So what gives with the markets? Let’s use the S&P 500. It was down 33.9% from its 2020 high on February 19th to its low on March 23rd (shortest bear market on record). It then rebounded 31.9% until April 29th (a dizzying bounce) and has remained essentially flat ever since. Unfortunately, the S&P 500 is still down 13.2% since its February 19th close, but we are no longer looking at a vicious bear market but rather a reasonable equity correction.
The rebound has been welcome, although mystifying to many investors. Just as the markets were headed straight up, the unemployment rate was skyrocketing (estimated to peak at around 15.8% this summer according to the Congressional Budget Office). And manufacturing activity was dropping to a level not seen since 2008. So why were investors so optimistic at the start of what could be the worst recession since World War II?
Let’s start with the notion of time. As mentioned in my previous blog, markets like to think ahead. They lead the economic data. As painful as the present is for many people, the markets are focused on 2021. If the news on the therapeutics and vaccine fronts remains positive (as they did this past week with Moderna announcing the successful creation of neutralizing antibodies in Phase I of its vaccine trials), an economic recovery remains possible for early 2021.
Then there is the concept of the Win-Win. Back in late April Jerome Powell, Chair of the Federal Reserve, said, “People are undertaking these sacrifices [via shutdowns] for the common good. We need to make them whole to the extent we have the ability.” The Fed is doing what it can – seeking to borrow $3 trillion this quarter alone to purchase various securities to ensure liquidity and a functioning economy. Likewise, the government has spent over $2.3 trillion in recovery programs to help individuals, (direct payments and unemployment support) small businesses (Paycheck Protection Program), and the medical community. But these programs are currently set to end this summer, long before the economy is likely to be back on track. While confessing that the Federal Reserve has no limits to how much money it can create and lend, Powell emphasized that the Fed alone could not save this economy. He pushed the federal government to do much more to keep individuals and companies solvent during the recession, in order to avoid a much more dire outcome.
The Win-Win theory is that if the economy returns to near normal activity next year, investors win, since the markets will reflect the good news well in advance. If the economy suffers longer term damage, markets believe both the Federal Reserve and Congress will further stimulate the economy. You often hear experts warning that this is “not the time for the government to be frugal.” Another win for the markets.
And then there is the belief that some of the Federal Reserves’ monetary benefits are ending up in the hands of the more well-off, who tend to save and invest what they cannot spend. This pattern is similar to the impact the Fed’s Quantitative Easing program had after 2008, when some of the stimulus ended up in the stock market. With interest rates at historically low levels, the acronym TINA (there is no alternative) still applies for stocks.
And finally, it is important to note that not all stocks have suffered from the shutdown. 58% of the S&P 500 stocks are COVID winners – meaning they benefit from the virus (think healthcare and tech). These stocks – particularly those with large market cap weighting — have cushioned the impact of the fall in equity prices.
While these ideas help to explain why the markets have risen in the past two months, they do not predict what lies ahead. That is because there is still a disconnect between what the markets are saying and what the economy is broadcasting. And while markets and fundamentals are often out of sync in the short run, they tend to converge in the longer run. This means that either the economy rises to match the markets or stocks fall to reflect the state of the economy.
Pessimists take their cues from economic uncertainty. For example, small businesses are responsible for around half of US employment, half of gross domestic product, and 40% of business revenue. (Barron’s). The fact that small businesses have reduced their employment by 40% since January, means that the impact of the shutdown has taken a tremendous toll on the entire economy. In addition, while the Paycheck Protection Program is currently supporting around 50 million jobs, many small businesses do not qualify or have struggled to figure out how to successfully apply for the forgivable loans.
The Bears worry that temporary layoffs necessitated by the shutdown will become permanent. As Strategas Research succinctly put it, “Workers can only be called back from furloughs if their company still exists.” The fear is that the damage being done by prolonged unemployment will take years, not months, to repair.
What we need is a virtuous cycle of good news. The cycle starts with the development of promising therapeutics and vaccines along with a true summer lull in coronavirus cases. This brings consumers out to shop or eat or enjoy leisure pursuits on a regular basis — a critical part of the recovery, as states embrace reopening of the economy. Seeing increased demand, businesses then hire back more workers, who in turn spend more money, raising confidence that we can recapture previous lifestyles while we learn to live with the virus. This confidence leads to more hiring and spending and ultimately a full recovery. This cycle is entirely possible (again, the bull case) but could be interrupted by any one or more of the following:
- A strong second wave of the virus
- Failure or substantial delay on the development of successful therapeutics/vaccines
- A reluctant consumer who chooses to save and adopt a simpler lifestyle rather than spend
- Political wrangling that blocks further stimulus packages designed to support states, individuals, businesses, and healthcare.
- A Federal Reserve adopting negative interest rates, which could destabilize some financial services
Who is right? The optimists who see the coronavirus as a nasty but self-limiting interruption to long term economic growth, or the pessimists who worry that the road back will be long, arduous and uncertain. Without a good pandemic road map, for now we are playing this one down the middle.
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