The word quarantine originates from the Venetian word quarantena which literally means 40 days. In 14th century Venice, passengers and crew would be required to isolate at port for 40 days before they were allowed to come ashore. There have been many periods where such quarantines were necessary over the last several hundred years. Fortunately, history is replete with stories of artists and scientists who developed some of their most notable works and discoveries while in forced isolation. For example, William Shakespeare penned a few plays in the early 17th century when the Globe Theater was closed during an outbreak of the Bubonic plague to enforce social distancing.
Shakespeare strictly adhered to a five-act structure for all of his comedies, histories, and tragedies, a useful format to introduce and resolve conflict in the dramatic arts. Since the early news of the virus in January, stock markets have already had three distinct acts. In this edition of Global Foresight, I will focus on the fourth and fifth acts – emphasizing where the economy and markets are likely headed in upcoming months and years.
Act I – A Remote Threat
When we last published Global Foresight in January, it was the early days of the coronavirus, with the crisis largely contained to Wuhan City, China. In January, a global pandemic was a risk on the horizon, but far from a certainty.
“While it is too early to assess the impact of the coronavirus on economies and markets, it serves as a reminder that equity valuations need to properly account for exogenous risks that can and will arise in a haphazard fashion. Currently, the U.S. market seems to be ahead of underlying fundamentals, leaving little margin for error in 2020, whether the catalyst is a global pandemic, disappointing earnings, or political risk.”
Despite the lingering risk of the virus, the market sentiment until mid-February was that this was a Chinaspecific issue whose impact would be limited to a temporary interruption in some supply chains. Investors shrugged off the risks propelling markets to solid gains that did not peak until around February 19th.
Act II – Global Pandemic
When the S&P 500 Index peaked on February 19th, there were 42 active cases in South Korea, the first country reporting a substantial local spread of the virus outside of China. Markets began their descent arguably triggered by the alarming rise in South Korean cases – from 94 on Wednesday February 20th, to 190 on the 21st, and 416 on Friday the 22nd. By the time markets reopened on Monday the 25th, South Korea’s cases jumped to 803 and the decline in global share prices gained momentum. The swift acceleration of cases in South Korea alarmed investors who began to massively de-risk to reflect the rising likelihood of a pandemic. Investor fears were further heightened with unprecedented closures of schools and sports leagues. Finally, the Lombardy region of Italy was closed on March 9th to all but essential activities, a process soon to be followed first across Europe, then the U.S., and eventually most of the world.
Act III – Fiscal Stimulus, Federal Reserve
Support, and Curve Flattening Act III abruptly marked a new period of investors turning more optimistic, focused on an expected peaking in cases as well as emboldened by record fiscal and monetary stimulus. The Coronavirus Aid, Relief and Economic Security (CARES) Act was passed on March 27th, a record-setting $2.2 trillion package to support workers and businesses. The Federal Reserve cut rates and unveiled a series of extraordinary measures to support liquidity across lending markets.
In Act III, we all became amateur epidemiologists steeped in the new vernacular of terms like, “flattening the curve.” These curves are new to this generation but have been used in past epidemics as shown below in a chart during the Spanish Flu.
Despite widely expected abysmal economic data, in Act III, markets experienced a powerful V-shaped recovery, recovering between March 24th and April 17th – roughly half the decline experienced from February 20 until March 23.
Act IV – Reopening the Economy
Act IV represents where we go from here now that fatalities appear to have peaked in the U.S and Europe. Investors are expecting the economy to normalize and that most people will begin to go back to work. While no one is certain when the economies will begin to open, there appears to be a broad consensus of late May based on what had been communicated from officials in Europe and the U.S.
The important question investors should ask is what exactly does re-opening the economy mean? Does everyone go back to work, or will it be stratified by age? Will all sectors be open for business? While Act III represents hope and optimism, Act IV is set up for disappointment if the economy does not reappear exactly as before. Realistically, the continuation of social distancing will be required to some extent to prevent the virus from reigniting. We can envision offices re-opening, but perhaps with a staggered workforce at first. Clearly this would be an upgrade from the last several weeks when most offices were closed to allow for less density in the workplace.
The restart of the economy becomes more problematic in discretionary consumer sectors that thrive on crowding – theaters, shops, restaurants, and arenas. Until we see a material improvement in reducing the length of prolonged hospitalizations (not to mention fatalities), the economy will not magically “reopen” to where it was before. Importantly, a sooner than expected development of a treatment or vaccine would change the trajectory of recovery. We expect the economy will be different and not be fully functioning until we can fully open consumer sectors.
