In this article, we review:
- Historically catastrophic economic numbers
- The market’s strong rally since late March in the face of these currently disastrous reports
- What we believe to be the four major catalysts driving the equity and credit markets
- While long-term market opportunities have improved, investors should still recognize uncertainties and volatility will likely persist
Horrendous economic numbers resulting from the COVID-19 pandemic and its corresponding business shutdowns are now officially rolling in, and they are every bit as bad as expected. On May 8, the Bureau of Labor Statistics released the April Employment Report, which was not surprisingly the worst in history with 20.5 million jobs lost and an unemployment rate of 14.7%. These job losses were about 10 times higher than the previous record monthly job losses of 2 million in September 1945, and in all likelihood the unemployment rate will rise in the month ahead as government statisticians scurry to catch up with those classified as absent from work but not yet as unemployed. In a month like this past one, the counting just cannot seem to keep up with the actual job losses.
In the weeks to follow, more historically dismal numbers will be reported. These will include metrics such as retail sales, personal spending, and the Institute of Supply Management Manufacturing and Non-Manufacturing Purchasing Manager indexes, all of which could post their worst monthly reports ever. These and other wilted short-term measures of the economy will likely lead to a second quarter gross domestic product contraction of -30% or worse, with S&P 500® underlying year-over-year negative earnings growth in the neighborhood of -25% for the first half of the year. While these types of pending numbers are far from unexpected, they will still likely be quite sobering as they are announced in the days and weeks ahead.
Yet with disastrous economic reports of this nature, previously deemed unimaginable just a few months ago, stocks and the credit markets have experienced one of the strongest bounce-back rallies on record. As of the market close on May 11, the S&P 500 has increased 34% off of its March 23 low and is now down less than 10% from its 2019 close. The NASDAQ has risen 39% since late March and is now actually over 2% positive for the year. High-yield credit spreads have narrowed by more than 3.5% to about 7.5% versus comparable maturity Treasury bonds since late March, and corporate investment-grade spreads have fallen by almost half their margins, from just over 4% to about 2.2%.
This Rocky Balboa-like market bounce off the canvas has unleashed the question: Are markets now totally disconnected from reality, or is the worst behind us and a future economic recovery not as distant as previously feared?
We come down more on the latter side of this debate. We believe there have been four predominant catalysts driving the markets higher over the past several weeks, and also feel they could have a continued strong effect between now and year end. These are:
Implementation of the CARES Act Economic Stimulus Package – We are now seeing the enactment of the $2.2 trillion Coronavirus, Aid, Relief and Economic Security Act (CARES Act), passed by Congress in late March, on a national basis and now with an additional $480 billion added in late April. In addition to $500 billion allocated to mid- and large-sized businesses (500 or more employees), approximately $650 billion has also been allocated to small businesses (fewer than 500 employees) under the Paycheck Protection Program, which is vital as small businesses employ about half of the total U.S. labor force. The CARES Act also provides for lump-sum payments to individuals and families as well as enhanced unemployment insurance benefits to displaced workers. Also including about $150 billion to state and local governments, which should ultimately prove helpful to the municipal bond markets, the CARES Act has been viewed by the market as an important bridge to help the economy during its transition to a recovery. We also believe there is a strong probability we could see a CARES II Act sometime later this year, perhaps totaling an additional $2 trillion or so.
Historical Monetary Stimulus from the Federal Reserve – Since the first week of March when the Fed began taking short-term rates to zero, the committee has re-initiated large-scale, open-market asset purchases (also known as quantitative easing or QE) on an open-ended basis and at levels looking to soon dramatically outpace the $4 trillion that was implemented during 2008–2014 in the immediate aftermath of the financial crisis. In fact, in the two months since the Fed announced its return to QE, it has already purchased more than half of what they did in the six years during and following the Great Recession. Moreover, the venue of what the Fed is now buying in the open market has expanded meaningfully to now include not just Treasury bonds and agency mortgage-backed securities, but also corporate high-yield and investment-grade bonds, municipal bonds, commercial mortgage-backed securities, and even private loans issued through the CARES Act. The unprecedented magnitude of this monetary stimulus has and should continue to provide strong support and liquidity for the equity and credit markets. In addition, near-record-low levels in long-term Treasury yields (10-year rate .68%) make equities comparatively more attractive, even assuming reduced earnings and dividend yields.
Improving Medical Data Trends – Despite the grim news regarding the cumulative COVID-19 cases in the U.S. and globally, as well as the rising numbers of fatalities that are difficult to listen to let alone interpret, there are signs the overall virus trends are improving. Since mid-April, the ratio of recovered cases to total reported cases in the U.S. has more than doubled in percentage terms from approximately 8% to 20%. This has occurred while the fatality rate has remained basically stable over the past month at just under 6% and the ratio of serious cases to active cases has also remained low at less than 2% (Worldometers.info). This infers if the fatality and serious case ratios can remain constant, a higher percentage of the active cases can be resolved as recoveries, potentially helping the U.S. to reach a recovery to total cases ratio above 50% by the fall, closer to world leaders such as Germany, Switzerland, Ireland, Israel, Austria, and South Korea. Should this level be achieved, there will be a stronger argument to further re-open the economy.
Early Phase Reopening of the Economy – On April 16, the White House announced a three-phase plan to reopen portions of the economy, however the decision to implement those phases, or similar ones, was ultimately left up to the individual states themselves. Since that time 43 states have announced new or pending plans to allow for business openings under social distancing restrictions mostly pertaining to restaurants, retail businesses, gyms, recreational areas, select non-essential businesses, social gatherings, and elective surgeries. These re-openings are also occurring alongside relaxed and widely debated stay-at-home orders while the nation continues to weigh medical safety versus financial recovery at a time when virus numbers continue to rise and the economy is facing its worst single quarter of contraction since the 1930s. In attempting to balance these two important objectives, the market has reacted well to the recent re-openings and will likely continue to do so. As the trend of re-openings continues, it likely lends credence to the arguments this 2Q could represent the depths of the contraction, potentially inferring the start of quarter-over-quarter growth in 2H20. This would also likely be favorably received by the market provided we do not see a resurgence of worsening virus data.
These four catalysts have played a major role in the impressive market recovery since late March and will likely continue to do so in the weeks and months ahead. Yet even in the aftermath of the fastest 35% decline in S&P 500 history culminating on March 23, stocks have still traveled very far and fast since that day. So while there is a strong case in our opinion these catalysts will continue to shape a highly favorable long term profile for the markets, investors should also recognize current uncertainties and ongoing volatility still make this environment ill-suited for faint hearts or short time horizons.
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