In this article, we review:
- The rising risk of recession in the U.S due to COVID-19
- Our expectation of negative gross domestic product (GDP) growth in the upcoming second quarter
- A look at the Fed’s most recent 1% rate cut and associated $700 billion asset purchase plan
- The recent wave of cancellations throughout the economy and their potential impacts
- The importance of fiscal policy in fighting the economic impacts of the virus
- Stock and bond market volatility, which is likely to continue
- Recent historical declines in long-term interest rates
- Why investors should focus on long-term entry points rather than calling a market bottom
The coronavirus (COVID-19) is expected to have widespread negative impacts on the U.S. and global economies throughout at least the next several months. While there is universal agreement as to the directional effects over the remainder of 2020, there remains a lack of consensus as to the severity and duration of the overall impact. Here is what we believe investors need to know as the virus moves from the winter to the spring months and we await hard economic data.
Recession risk in the U.S. has risen sharply in recent days. While the term recession is often bantered about somewhat interchangeably with an economic slowdown, the standard definition is two consecutive quarters of negative GDP growth, and that probability has increased materially over the past week as the virus has created extreme changes in business, social, and consumer behavior. As numbers quantifying the financial impact of these changes are at least weeks, if not months, away, it is clear to us that overall recession risk has risen significantly, to above a 50% probability between now and the end of 2020.
The Federal Reserve has responded to this increasing economic risk with dramatic force by reducing short-term rates to zero and reinstituting large-scale asset purchases. On Sunday March 15, the Fed announced it was reducing the Fed Funds rate by a full 1% to a target range of 0–.25%, effectively returning to a zero-rate environment. In addition, it also announced the re-application of widespread open market asset purchases, also known as quantitative easing, or in this case the planned purchase of $500 billion in Treasury bonds and $200 billion in agency-backed mortgage securities in the coming months. In a statement released just two days before its scheduled March meeting, the Committee wrote: “The effects of the coronavirus will weigh on economic activity in the near term and pose risks to the economic outlook,” and, “The Committee expects to maintain this target range until the economy has weathered recent events.” While we believe this set of actions is welcome news, it also reflects the reality that the Fed has now done just about all it can to fight the economic effects of COVID-19. The next advance forward in the battle will need to come from fiscal stimulus.
We believe recession risk has increased this past week in large part due to a mass shift from caution to cancellations throughout the economy. Coronavirus concerns have been rampant in recent days, as shown in the actions of corporations, educational institutions, and the world of sports. Companies are canceling travel and conferences, and sending workers home. More than 150 colleges representing approximately 10 million students, many of them large state universities serving as the economic backbone of small- and mid-sized towns, have moved to online classes and sent students home until the fall semester. These actions will undoubtedly have negative reverberations throughout the economy.
Nowhere has this wave of cancellations been more dramatic than in the world of professional and collegiate sports. In a matter of just a few days during the week of March 9–13, the NBA and NHL canceled their seasons, the NCAA canceled its March Madness basketball tournament, and the PGA canceled The Masters. Major League Baseball canceled spring training and postponed the April opening of its season. Bear in mind these leagues and events have been in existence since the early 20th century and have withstood economic depression and world wars without cancellations. The fact COVID-19 has done what the 1929 stock market crash, Pearl Harbor, the Cuban missile crisis, and 9/11 could not, is something that should not be taken lightly.
Since COVID-19 likely did not start having broad economic impacts until about the end of February, we believe 1Q20 GDP growth will remain positive at about 1% but below original expectations of 2% or higher. If this turns out to be the case, it would mean two consecutive quarters of negative GDP growth would not begin until the beginning of April and run through late September, providing some time for COVID-19 infection and fatality rates to possibly mitigate during the second half of the year. So for this reason alone, at least the technical definition of a recession is not a foregone conclusion. However, if first quarter GDP dips negative, we will assuredly have consecutive quarters of economic contraction in 1Q and 2Q. We realize much of this is definitional hair splitting; the important point being that we are looking at a severe decline in economic activity over the next three-to-six months, sending the economy into negative growth for that time frame.
