The last week’s market highlights:
Quote of the week:
“Leave some room in your heart for the unimaginable.” ̶ Mary Oliver
Gauging the shape of the recovery
Last week brought some positive news in the battle against the coronavirus. In the U.S., the contagion curve continued to flatten in hard-hit hotspots such as New York City, and growth of new COVID-19 cases overall started to slow significantly. These developments prompted President Trump to take the first step toward re-starting the economy. On Thursday, he issued federal guidelines allowing governors “to take a phased and deliberate approach to reopening their individual states” following weeks of shelter-at-home mandates. To do so, states will have to walk a tightrope between preventing a second wave of infections and facilitating an eventual return to “normal” life.
The gradual lifting of state restrictions is one of many necessary actions in the multifaceted effort to revive the U.S. economy. While the Federal Reserve has already stepped up with two “bazooka” blasts of targeted monetary stimulus, even more policy support may be needed. Chair Jerome Powell recently pledged to use the Fed’s powers “forcefully, proactively and aggressively until we are confident that we are on the road to recovery.” In light of his comments and hints in recent press releases, we’re expecting the Fed to take further action, including potentially purchasing municipal bonds in the secondary market and strengthening its backing of bank loans made to small and medium-sized businesses.
On the fiscal front, Congress will need to augment the $2 trillion CARES Act—and quickly.
Here’s a stark example of why. On April 16, the Small Business Administration reported that the $350 billion Paycheck Protection Program (PPP) had run out of money. The PPP was a CARES cornerstone that offered forgivable loans to small business owners if they used the proceeds to meet payrolls, mortgage interest, rent and utilities. Providing relief to Main Street establishments is essential, as their health is key to keeping the economy firing on all cylinders. Indeed, businesses with five to 99 employees collectively employ 36.5 million workers, representing almost 30% of the nation’s workforce.6
Assuming continued ample stimulus from the Fed and Congress, along with the successful reopening of individual states, how might the U.S. economy respond?
The best-case scenario: a sharp, “V-shaped” recovery. That would require a quick, robust and sustained economic turnaround, which we don’t anticipate. There are still too many unanswered questions related to the coronavirus itself, and the economy’s freefall is showing further signs of being as bad as we’d feared.
Last week brought 5.2 million first-time unemployment claims, bringing the 4-week total to over 22 million.7 Putting that number in perspective: in about a month, the COVID-19 pandemic has wiped out nearly all the jobs than the economy had created since the end of the 2008-09 financial crisis. And in our first glimpse of hard data showing how the virus has affected consumer behavior, retail sales plunged 8.7% in March, their biggest one-month fall ever.8
If the best-case V-shaped recovery is unlikely, in our view, so too is an “L-shaped” trajectory for U.S. GDP growth. This scenario assumes the economy won’t rebound for years after its anticipated steep decline. But with restrictions that brought life to a standstill expected to ease over the next month or two, we expect positive growth in the second half of 2020. We’re cautiously optimistic that certain segments of the economy, perhaps starting with small businesses such as restaurants and retail shops, will begin to open up during the summer. Europe may act as a model in this regard. Last week, a number of countries, including Austria, Denmark and Germany—the region’s largest economy—began relaxing restrictions on schools and small shops or planning to do so.
Taking into account all of these factors, we think the most likely scenario is a recovery shaped not like a letter but like a checkmark: a sharp downturn followed by a slightly flatter upturn that goes beyond the pre-coronavirus level of global GDP, surpassing it roughly two years after the trough. To illustrate, the most recent World Economic Outlook from the International Monetary Fund, released on April 16, projects that the U.S. economy will contract by 5.9% (annualized) in 2020 before growing at a robust 4.7% rate in 2021.
Such a healthy projection may raise eyebrows. After all, the U.S. didn’t grow at even a 3% rate in any calendar year since following the 2008-09 global financial crisis. Why might this recovery be so much faster and sharper?
- A healthy banking system. New regulations implemented after the financial crisis have strengthened banks’ balance sheets.
