In our outlook for 2020, we postulated a pro-growth, pro-cyclical stance was warranted, given the underlying strength of the U.S. economy and the burgeoning signs of a rebound in growth abroad that would provide a favorable setting for risk assets.
A Black Swan event in the form of the coronavirus (COVID-19) has interfered with that development. If past is prologue, this outbreak should wither eventually and the negative economic impact prove transitory. The positive impulse from low interest rates,
low energy prices, fiscal stimulus from China and possibly elsewhere, and what was already a firming macroeconomic backdrop, should allow the pent-up demand-led recovery to unfold quickly in the coming quarters.
While volatility will persist nearer term as the virus’ news evolves, we continue to advocate for a constructive stance on equities, as the underpinnings of support should resume their pre-virus improvement. In our judgment, the reasons for investors to stay long equities that we laid out in our Outlook 2020 piece have been delayed by the coronavirus outbreak not derailed by it.
A review of previous sizable and lethal viral outbreaks (with the Severe Acute Respiratory Syndrome (SARS) being a good example because like the coronavirus outbreak it emanated from China) suggests risk assets are likely to find a bottom once the number of COVID-19 cases peaks. Investors reacted to that expectation when, several weeks ago, it appeared reports of new cases had crested which helped to propel stocks to all-time highs. Today, while we are still seeing a slowing pattern in the confirmed cases inside the Hubei province, news show a spike in the numbers reported in other countries. That setback has served to unnerve market participants, which unleashed a heavy bout of price volatility.
Estimates are proliferating around the impact this will have not only on China, but the global economy at large. While nobody knows for sure, the expected diminution will be materially different than when SARS erupted in 2003 given China is now four times
larger and plays a prominent role in supply chain transmissions. However, the good news is that the U.S. economy has been quite strong while economic data abroad provided clear evidence a rebound from the sluggish pace of last year was underway. Forthcoming
reports should better gauge the impact but it is encouraging that the macro backdrop was firming preceding the outbreak. That should help the improving global condition to restart once the spreading of the virus and been arrested, thereby delaying
rather than derailing the fundamental support for economies to expand and equity markets to rally.
Economic expansion holds in the U.S.
From a domestic perspective, the expansion is in very good shape. Easy monetary conditions will support a range of activities, and a potent labor market will continue to give households the confidence and wherewithal to prime the consumption pump. Consumer
spending depends on household income, the condition of household balance sheets, and households’ willingness to spend. The labor market remains extremely tight, with the unemployment rate at a 50-year low, and the prime-age labor force participation
rate (those between the ages of 25-54) trailing only the peak reached during the dot-com era. That bodes well for household income. To be sure, households can use income to increase savings or pay down debt instead of spending it, but it does not
look like they will. The savings rate is already quite elevated, having returned to its mid-‘90s levels, households have already run debt down to its post-dot-com bust levels, and debt service is less demanding than it has been at any point
in the last 40 years. The health of household balance sheets, and the recent pickup in the expectations component of consumer confidence surveys, suggest that households have the ability and the willingness to keep consumption growing at a vigorous
Business investment could be at risk of declining enough to dilute some of the positive effect from consumer spending. Indeed, it was a drag in 2019, declining in each of the last three quarters to end the year more than 3% below its peak. We expect it will hold up better this year, however, as the capital spending intentions components of the survey of smaller businesses and the regional Federal Reserve manufacturing surveys have both turned higher. The trade tensions with China weighed heavily on business confidence in 2019, but the signing of the phase-one trade agreement lifted that cloud, and we expect that capex will revive in line with confidence once COVID-19 outbreak has been subdued.
News abroad has rebounded and should similarly only be temporarily set back by COVID-19. China has already stepped up efforts to stimulate growth and, not only do they have the scope to continue to, they most certainly will as they face next year’s
100th anniversary of the Communist Party. Next year is also the end of the decade the ruling party declared they would achieve a doubling of the country’s economic output, which requires growth to remain close to its trend level of 6%. This
is unlikely realized unless the recovery from the downshift in activity in at least the first quarter of this year is quick and forceful.
If the number of new infections looks to decline in the coming weeks, investors will likely look through the plunge in the data on first quarter growth as a bounce back in the second and third quarters should follow. Should that unfold, as we expect, then equities can resume their advance, which is why we continue to lean on the side of optimism by maintaining our positive forward-looking view on global equities.
We know that previous significant viral outbreaks, such as SARS, MERS, H1N1, Ebola and Zika, were followed by market gains that averaged roundly 9% and 10%, respectively, in the 60 and 90 days following the first case being reported. News of the first
case of COVID-19 came on January 21st of this year so we will watch closely to see if this historical pattern is an analog for this virus. In the meantime, the S&P 500 index, a proxy for the U.S. stock market, has fallen over 5% from the alltime
high reached just a week ago. Since 1927, there has been more than 200 declines of 5% or more and the median drop accompanying the decline once the 5% threshold has been breached, is 8.2%, while the average is a bit deeper at 11.9%. None of this is
to suggest that will be the case this time, but it does contextualize the drop so far as being quite ordinary. Certainly, we could go lower, but the avoidance of a recession should limit its depth. After all, if there is no recession, there will probably
not be a bear market because historically the two coincide.
To be sure, this assumes the pace of economic growth is merely trimmed rather than wrecked. However, we do have sympathy for a more pessimistic view in which the virus devolves into an increasingly lethal pandemic, and therefore, we are not so dogmatic as to remain constructive in our forecast if the virus outlook worsens materially. While we assign a low probability to that view, we acknowledge it. Stay tuned.
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