February 26, 2020
“It’s not so much a question of IF we will see an increasing number of cases in the U.S. anymore, but rather more a question of exactly WHEN this will happen and how many people in this country will have severe illness.”
– Dr. Nancy Messonnier, Head of the National Center for Immunization and Respiratory Diseases at the CDC
“The only thing we have to fear is fear itself.”
– Franklin Delano Roosevelt
With announcements like the one above from Dr. Messonnier, it’s no wonder markets are on edge. On January 30th, we wrote a note on the coronavirus outbreak. Our conclusion was: “The headlines will continue to affect investor sentiment until we see a plateau in the number of diagnosed cases. An acceleration of the incidence of the virus, an increase in person-to-person infection, or an increase in the mortality rate would cause severe damage to the stock market given that the worst cases are most certainly not priced in. That has benefited clients to date – the reduction in risk taking has been orderly. But this is nature we’re dealing with, and it can be fickle and unpredictable. Caution is warranted until the virus is contained.”
Clearly the virus – now known as COVID-19 – is not completely contained. Official figures released today tell a story of a widening crisis (as of February 25, 2020):
- Total confirmed cases are now 80,238 in 34 countries
- Cumulative death toll is at least 2,700
- The World Health Organization said officials are preparing for a potential pandemic (an epidemic of disease that spreads across a large region)
- The outbreak has arrived in force in Italy with 322 confirmed cases (out of a total of 377 in Europe)
- Anthony Fauci, the Director of the National Institute of Allergy and Infectious Diseases, said “We urgently need a safe and effective treatment for COVID-19. Although Remdesivir has been administered to some patients with COVID-19, we do not have solid data to indicate it can improve clinical outcomes”.
- An American is the first participant in a National Institute of Health-sponsored U.S. trial that will evaluate an investigational antiviral – Remdesivir – for the treatment of COVID-19.
- In some ways the COVID-19 outbreak is significantly worse than prior coronavirus outbreaks. In other ways it is not as bad – see the comparison chart below.
- As of February 26th, there is no specific treatment yet available for coronavirus1.
Fear has temporarily taken hold of the equity markets. What was an orderly sell-off in January, followed by a period of complacency and higher equity prices in February has mutated, much like a virus, into a disorderly rout. The sharp equity market sell-off of the past four trading days since February 20th has renewed fears of the potential economic damage caused by the global response to the novel coronavirus, especially given the stretched valuation levels reached in recent weeks. Consider the state of play:
- The S&P 500 reached an all-time high on February 19th of 3,393
- The Price Earnings (P/E) ratio, a measure of equity market valuation, stood at 19.4x on February 20th, more than one standard deviation above the long term mean of 16.1x
- Tuesday’s close (Feb 25th) the S&P 500 stood at 3,128, down about 8% from the all-time high
- The P/E ratio after the recent sell-off was 17.9x, still above the long-term average (16.1x) and the recent 3-year average (17.3x)
The market was vulnerable to a pull back at these valuation levels, should a suitable catalyst present itself. Such a catalyst arrived on Friday last week. Nothing has yet appeared to break the fever of negativity. On Tuesday, February 25, Federal health authorities said they now expect a wider spread of COVID-19 in the U.S. and are preparing for a pandemic. They add that they remain unsure about the severity of the potential health threat. The Center for Disease Control and Prevention said the agency expects a sustained transmission of the virus and called for businesses, schools and communities to brace themselves and plan for potential outbreaks. “We expect we will see community spread in this country, meaning the virus circulating within local communities,” said Dr. Messonnier, Director of the National Center for Immunization and Respiratory Diseases at the Centers for Disease Control and Prevention. Uncertainty has increased. The market has responded to this uncertainty accordingly. In a flight to quality, U.S. Treasury yields have fallen to historical, multi-century low levels. The bond market was, once again, an effective early warning system as yields fell nearly 0.50% in January, well before the recent market turmoil.
When thinking about how this will resolve, we need to address both the possible solutions to the spreading virus outbreak and the spreading panic in the capital markets. How best to deal with the virus is still unknown, but it is certain that a solution will present itself in the form of a vaccine, a reduction in new cases due to effective remediation, a change in the weather, or that a treatment solution will arrive and dampen the uncertainty surrounding morbidity and mortality rates.