We have looked to China for cues to how we can reopen since they have largely controlled the spread of the virus with its lockdown. China tried reopening movie theaters and subsequently closed them down after a few days. Restaurants have been forced to remove tables to limit density, while sporting events and concerts have yet to resume. Most importantly, China tracks individual health records and utilizes facial recognition to monitor and control its spread, measures that will likely prove not only socially unacceptable in the West but may not be legally enforceable.
Finally, we need to have testing become much more widely available and cheaper and faster. As of April 12th, we have tested less than 1% of the U.S. population. We are just now rolling out antibody tests that will enable us to determine who has already been exposed to the virus. But it will take months (if not longer) to scale up both types of tests. Expect facemasks to be with us for months to come until testing ramps up.
We expect volatile markets will persist in ACT IV until there is more visibility on a treatment as even limited social distancing will curb aspects of the economy. Without a full resumption of economic activity, it is difficult to envision earnings reaching 2019 levels when the S&P 500 Index EPS was roughly $163 per share. A modest haircut to those earnings suggests $150 to $155 is more realistic for the S&P 500 Index EPS for 2021. With its recent rally to 2800, we are now just over 18x 2021 S&P 500 estimated earnings. This strikes us as an unfavorable risk versus reward, especially should we need to enforce another shutdown of the economy in the fall when many experts expect the virus to gain seasonal momentum.
ACT V – Vaccines, Treatments, and the New Normal
Let’s assume the projections of 12 to 18 months for a vaccine are reasonable (and for the optimistic, there are already 70 being tested including three in human trials). What does the global economy look like without the threat of social distancing weighing heavily on so many sectors?
We entered the global financial crisis with national debt to GDP at roughly 63% and exited (after spending massively to manage through the crisis) with debt at 91% of GDP. In subsequent years, just to maintain growth of 2.5%, we racked up annual deficits that have driven the national debt to GDP to 105%. Given the collapse in GDP and the massive size of the CARES spending package which equates to just over 10% of GDP, we expect the national debt to be roughly 120% of GDP by 2021.
The CARES stimulus may carry us through the crisis, but it is wishful thinking to expect that the U.S. (or any other country) emerges from this stronger than ever. While there may have been no other option, there is a material cost to shutting down an economy that will be paid for in later years as deficits will likely constrain our ability to use fiscal stimulus in the future.
During any dislocation you can expect to see winners and losers. Travel and leisure, two sectors we have long favored for their growth and demographic positioning, look impaired with overcapacity until there is a vaccine. Commercial real estate may feel the impact of behavioral shifts amongst their clients that have been functioning smoothly with workers at home, something that may influence future office design as companies may make do with less space.
Early winners appear to be companies with size, scale and the balance sheets to weather the slowdown. Smaller retailers may continue to lose out to the behemoths that have built out their online distribution. Technology companies should continue to thrive as we have seen the value of connectivity and data security during this extended period of working from home.
We expect climate change will be tied to any future infrastructure spending and will regain more focus. Companies with technologies and services geared toward reducing carbon emissions have the potential to be long term winners as regulations will drive spending towards carbon neutrality.
We can envision ride-sharing taking greater share as consumers may cut back on big purchases such as owning an automobile. Even the broader luxury goods category may no longer be a safe haven as its core customers reside in geographies that have been especially hard-hit by weaker equity markets, property markets, and oil prices.
In ACT V, the world will feel more normal as some of the trends described above, such as larger companies becoming ever-more dominant, have been ongoing for years. Markets and economies have always recovered from various setbacks and we expect will again in time. However, the return to normalcy may take more time than with past economic cycles and we may not feel as prosperous until it does.
We believe we have seen three distinct market “acts”, each of which lasted only weeks but contained a year’s worth of market movements. While the worst-case scenarios feared in Act III likely will not come to pass due to the steadying influence of fiscal and monetary stimulus, we are poised for more market volatility as investors grapple with the new economic norms of social distancing, even in a reduced form, impacting many key sectors.
A group of influential economists just published a working paper for the National Bureau of Economic Research. They estimate a startling 11% economic contraction in 2020. By comparison, during the global financial crisis, GDP dropped only 2.8%. Despite the massive contraction, the S&P 500 and the Nasdaq are down less in 2020 (as of April 17th) than they were in the fourth quarter of 2018. In 2018, investors were spooked merely by an inverted yield curve which led to a bigger market sell-off than we have seen so far in 2020. Stock markets are lower than they were back on January 1st, but they are not a better value today due to a greatly reduced earnings outlook for 2020 and 2021.
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