Concerns and consequences of the novel coronavirus (COVID-19) have increased significantly in recent days. President Trump acknowledged this week that the impact of the pandemic could last into the summer months, with more states and counties announcing lockdowns. At this moment, it is almost certain the United States and the global economy will dip into a recession.
Given the shortage of testing equipment and COVID-19’s long incubation period from the time of initital exposure to the time individuals first report mild symptoms, it is likely that cases in the U.S. will increase significantly in the coming days and weeks. Moreover, the lack of a vaccine is triggering individuals to practice social distancing to reduce risks of exposure and prevent rapid spreading that has the potential to overwhelm the health care system. One problem of social distancing is that it negatively impacts economic activity and consumer spending, especially as more people stay in their homes, avoiding restaurants and retail stores and canceling vacations and business travel.
Roughly 70 percent of the U.S. economy comes from consumer spending. Given the uncertainty surrounding COVID-19 and the increasing practice of social distancing, we can expect a significant blow to both consumer confidence and spending. For example, consider that restaurants alone account for approximately 3.5 percent of GDP, whereas travel and tourism make up an estimated 10.4 percent of the U.S. economy. The longer the virus remains uncontained, the more likely businesses will close and consumers will continue cancelling travel plans. Following is a chart from Oxford Economics showing the level of risks for different sectors of consumer spending.
While this information is certainly alarming, there is a chance that we will not face an extended recession. Recent data suggests that economic activity in China has begun to pick back up, as retailers, such as Apple, reopen their stores. Despite these signs of improvements in China, the U.S. is unfortunately at the early stages of the outbreak.
As indicated in the chart below, various research outlets are predicting a sharp contraction in Q2 of 2020 with a subsequent rebound in the second half of the year. It is important to note, however, that many of these firms have continued to adjust their estimates to the downside as the virus and the potential implications have grown dramatically in recent weeks.
While the coming weeks and months will certainly be challenging, any assistance from the Federal Government will be helpful to reduce the pressure resulting the virus and provide a bridge until the virus can be contained. There are two primary means through which the government can accomplish this goal.
On Sunday, March 15, the Federal Reserve cut interest rates to the effective lower bound of 0 – 0.25 percent and announced new rounds of quantitative easing (QE) by buying $500 billion of Treasury Securities and $200 billion of mortgage-backed securities. The Fed also removed the reserve requirement and cut the discount rate (the rate at which banks borrow from the Fed) to 0.25 percent. Although this may help to prevent current concerns over the financial system from boiling over, it alone will not be enough to fight off a recession given how low interest rates have been for some time.
The federal government has announced various actions intended to support consumers and businesses that need to pay their bills, but, as of this writing, very few things have been finalized and signed into law. Following are some of the measures already enacted and others being discussed:
As of this writing, the market, as measured by the S&P 500, is down approximately 30 percent
from the highs in February, representing the fastest decline into a bear market in history. Given all the uncertainty surrounding COVID-19, including the economic implications and effectiveness of government policies, projecting where the S&P 500 will be in the coming weeks will be challenging. There likely will be weeks, if not months, of bad news, both about the virus and economic data, which will weigh on investor sentiment.
While this is concerning, we believe the government’s policies will work because they have to. As illustrated in the chart below, the forward P/E on the S&P 500 declined to 13.6, which is 16.5 percent below the long term average.
Since valuations are mean reverting, we can assume that to be the starting point in terms of a rebound, which we can expect sometime in late 2020, provided the virus is contained and the shock to the economy abates. If containment can occur more quickly and government stimulus is properly targeted and effective, this could happen much sooner.
Furthermore, it is important to note that there is a distinction in different types of bear makets. As the chart below illustrates, historical bear market can be broken down into three categories:
The current bear market can be considered event-driven resulting in both massive supply and demand shocks throughout the global economy. That does not mean the market is immune from becoming structural or that it will not decline further in the near term. Rather, it highlights the importance of the timing, amount and legitimacy of government support. With that said, it is important to note that event-driven bear markets typically lead to declines of approximately 30 percent, which is where we are now, and they tend to be shorter in duration with less time to recovery.
To date, the coronavirus has caused the quickest shift in economic activity and market conditions in modern history, and it continues to be a rapidly developing situation. The coming weeks and months will be challenging, and we can expect there will a barrage of bad news about the number of infected lives and economic data. Yet, one should never discount America’s fight and our ability to rise to challenges. Over the past few days, testing capabilities have increased significantly, vaccine trials have been expedited, and the government has stepped up with recovery plans.
The advisors with PWA will continue to monitor developments closely and make adjustments to clients’ discretionary portfolios, as needed. We will stand by you and keep you informed through these challenging times. If you have any questions or concerns, please reach out to us.
About the Author: Joseph Karl, CFA, is chief investment strategist with Provenance Wealth Advisors (PWA), an Independent Registered Investment Advisor affiliated with Berkowitz Pollack Brant Advisors + CPAs, and a registered representative with Raymond James Financial Services. For more information, call (954) 712-8888 or email firstname.lastname@example.org.
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Joseph Karl, CFA, is a registered representative of and offers securities through Raymond James Financial Services, Inc., Member FINRA/SIPC. Raymond James is not affiliated with and does not endorse the opinions or services of Berkowitz Pollack Brant Advisors and Accountants. PWA is not a registered broker/dealer and is independent of Raymond James Financial Services. Investment Advisory Services offered through Raymond James Financial Services Advisors, Inc., and Provenance Wealth Advisors.
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