On the other hand, the Federal Reserve is exactly what the doctor must order to treat panicked capital markets. It is instructive to think about two scenarios: one where the global economy is not materially damaged by the measures taken to contain COVID-19, and one in which U.S. GDP does slip significantly below a 1.5% growth rate. Our base case remains “no recession” in the U.S., and that implies only modest damage to corporate profits. Then, it is a matter of assuming a P/E ratio that better reflects the current level of uncertainty surrounding both profits and monetary policy. If we assume corporate profits (S&P 500 4Q forward earnings) remain above $170, and the P/E ratio decompression ends at around 17x (both reasonable assumptions currently), then we should see a floor on the S&P of around 2,890 or about -8% lower from here. Painful, but manageable, and our best guess of a risk case. If, however, this pushes the U.S., or a significant part of the global economy into recession, then we could see significantly more damage done as both corporate earnings and P/E ratios are compressed meaningfully – this must remain a tail risk until the number of cases of the virus plateaus. A bear market (-20% in equity levels) cannot be ruled out in this scenario.
Market participants increasingly expect the Fed to make an announcement or lower rates to break the fever. They will do so, and in time, to avoid the worst-case scenarios. We can be sure that U.S. central bankers are monitoring the spreading virus. Federal Reserve Vice Chairman Richard Clarida said it is “still too soon” to say whether it will result in a material change to the outlook. The markets are more certain about what the Fed needs to do; there are increasing bets being placed on further easing in the Federal Funds futures market. An open question remains. If the Fed waits too long to act, will it have enough “medicine” to cure what ails capital markets? The longer the Fed waits, the more damage will be done.
Our outlook for the economy and markets is based on macroeconomic fundamentals and is informed by a review of financial conditions. As a reminder, when financial conditions are easing, economic conditions improve in the future. Recall that “financial conditions” refers to stock prices and stock price volatility, credit spreads, interest rates and the U.S. Dollar. Financial conditions are tightening today. Stock prices are meaningfully lower and stock market volatility has increased. This dampens future economic activity. On the other hand, lower interest rates help to ease financial conditions. The U.S. Treasury 10-year is at an all-time, 229-year low. The Fed can also directly affect financial conditions by lowering the Fed Funds rate. The Fed will do so if economic growth is threatened.
We think the Fed will act with due haste. The markets will settle on the news, but an immediate return to record equity levels is not an offer. Investors will take time to recover from this shock to the system, and risk-taking will return only gradually as a full assessment of the longer-term economic implications is revealed in the upcoming data.
Our BASE case: should the stock market continue to wobble, the Federal Reserve will step in to support economic growth with soothing rhetoric or actual Fed Funds rate cuts/balance sheet expansion. This will support risk-taking and the stock market and put a floor under the worst-case scenario.
The Fed is not predisposed to reduce rates but given the inflation outlook, it has the scope to do so. Last week the Fed released the meeting minutes of its January 28-29th policy meeting. Members of the Fed’s interest rate setting body (the Federal Open Market Committee, or FOMC) addressed the recent outbreak by stating that the “threat of the coronavirus, in addition to its human toll, had emerged as a new risk to the global growth outlook.” However, they also expressed confidence in the ability of the U.S. to continue the record run of economic growth and job gains. They cited a reduction in trade-related uncertainty that had dampened business investment spending throughout 2019. Furthermore, the FOMC said that consumer spending, a key element of GDP, should “remain on firm footing, supported by strong labor conditions, rising incomes, and healthy household balance sheets.”
The markets are gripped by fear. The Fed has the cure. The federal health agencies are preparing the markets for a prolonged bout of virus-induced uncertainty. All this can change with either an announcement of a treatment protocol, or more likely, a response from the Fed. There is also a possibility that the market falls to a level that induces investors to buy based on more attractive valuation levels. This is not far-fetched if corporate profits remain stable at or above $170 – that remains our base case. This fever will break.
It is our belief all will be well once valuations have re-rated to reflect the increasing uncertainty, and sentiment returns to normalized levels. To paraphrase FDR: “All we have to fear is fear itself.” Stay focused on the long term, the Fed has your back.
For regular updates and market flashes authored by Beacon Pointe’s CIO, follow @BeaconPointeCIO on Twitter.
1 WORLD Health Organization (WHO). Coronavirus. 2020. https://www.who.int/health-topics/coronavirus (5 February 2020, date last accessed)
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