In this article, we review:
- Continuing COVID-19-induced market volatility
- Potential economic impacts of the virus
- Gauging the risk of recession
- The recent drop in oil prices and related impact
- Short- and long-term interest rate declines
- Overall impacts to equity valuations
- February employment report
- Super Tuesday and election landscape
As the coronavirus (“COVID-19”) continues to spread on a worldwide basis, markets have been wrestling with how to interpret the potential economic impacts and the inevitable chain reaction now in motion. Amid this uncertainty, recent days have not only seen extreme market volatility but also a wave of medical, economic, and politically based news events, any of which under normal market circumstances would dominate headlines. However, in this new COVID-19-driven environment, they are forced to compete for investor attention. Here we take a summary look at what has contributed to a historic week in the markets and current conditions that show few signs of calming anytime soon.
- Market volatility will likely continue. As 1,000 point moves in the Dow now become increasingly common, investors should brace for more wide fluctuations on a daily basis as COVID-19 news remains fluid in regard to infection and fatality rates, as well as geographic expansion. Unfortunately, these numbers continue to increase at a rising pace globally and much of the current downside volatility in stock prices is being driven by ongoing attempts to estimate the effects of the virus on the U.S. and global economies, as well as profitability to individual companies. Selling pressure has continued to increase, and on the morning of March 9, the Dow Jones and other major indexes opened down more than 7%, triggering exchange circuit breakers and a temporary 15-minute halt in trading for the first time in more than 20 years.
- COVID-19 cases have now eclipsed 100,000 globally with fatalities now in in excess of 3,600. Highest-risk countries continue to be China, Iran, South Korea, and Italy with Level 3 travel warnings issued by the Centers for Disease Control (CDC). Japan is at a CDC Level 2 warning and Hong Kong is at Level 1. In the U.S., total cases are now above 500 with fatalities last counted at 21. So far eight states have declared a state of emergency, including California, New York, and Florida.
- The markets are now dealing with a substantial leg down in the oil markets. Over this past weekend, Saudi Arabia and Russia were unable to come to terms on reducing global supply levels so to support plummeting crude oil prices already declining from the anticipated economic impacts of COVID-19. As a result, OPEC’s expected production cuts will not go into effect, and somewhere around an additional 3.5 million barrels per day will likely now be pumped as compared to previous expectations This in turn sent crude prices tumbling by approximately 30% to below $30 per barrel, its largest single-day decline since the first Gulf War in 1991 and a level not seen since 2016. This will likely have negative impacts within the energy and financial sectors as operating profitability for producers will fall and credit conditions for energy producers are likely to tighten. The energy sector currently represents approximately 6% of the S&P 500® total market capitalization and about 12% of high-yield bond issuance.
- There will undoubtedly be negative economic consequences of the virus though quantifying the magnitude remains a moving target. In the U.S., where the virus most likely did not begin materially impacting consumer and corporate behavior until probably about early-to-mid February, most estimates for 1Q20 gross domestic product are being taken down by an incremental 0.5%–1.0% putting a final number somewhere in the 1.25%–1.75% range off of initial forecasts of above 2%. We caution that with more than three weeks to go in the quarter, these projections could change quickly and with a downward bias. The travel and leisure sectors are, of course, being hit the hardest. Declining oil prices will impact the energy sectors and, from a broader perspective, consumers are likely to become more conservative in their spending at least in the immediate future.
- While the risk of a recession has increased, we do not believe it is inevitable. We believe a lower growth scenario is likely in 2020 that avoids the standard definition of two consecutive quarters of negative growth. As 1Q20 will still most likely post positive growth, this means a recession would need to occur during the second and third quarters and/or the third and fourth quarters, which we feel at this point is highly challenging for anyone to forecast with confidence, particularly if containment efforts improve.
