Coronavirus: A US Market Outlook
The spread of the novel coronavirus beyond China has driven a wide-ranging reassessment of the global economic outlook based on the trajectory of COVID-19. Please refer to the Coronavirus Update published by the Athena Research team for an expanded overview of the virus and our initial assessment of its potential economic impact.
We begin our analysis from a place of humility given the complexity and fluidity of the situation. We are not public health experts and are not looking to opine on the health outlook beyond our heartfelt concern for people’s well-being. However, we have lived through panics before and have seen that the market typically finds a way to move forward in cases of exogenous events like virus outbreaks, geopolitical crises, and natural disasters. Given the uncertainty surrounding the development of coronavirus, it is prudent to consider the outcomes from a probabilistic angle.
Last week, the sanguine outlook of January dissipated as the initial base case of the virus being contained in China followed by a V-shaped recovery gave way to rising concerns. Fear of a broader outbreak led to a steep repricing of global risk assets, with the S&P 500 entering correction territory with a decline of more than 11%. Collectively, the Athena Research team believed the market outlook was probably too complacent to start the year and may currently be too draconian. The truth likely lies somewhere in between.
A V-shaped recovery is now our upside case. The duration of the coronavirus outbreak and containment timeline are key variables. Our base case is for a U-shaped recovery, factoring in a potentially longer and more significant market impact from the spread of the disease and/or containment efforts. As noted by Mohammed El-Erian in Bloomberg, "goods markets respond more slowly to shocks than financial ones. This is the case with the coronavirus. The initial sudden-stop shock has played out more slowly and gradually than what the global economy experienced during the financial crisis. And, I fear, it can take longer to restart economic activity once it is deeply disrupted.” It’s important to note that our base case scenario does not factor in a recession. Our left tail scenario is a more prolonged economic slowdown due to factors that may include a fear-driven market decline, supply chain disruption, or severe stringent social distancing measures.
Athena constructs diversified client portfolios that are intended to preserve and grow wealth over a long-term horizon. We recommend clients remain near their strategic targets or reevaluate those targets if they are not in line with a client’s level of risk aversion. Athena’s overweight to cash and enhanced cash can provide dry powder for opportunistic investments, though we do not think that valuations are generally low enough at this point to add risk. Per Bloomberg data, the S&P 500’s P/E ratio declined from a high of about 22x to approximately 20x as of March 2, 2020, which remains well above the long-term average of 16.5x. The extraordinary all-time low yields we are experiencing in US government bonds argue for maintaining an equity allocation. According to Goldman Sachs, 70% of S&P 500 companies have a dividend yield above the yield on the 10-year Treasury and the S&P’s 5.6% earnings yield is 4.4 percentage points above the yield on the 10-year. Though we expect earnings estimates to be downgraded, equities have historically exhibited resilience amid tepid earnings growth absent a recession.
Additionally, we do not think it is prudent to sell equities at this point given the velocity of last week’s market rout. It was the fastest equity market correction in history, which we think was partly due to technical factors such as commodity trading advisors (CTAs) exacerbating market momentum.
As of March 3, 2020, the situation is still highly fluid. The widely anticipated monetary policy response failed to have its intended effect. The Federal Reserve (Fed) cut its target rate by 0.5%, only to see the yield on the 10-year Treasury fall to an all-time low below 1%. The surprise rate cut raised questions about information asymmetry, the central bank’s independence, and efficacy as Fed Chair Jay Powell admitted the limited ability of monetary policy to counteract the coronavirus. Additionally, the March 3, 2020, meeting of G7 monetary and fiscal authorities did not announce economic support measures as markets anticipated, though they reiterated their ability to do so if necessary. In addition to broad market declines also on March 3, we are mindful of negative outliers in the travel, banking, and technology sectors. There will be winners and losers in the current climate and our initial impression is that active management in equities has been helpful thus far.
The downside case is important to monitor but we feel that narrative overtook media coverage last week whereas we think there are important potential mitigants that may help buffer the US outlook. The US-China trade war encouraged manufacturing businesses to stockpile inventories, which are 1.4x sales as of December 2019. This will help businesses maneuver around short-term supply chain disruptions. Additionally, as we learned through the course of the trade war, the US has a relatively insulated economy compared to the trade-oriented markets of Germany and South Korea.
There are also green shoots in high frequency indicators in China including coal consumption and labor returning to cities after the Lunar New Year shutdown. Per the World Health Organization, “this decline in COVID-19 cases across China is real. Several sources of data support this conclusion, including the steep decline in fever clinic visits, the opening up of treatment beds as cured patients are discharged, and the challenges to recruiting new patients for clinical trials." This is critical since despite concerns of COVID-19's global spread, China accounts for 90% of all global confirmed cases and 96% of all COVID-19 fatalities as of March 2, 2020.
Longer term, it is expected the cumulative impact of the trade war and coronavirus will encourage US firms to deeply investigate their supply chains and consider potential alternatives to China, especially for critical goods like antibiotics.