What’s priced in? Where do we go from here?
Our Top Market Takeaways for March 18, 2020.
The saga continues
Following the S&P 500’s largest daily decline since 1987 (-12.0%), markets clung to the idea that fiscal stimulus might be right around the corner. The S&P 500 recovered +6.0% yesterday (doesn’t seem like much compared to the +/-9% days as of late, but it’s still above the ~5% daily swings implied by the VIX and above the 4.4% average daily move during this bear market). International markets followed suit, as MSCI EM (+7.0%), MSCI China (+6.3%), Japan’s TOPIX (+2.6%) and the Stoxx Europe 600 (+2.3%) all ended yesterday in the green. U.S. Treasury 10-year yields sold off for the fifth time in the last six days and are now back above 1.0%, sitting at 1.11%.
Today, markets are taking another turn lower. After a mixed night in Asia (CSI 300 -2.0%, TOPIX +0.2%), the Stoxx Europe 600 lost -3.9% and the S&P 500 is back under pressure, down nearly -9.0% at 2:00pmET. We expect daily swings like these to continue in the weeks ahead as markets work to price in the extent of the economic decline.
So what was *new* in the news yesterday?
- Most headlines were centered around U.S. fiscal policy and how it will be used to combat COVID-19’s impact. The White House and Congress are trying to get something done ASAP, and they are floating the idea of a package worth at least $1 trillion. While exact details are not yet known, this package could include industry-specific support to those companies negatively impacted, as well as direct payments to Americans.
- The Fed continued its rush of monetary stimulus. The Central Bank reintroduced Commercial Paper Funding Facility (CPFF), which is meant to ease liquidity concerns by opening a channel for primary issuance and providing corporates with funding.
- Former Vice President Joe Biden swept Arizona, Florida and Illinois in another handful of primaries. Biden is a near certainty to win the Democratic nomination.
- Bank of America’s most recent fund manager survey showed the largest month-over-month drop in global growth expectations in its history (the survey started in 1994), and lowest global EPS expectations since the global financial crisis. The survey also showed that cash levels jumped from 4.0% last month to 5.1%, representing the fourth-biggest monthly increase in cash allocation since 2001.
Markets are clearly fixated on the policy response to the COVID-19 disruption, and we think the fiscal policy response will play a critical role in the path forward from here.
What’s priced in, and where do we go from here?
The first step in determining where we’re going is to examine an existing template. Almost exactly two months ago, the Chinese economy shut down in an effort to control the spread of COVID-19. We are just starting to get statistics that quantify the extent of the slowdown. They paint a historically weak picture for growth. As Alex Wolf (our Asia Strategist) noted, industrial production, retail and automobile sales, and fixed asset investment all suggested the largest contractions on record. An optimist could argue that things are getting better (all indications are that the economy is back running at 60%–80% of its full capacity), but Chinese growth in the first quarter was historically bad, and now the economy has to deal with tentative domestic and external demand as the virus spreads around the world.
Despite being the epicenter of the outbreak, Chinese assets have outperformed their global counterparts this year. Consider that the S&P 500 is down -25% year-to-date. Offshore Chinese stocks are down -15% year-to-date, while onshore Chinese equities are only down -9%. How can that be, you ask? First, it’s worth noting that valuations for each market started at a different place: U.S. valuations were stretched by most estimates, while Chinese valuations were about in line with historical averages (in other words, Chinese stocks had less room to fall).
We also think it has a lot to do with both direct government intervention in the market itself and policymakers’ proactive, coordinated and robust effort to backstop businesses and stimulate growth. Critically, the unemployment rate in China did not rise nearly as much as we would have expected, given the bleak growth rates, and government spending is going to contribute the vast majority of real GDP growth this year. Clearly, comparing the Chinese political machine to the United States is, to put it mildly, apples and oranges. But China’s experience does suggest that the government will play a critical role in determining the ultimate severity and duration of the economic and market downturn.
So what growth outcomes are priced in now? It seems inevitable that the United States and Europe are likely to experience similar growth experiences through the rest of the first quarter and through the second quarter. Indeed, the current drawdown in equities (25%–30%), level of high yield and investment grade spreads (~900 and ~280), and move in Treasury yields all suggest that a major growth slowdown is coming. However, what does not seem priced is a deep recession characterized by stubbornly high unemployment and scar tissue that inhibit investment once the catalyst resolves itself.
Wait, how bad could it get? You might recognize this chart—we’ve used one similar to it in recent Top Market Takeaways notes. Last time we used it, we noted that the moves in assets have been commensurate with the average recession. This time, we compare them to a severe global recession, during which it would not be unheard of to see a -45% drawdown in stocks, high yield and investment grade spreads at 1,300 and 350, respectively, and Treasury yields close to zero. In that case, we are only around halfway there in terms of asset pricing.
What is the difference between what markets are expecting now (a typical growth slowdown) or a global recession (where we would expect more downside)?
To us, it is simple. Markets are still expecting the rise in unemployment to be relatively mild (think a rise to around 4%–5.5%), and the combination of monetary and fiscal policy to keep credit flowing to the economy and to cushion the economic decline. Then, once the virus clears, the economy will need stimulus to get going again. This seems to be the path China is following, and the United States and Europe should consider following the same.
I get what the Fed is doing to support the financial system. How much fiscal stimulus do we really need?
A $1trn package would likely be sufficient, while a $1 trillion package would likely provide a serious jolt. For context, the American Recovery and Reinvestment Act, which President Obama signed into law in February 2009, was an $831 billion package (~5.75% of that year’s GDP).
To map that to unemployment, economists use a rule called “Okun’s Law.” Generally, you can estimate the change in GDP relative to potential by observing the change in unemployment. Thanks to algebra, and by making assumptions around fiscal multipliers (a measure of efficacy), we can solve for the degree to which stimulus could help offset a rise in unemployment.
In this example, we assume that the legislative package will come in three phases. The first one is already done, and focuses on the healthcare system and actually fighting the virus. The second phase is likely to come soon, and will likely focus on the sectors of the economy that are most at risk (airlines, travel and leisure, broadly). The final phase will likely focus on actually stimulating the economy out of the COVID-19 recession through broad measures. We show two “total” bars, one at $850 billion total and one at $1.2 trillion (which was the number floated by the Trump administration yesterday).
Using Okun’s Law, we think that a ~$850 billion package could offset about half of the rise in unemployment that we see in an average recession.
Are you more concerned about quantity or quality? Great question! First, there is a size threshold that will be necessary to get the market’s attention. After that hurdle is cleared, the quality of the legislation will be critical. If the bill is composed mainly of payroll tax cuts dispersed over a long period of time, that is very different from injecting cash directly into the hands of businesses and households that need it. There is also a distinction to be made between fiscal stimulus (designed to give the broad economy a boost) and fiscal support (which offers targeted relief to those who need it). We can break that down once we have a better sense of the actual legislation.
Overall, fiscal stimulus can be a powerful tool to mitigate downside. Avoiding a substantial rise in unemployment has massive implications for American workers, Main Street businesses and Wall Street asset prices.
All market and economic data as of March 2020 and sourced from Bloomberg, FactSet and Gavekal unless otherwise stated.
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