As of Tuesday March 17, the S&P 500 has declined about 25% from its peak on February 19, and about 20% from the start of the year. Volatility is at highly elevated levels, and we’ve seen similar extremes in other financial market indicators we follow, such as the interest rate premium charged to risky borrowers, and the proportion of stocks with prices below their 200-day average. These are highly unusual times in the capital markets.
Economists and strategists are trying to determine what the impact to corporate earnings will be from the pandemic, both in terms of timing and magnitude. At this point, our best guess is that economic activity will be depressed for a quarter or two, after which a rebound is likely.
If we look back to prior pandemics over the past two decades, the stock market has already exceeded its average decline when investors grew concerned regarding the impacts of SARS, MERS, swine flu, bird flu, and Ebola. Those declines averaged about 7%, and, on average, the market rebounded to higher levels over the next six months. We believe that making this episode worse is that some industries will be impacted quite negatively by consumers curtailing their activities in ways we did not see in the past.
We believe that service-oriented industries such as restaurants, hotels, and other travel-related companies will be particularly hard hit, as conferences, athletic events and other gatherings have been cancelled. These sectors will most likely endure severe revenue impacts that may never be recouped. The damage may be limited in other areas to a near-term pause in revenue that is partially recouped in future periods. This may occur in industries such as manufacturing, transportation of goods, healthcare, and technology. Some firms may see little impact at all on their business. A lucky few may even benefit. (More on this below.)
As a result of the pandemic and the steps being taken to slow the spread of the virus, it now seems likely that the U.S. could experience a period of decline, followed by a catch-up which recoups some but not all of what was lost before. And then, perhaps a year from now, growth could revert to its prior trajectory before the pandemic struck.
Fortunately, we believe the U.S. economy entered this episode from a place of strength, with low unemployment and a consumer that on average has been confident, saving money and improving their finances. But in other parts of the world, particularly in Europe, economic growth has been far slower, and it is possible that the pressures from this pandemic will push the global economy into recession. We think that the U.S. may experience a mild recession as well, if the pandemic lasts longer than the second quarter before growth resumes. This is using the technical definition of recession, which is more than one quarter of negative growth. If recession strikes the U.S., we believe it will be short-lived.
The recent failure of OPEC and Russia to agree on oil production cutbacks, despite the pandemic’s impact on demand, has caused the price of crude oil to plummet into the $30s per barrel, a level not seen in about five years. This has added to pressures on capital markets, since many shale oil producers are not able to achieve profitability at such low prices. But we believe that the resulting lower gasoline prices will put more discretionary income in the pockets of consumers, precisely at a time when it may be most needed. A lower oil price will also help many companies achieve lower costs to the extent oil is an input, such as for transportation.
To date, we think that the global fiscal and monetary response to the pandemic has been inadequate to calm investor fears, as the lack of coordination between central banks in the U.S. and internationally has weighed on security prices and sent bond yields to record lows.
Upcoming U.S. elections may be a secondary factor impacting market volatility. The rise and subsequent fall of the Sanders campaign first weighed on and then supported the stock market. More recently the Trump administration’s missteps in managing the crisis may be weighing upon the stock market as well. Successfully dealing with this unprecedented pandemic could become an existential issue for Trump’s re-election, and reduced investor confidence in a Trump re-election may also be weighing on the market.
In similar periods in the past, we have seen that extreme volatility often marks peak pessimism; it eventually passes, and then more normal conditions return. We’ve seen this play out before, whether in the depths of the December 2018 decline, the 2016 pullback relating to the sharp decline in the price of crude oil, the summer 2011 pullback after S&P downgraded US debt, and even the financial crisis of 2008-09. Particularly after the market has experienced a sharp pullback such as we’ve experienced in these last few weeks, being too bearish at this juncture seems unwise to us.
In those past market episodes, government officials and central bankers understood that strong measures were needed to help maintain confidence in the system. As a result, the odds have increased that we may get a ‘shock and awe’ type of policy response, even though so far investors have been underwhelmed by what we have seen. There have been many proposals and half measures, but, as of yet, nothing on the scale of what will probably be needed. Though dysfunction in Washington is prolonging the process, we expect the government to eventually act as necessary, because it is in all parties’ best interests to do so.
It is also possible that some pharmaceutical solution might be discovered that is successful at treating the most difficult cases, which would be good news that could materially change the views of many investors with concerns about the pandemic’s ultimate impact. Relatedly, the spring season will be upon us soon. As we have seen with the flu each year, warmer weather tends to curtail the number of new infections. It has been theorized that the arrival of warmer spring weather could help to slow or stop the COVID-19 outbreak.
Lastly, China, South Korea and Japan are all further along in the progress of the outbreak. If we see a material downtrend in new infections being reported by those countries, it may bode well for the outcome of the pandemic and the ultimate number of cases which are reported in the U.S. This might also provide relief to investors concerned about the ultimate scale of the outbreak here.
One last thing to consider is that, at the firm level, in times of market or economic stress, the best-positioned companies often make significant gains in market share. We expect to see similar winners this time around.Consider Amazon, a company that had already moved aggressively into same-day delivery of goods, including groceries, from its Whole Foods stores as well as its Amazon Pantry offering. In addition, Amazon Web Services is one of the leading providers of cloud computing, which enables software-based services to be delivered over the Internet. As the pandemic forces retailers to close stores and office employees to work from home, consumers may purchase more goods online, and companies may rely more on the cloud. As these groups make greater use of Amazon’s services, some portion of them will discover just how easy and efficient Amazon makes their lives, and they will not return fully to prior ways of shopping and working.
Another example may be digital payments. As many of us now obsessively wash our hands and avoid contact with things we didn’t even think twice about touching a week or two ago, one thing that some now consider ‘dirty’ is cash, since it may be a means to transmit infection. As some consumers discover just how easy it is to use digital payments services, offered by companies including Apple, MasterCard, Visa and PayPal, some portion of them may shift their payment habits to digital.
Finally, as colleges and schools close down to help try and mitigate the spread of the virus, parents and students are being forced to shift to digital tools to enable online classroom learning. There are many software companies that will now be in the spotlight as demand for such products increases, as well as for hardware to enable the digital learning sessions. In China there is already a shortage of Apple’s iPads because so many parents have purchased them for their child. We may see similar trends here in the U.S. Volatility may be with us for the time to come, but we believe that this too shall pass.
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