- Stronger household balance sheets. Americans have entered this downturn with a lot less debt, and a much smaller percentage of their income is being used to service that debt.9
- Swift, expansive global stimulus. The Fed and its global central bank counterparts have acted more quickly and aggressively to combat the COVID-19 outbreak. And global fiscal stimulus (about $8 trillion as of April 2020, according to the IMF) has already dwarfed that spent in the wake of the financial crisis.
Economists and analysts haven’t hesitated to offer widely divergent views on the depth and length of the downturn, or the extent and strength of the recovery. But their forecasts will take a back seat to the guidance provided by health-care experts. As New York Governor Andrew Cuomo recently put it, “Tell me what our infection rate spread is…and then the experts will tell us the best course of conduct.”
Stocks continue to climb, yet U.S. Treasury yields remain near record lows. What gives?
As expected, the U.S. economy ground to a halt in March. Last week’s calendar of economic data brought grim reminders:
- Retail sales shrank 8.7%.
- Industrial production, a gauge of factory, utility and mining output, fell 5.4%, its biggest one-month decline since 1946.10
- The Conference Board’s index of leading economic indicators suffered its worst month ever. And an astonishing 22 million Americans have filed first-time unemployment claims over the last four weeks.
Shrugging off these and other dismal data releases (like March’s loss of 700,000 payrolls) equity bulls have declared, “It’s rally time!” With its 3% gain last week, the S&P 500 Index has surged 28.5% since bottoming on March 23.11 To what do we attribute the extra pep in their step? Investors are counting on a 2021 earnings recovery backed by a number of optimistic assumptions: continued progress containing COVID-19’s spread; confidence that unprecedented global fiscal and monetary stimulus will achieve its desired ends; and faith that the labor market will come roaring back once the country’s lockdown eases and ultimately ends.
Meanwhile, the U.S. Treasury market is taking a far less sanguine view of the economy’s long-term prospects. The yield on the bellwether 10-year Treasury, which tends to fall when the economic outlook appears bleak, declined 8 basis points during the week, to close at 0.65%—barely above its all-time low of 0.54% set on March 9. (Yield and price move in opposite directions.)
The 10-year yield has been suppressed by the Fed’s hefty purchases of Treasury securities (as part of its recent commitment to open-ended quantitative easing) and steady global demand for the higher payout offered by U.S. government debt. Although the 10-year yield may be exceptionally low by historical standards, it remains far above the -0.47% currently offered by 10-year German bunds, considered the safest asset in the eurozone.12
There’s also consistent demand for Treasuries from equity bears who caution that the U.S. economy’s reopening will be gradual at best, compounding the problems faced by businesses. These naysayers also reckon that the service sector (especially restaurants, travel and hotels), which makes up about 80% of U.S. GDP, is unlikely to experience a significant rebound until 2021, at the earliest.
So who’s right: the bulls or the bears? Neither one, in our view.
We think some skepticism over the recent equity rally is warranted. First, the U.S. still has no plan for rigorous testing, tracking and effective treatment of the virus, which will be necessary for economic activity to return in full. Second, we can’t determine with precision or confidence the depth of the impending recession. And third, a second wave of infections is possible. In terms of valuations, stocks aren’t cheap. Assuming a 20% drop in earnings in 2020 and a 23% surge in 2021—in line with our forecasts—the S&P 500 is trading at a price/earnings multiple of 20.5X, well above its 20-year average of 16.2X.13
At the same time, a 10-year yield of around 0.65% offers too pessimistic a view of long-term U.S. growth. While this recession will be painful, we think it will also be brief—shorter, in fact, than the one triggered by the 2008-09 financial crisis.
In summary, don’t expect stock prices to keep rising and Treasury yields to keep falling. Look for equities to give back some of their gains during weeks when coronavirus headlines aren’t quite so upbeat, and for Treasury yields to eventually edge back up as the pace of Fed purchases declines and optimism about future economic growth returns.