We extend our sincere good wishes and prayers to clients and families who have been adversely impacted by the COVID-19 virus. The following is our latest analysis of how the pandemic is impacting capital markets.
There are three different types of economic recessions. Recessions can be cyclical – that is, they can be a result of a natural downturn in the economy. As we saw in the 2008 financial crisis, recessions can also be secular, driven by financial excess. Lastly, recessions can be caused by events, which is what we are currently experiencing with the coronavirus pandemic. Event driven downturns tend to be shorter in duration with an economy recovering once the agitating event passes. Capital markets typically reflect the shorter span of event driven economic contractions with a quick selloff followed by a sharp recovery. This is what we witnessed this year. The stock market declined nearly 32% over 22 trading sessions in February and March. Since the March low, the market has nearly recovered all its losses.
This then brings us to future expectations. Consensus forecasts currently hold that the economy and corporate earnings will fully recover in 2021. Part of this is being driven by aggressive cost cutting. Several fortune 500 firms have announced mass layoffs, and this is acting to improve margin forecasts. Margin estimates started the year at 12.1% before falling to a low of 9.5%. They have since recovered to 11.4%.
Yet, most of the rosy 2021 earnings forecast is being driven by an expectation that the economy is past the worst part of the pandemic-driven downturn.
At this point our concerns are twofold: (1) We have witnessed a number of instances where crowd psychology has pushed speculative stocks far higher than we believe is warranted. Economic fundamentals may never be able to support some of these valuation gains; (2) More critically, there has been a substantial surge in new coronavirus infections such that some states are backtracking on their “reopenings.” However, we have seen that the relationship between the stock market and the coronavirus appears to be centered on patient deaths rather than new infections with the stock market leading patient deaths by roughly three weeks (chart below). Fortunately, researchers and healthcare providers have learned a lot about treating COVID-19 patients since the onset of the crisis. For example, Gilead’s remdesivir has been shown to be effective at improving patient recovery rates. Our hope is that improvements to the medical community’s approach to addressing this crisis helps mitigate any rise in patient deaths over the coming weeks and months despite the rise in infections.
The stock market is likely to be more fragile than many believe, so we would not be surprised by an interim correction. Long term, we believe that earnings will continue to be the catalyst that drives markets higher. However, the timing of earnings growth remains as the biggest question.