- Both short- and long-term interest rates have plunged over the past week. The Federal Reserve implemented its first intra-meeting rate cut in more than a decade on March 2, when it reduced the Fed Funds rate by .50% to a target range of 1.00–1.25%. Market expectations are that more rate reductions are on the way, as the Fed Futures market is forecasting at least another .50% cut at the Fed’s March 17 meeting, followed by another .25% or .50% at the April 29 meeting. Effectively, the markets are expecting U.S. monetary policy to be back in a zero interest rate environment by Memorial Day. While these rate cuts are unlikely to provide any economic relief in regard to health-related consumer decisions, such as boarding an airplane or visiting crowded venues, they can at least help the financial flexibility of companies enduring a COVID-19-induced business slowdown.
- Long term interest rates have experienced a historic decline over the past two weeks. The 10-year U.S. Treasury yield cratered below its previous record low of 1.37% and all the way down to a March 9 opening rate of about .50%. This drop is nothing short of historically remarkable by any account. The 10-year yield reflects not only a global flight to safety as the coronavirus expands, but also the fact that even in at its newly re-priced level, it still remains positive, which is a favorable profile when compared to negative rates, such as -.19% in Japan and -.72% in Germany. While the precipitous decline in long-term yields is unfortunately being viewed as a negative catalyst for stocks, we believe there is a potential silver lining in that these materially lower rates can help consumers refinance long-term debt, such as mortgages, and can also provide meaningful support for equity valuations.
- As the equity markets continue to fall, we believe it is vital investors not become overly focused on calling a bottom in the market, as such speculation can often prove futile and frustrating. Following selloffs of this nature, perhaps the closest comparison last seen in the fourth quarter of 2018, we feel it is more important for investors to determine long-term entry points based on longer-term criteria. As expectations of economic and corporate earnings growth over the next two quarters or so have now transitioned from positive to questionable, it could be productive for stock investors to focus on what appears to be historically anomalous relationships between stock dividend yields and long-term interest rates, which are now at historically high spreads. We are believers that the two strongest potential catalysts for stocks following their recent declines is the possibility that containment of the virus can be achieved in 2H20 and that the recent historic interest rate declines will eventually prove additive to stock valuations.
- Ironically, job numbers for the February Employment Report released on March 6 were exceptionally strong and well above expectations. However, the conditions driving that labor growth are now considered miles into the rearview mirror. At 273,000 jobs added to the economy, this tally was about 100,000 higher than consensus forecasts and also featured upward revisions of another 85,000 for December and January, creating a three-month rolling average better than 240,000, the best seen in more than a year. Prior to COVID-19, this report would have been cause for celebration and likely a market rally. However the investment climate is far different from just a couple of weeks ago, when these job numbers were calculated. However we do believe some comfort can be taken from this jobs report in perhaps knowing the U.S. economy was on stronger footing prior to the COVID-19 outbreak than most may have thought, therefore perhaps mitigating the net-negative effect of pending impacts.
- Finally, there was Super Tuesday on March 3 featuring 14 Democrat party primaries, which any other week of the year would have been the lead story. However in this one, it quickly fell into obscurity, from a market perspective at least. Nonetheless, we believe the outcome of Joe Biden’s remarkable reversal from long shot to frontrunner (again) is pertinent to the market as it has dramatically reduced the probability of a Bernie Sanders presidency, something equity and credit markets will likely have difficulty with in 2H20 if a Democratic Socialist candidate were to win the party’s nomination.
In summary, the markets have clearly entered at least an interim period of heightened volatility and intensified investor angst. These conditions are being exacerbated by the fact that the overwhelming determinant of the downside volatility, COVID-19 and its infection rates, are medical in nature and beyond the scope of most market and financial experts or pundits to fully, or even come close to fully, understanding. Given this reality, we believe investors should focus on known metrics within the equity and credit markets and recognize there are no foregone conclusions or outcomes to the current crises. Time-tested valuation criteria and relationships between stocks and interest rates still have merit in our opinion, even amid medically driven selloffs such as this one.
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