We expect a sharp drop in GDP growth into negative territory during the second quarter as the mass cancellations made in recent days begin to take effect. We believe the odds are extremely high that we experience meaningful economic contraction (negative GDP growth) from April through June as, in addition to the widespread impacts previously mentioned, a beleaguered airline industry dovetails with an energy sector likely to take a hit from the recently enacted oil price war between Russia and Saudi Arabia. So suffice it to say, we could be on the cusp of the roughest single quarter of economic activity since the financial crisis of more than a decade ago.
The markets are looking for aggressive fiscal policy actions, in high-dollar amounts, to be injected directly into the economy. As a lower-interest-rate environment can perhaps help the financial flexibility of corporations and small businesses, it cannot convince consumers to board planes or go out to restaurants in spite of health risks, either real or perceived. This is why fiscal policy will have to pick up the tab more so than in past slowdowns. While the current legislation being negotiated between the White House and House Democrats addresses vital concerns, such as paid sick leave, enhanced unemployment benefits, food assistance, and free testing for the virus, it is essentially a disaster relief bill and not large-scale economic stimulus. Such larger fiscal stimulus apparently will have to come in another round of legislation and potentially in the form of universal payroll tax cuts, other tax holidays, or hard dollars invested by the federal government directly into the economy.
The equity and credit markets will likely remain highly volatile and at risk of more selling. Stock prices have fallen to levels not seen since December 2018, and on March 12 the Dow Jones Industrial Average declined 2,353 points (10%) for its worst day since the 1987 crash and the fourth worst day in history. In recent trading sessions, the S&P 500® has fallen to close to 30% below its record high of less than a month ago on February 19. Credit spreads have now blown out to levels not seen since the beginning of 2016, as high-yield differentials to comparable maturity Treasurys have risen to north of 7.50%. Clearly, COVID-19 has pushed the financial markets into a “not for the faint of heart” zone unseen in more than a decade.
Interest rates have also seen historic volatility. This is particularly true at the longer end of the yield curve, where the 10-year Treasury yield fell to 0.31% during intraday trading on March 9, down from 1.56% on February 19 and 1.92% when the year began. Closing March 16 at .80%, this 10 year-yield is still well below the previous record low of 1.37% in July of 2016 and creates a challenging backdrop for bond investors. Given these conditions, we feel fixed income investors are potentially well positioned in high-quality, short-term maturities below benchmark durations.
There is light at the end of the tunnel. The problem is nobody seems to know how long the tunnel is right now. However, a few things are important to note:
- While the upcoming second quarter will likely be ugly in terms of negative GDP growth, perhaps the worst since the financial crisis of 2008–2009, the slowdown could be short lived if virus trends seem to abate by summer, as it appears they now have in China.
- Should that prove to be the case, we would be coming out of that scenario with substantially lower interest rates and quite possibly meaningful fiscal stimulus at work. This could potentially be very favorable for stocks and the credit markets.
- As we have said previously, stock investors should not become obsessed with calling a market bottom, likely a futile exercise in our opinion, but instead focus on long-term entry points. With this in mind, there is some evidence we could already be there. Case in point, as of the March 16 close, the S&P 500 dividend yield is now 1.50% above the 10-year Treasury rate (2.30% vs. .80%), its highest in more than 50 years.
- Following this recent selloff, the markets could very well look quickly past a potential “U-shaped” recovery both medically and economically, provided there is hard data such an improving scenario might be in the works. This will be dependent upon COVID-19 infection and fatality trends, interest rates across the yield curve, and aggressive levels of fiscal stimulus. We believe investors should recognize such an upward move in stocks and the credit markets under these potential future conditions could be quick and meaningful.
In summary, we believe recession risk has significantly increased over the past week and economic activity in the upcoming second quarter could be the worst in more than a decade. However, the recent drop in stock prices and bond yields might now be close to fully discounting this imminent slowdown. Investors should closely watch COVID-19 infection trends, a potentially steep second quarter GDP decline into negative growth territory, levels of short- and long-term interest rates, and potential fiscal stimulus. All of these dynamics should be viewed under the realization that stocks and the credit markets could fall further but are likely now at or closely approaching attractive long-term entry points.
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