprecedented action by announcing an unlimited commitment to purchasing assets in the open market, which will now include not just Treasury bonds and agency mortgage-backed securities, but also corporate bonds, municipal bonds, and commercial mortgage-backed securities. In addition the Fed will be providing a Main Street Business Lending Program to support small- and mid-sized businesses. As we have said previously, actions by the Fed in this environment will not address the root cause of the coronavirus-induced economic contraction, however these aggressive measures will allow greater financial assistance for adversely impacted businesses and a higher degree of liquidity for investors.
Fiscal stimulus awaits and it could come in large dollar amounts. The White House and Congress appear to be in the final stages of drafting a fiscal stimulus package potentially totaling $2 trillion. It’s believed to consist of a combination of direct payments and tax relief to individuals, small business loans, and financial assistance or investment into distressed industries such as airlines, hotels, and other transportation- or leisure-related businesses. Should the pending legislation actually represent this dollar amount, it would approximate 10% of the total U.S. economy. Like the Fed’s monetary actions, this fiscal policy response may not address the root cause of the upcoming economic contraction, but it will provide much needed financial assistance to struggling companies and sectors of the economy. In addition, at the point of a future recovery it could also provide a meaningful tailwind.
Longer-term interest rates are beginning to reflect the implementation of fiscal stimulus. With the Fed taking the Fed Funds rate back to a target range of 0–.25% and the 10-year Treasury rate rising back toward a full 1% as a large fiscal package is anticipated, we are now looking at the steepest yield curve between these two rates since 4Q18. While rates have been volatile in recent weeks, the movement in the 10-year yield is material when compared to its intraday low of .31% on March 9. The widening slope should provide some relief to banks and other financial institutions.
The impacts of COVID-19 have been brutal and relentless over the past month. As the economic, earnings, and credit impacts to companies are known to be negative and far reaching at least in the short term, the magnitudes are still a moving target, and in recent days that movement has clearly been in a downward direction. However, we believe it is important for investors to remember that calling a bottom in this market is difficult and likely futile, and that the end of prior modern day recessions in 1982, 1991, 2002, and 2009 were followed by meaningful upward moves in the markets during the years to follow. This is worth noting in our opinion, particularly in the event the expected economic contraction proves to be relatively short lived and the effects of current and pending monetary and fiscal policy remain in place afterward.
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