The investment implications of COVID-19: March 17 update
Dr. David Kelly
The spread of COVID-19 continues to have a dramatic impact on lifestyles, economic activity, monetary and fiscal policy, and financial markets. For investors it is important to maintain a disciplined approach in considering the implications of the virus.
There are essentially five issues that need to be examined in such an approach:
- The progress of the disease and its trajectory
- The economic impact of private and public measures to contain it
- The actions of monetary and fiscal authorities to mitigate these effects
- How markets have responded
- A disciplined approach to investment decisions
On the disease itself, the global numbers are, unfortunately, on roughly the same trajectory as a week ago. As of Sunday, March 15, according to the World Health Organization, there were 72,469 confirmed cases outside of China, up 193% from a week earlier. The crude mortality rate, (measured as cumulative deaths divided by cumulative confirmed cases) was an alarmingly high 3.5%.
If the disease were to continue to spread at the same pace and with the same mortality rate, it would have a devastating human toll. However, while the situation remains very grave, there are reasons to believe that both of these numbers will improve somewhat in the weeks ahead.
First, the true mortality rate is likely much below a simple calculation of the cumulative number of deaths divided by the cumulative number of confirmed cases. This is because there are very likely many more mild cases of the virus that have not been reported.
Second, some countries, and most notably South Korea, appear to be succeeding in halting the growth of the disease through widespread testing and social distancing. In the last week, the number of cases in South Korea rose just 14% and the crude mortality rate so far is just 0.9% - well below the 3.5% number reported so far for the world outside of China. The rest of the world is, belatedly, adopting these measures and this should both slow the spread of the disease and reduce its mortality rate.
Third, there may be some seasonality to the virus, as witnessed by lower reported case numbers in the southern hemisphere, and, whether there is or not, better treatments and an eventual vaccine should, in time, greatly reduce both the mortality rate associated with the disease and the pace at which it is spreading.
The economic impact of social distancing
Having said all of this, the world has woken up to the very real threat of COVID-19 and public and private responses have triggered a breathtaking array of changes in lifestyles. In the U.S., these changes have included the cancellation of major organized sports and entertainment events, dramatic declines in airline travel and hotel bookings, a complete halt in the cruise line industry, severe declines in visits to restaurants and bars, less severe declines in traffic at retailers other than grocery stores, the wholesale cancellation of industry conferences, and the closure of many schools and colleges.
The fact that this all occurred late in the first quarter, combined with surging sales of food and necessities, suggests a still solid first-quarter gross domestic product (GDP) number. However, it appears inevitable that the U.S. economy will enter recession in the second quarter and this recession could be quite severe in terms of its initial decline in GDP. In particular, reasonable assumptions on a decline in spending across the most impacted sectors of the economy could easily yield an annualized decline in real GDP of between 5% and 10% in the second quarter.
Thereafter, in a best case scenario, social distancing achieves a sharp slowdown in the spread of the disease and new fatalities. This allows authorities to authorize a slow return to normality, albeit with strict social distancing guidelines. Even in this scenario, the knock-on effects of employment losses from a traumatic second quarter could well result in a further quarter of negative economic growth in the third quarter, meeting the unofficial definition of a recession. Thereafter, however, the economy could begin a slow recovery.
It is also important to recognize that this recession will be quite different from the 2007-2009 experience. That recession, which was centered in the construction and financial services industries, was very significant from a corporate earnings and equity market perspective, somewhat less so from a GDP perspective and less significant still from an employment perspective, despite the fact that the unemployment rate topped out at 10.0%.
This recession will be centered in the leisure, entertainment and food services and retail sectors. These industries account for more than a fifth of U.S. employment but are less significant when measured in GDP terms or as contributors to the stock market. Consequently, the most immediate impact of the recession should be a sharp rise in unemployment, while corporate profits, although very cyclical, should fare better than in the Great Financial Crisis. However, beyond the initial impact of social distancing, the pace at which the economy is likely to recover depends, to a significant extent, on the effectiveness of monetary and fiscal policy measures.
The monetary and fiscal response to COVID-19
In an emergency move on Sunday, the Federal Reserve cut the federal funds rate by a full 1.00% to a range of 0-0.25%, following a 50 basis point cut on March 3. In addition, it resumed quantitative easing, pledging to boost its holdings of Treasuries by USD 500billion and mortgage-backed securities by USD 200billion over coming months. In further measures to encourage bank lending, it cut the discount rate by 150 basis points, set reserve requirements at 0% and urged banks to use capital and liquidity buffers to lend to households and businesses affected by the crisis.
Other major central banks are also in easing mode and all major developed country central banks are likely to move policy rates to near zero in the days ahead. However, while these moves may ultimately support equity markets (by funneling money from bonds and cash accounts towards stocks), the uncomfortable truth is that monetary authorities have no real ability to combat the type of economic weakness that is emerging from social distancing.
In the U.S., on the fiscal side, the House has passed a package that includes paid emergency leave and free COVID-19 testing. However, this will neither provide a significant fiscal boost to the economy nor provide adequate protection to laid-off workers. On this second point, unfortunately, workers in the leisure, hospitality and retail industries have some of the lowest wages and shortest hours in the country.
Most unemployment benefits are calculated as a fraction of earnings in recent quarters, often equaling half of those earnings. Because of this, while many of these workers will be eligible for unemployment benefits, these benefits will be completely inadequate for those who were already struggling to live paycheck to paycheck. This also won’t help the self-employed, or those working short hours or the many businesses, large and small, that will be pushed towards bankruptcy by this sudden recession.
A further fiscal package, perhaps containing some protection for small businesses, enhanced unemployment benefits and a payroll tax cut is likely to be implemented in the coming months. However, it is unlikely to be sufficiently large or arrive sufficiently soon to ward off a significant recession. Outside the United States, the story will likely be similar, with meaningful fiscal packages still only able to mitigate some of the effects of a global recession rather than prevent it from occurring.
The market reaction
Global markets have reacted violently over the past three weeks as the implications of COVID-19 have come into sharper focus, with the Dow Jones Industrial Average rising or falling by more than 1,000 points in nine of the last 15 trading days. Overall, since hitting an all-time high on February 19th, the S&P500 has fallen by 20% while, measured in U.S. dollars, the MSCI-EAFE index has fallen by 27% and the MSCI-EM index has declined by 19%. Meanwhile, the 10-year Treasury Yield has fallen from 1.56% to 0.80%, while the dollar has drifted down, perhaps reflecting smaller interest rate differentials among developed countries. Within the U.S. equity market, large-caps have outperformed small caps while growth stocks have done better than value.
While all of this is dismal, it does suggest that relative valuations in the U.S. equity market have not yet been disturbed by the market slide. In addition, the selloff has left the U.S. dollar looking overvalued and international stocks looking relatively undervalued, as was the case before the slump. For long-term investors, this suggests there are still important opportunities for strategic overweights and underweights, even as they assess the more immediate implications of a social distancing recession.
A disciplined approach to investing
Finally, how should long-term investors respond to the COVID-19 market slump? A few principles are important:
- Recognize that no matter the trauma caused by the virus, these effects are temporary. If 2020 is the “Year of the Virus” then 2021 will very likely be the first year of the recovery from the virus. The value of stocks depends on earnings for years and decades into the future – not just the year ahead.
- While many will have the urge to reduce risk in their portfolios they should recognize that the market has, to some extent, already done that for them. A simple portfolio weighted 60% to the S&P500 stock index and 40% to the Barclays Aggregate bond index at the start of the year, would now be weighted 55% stocks and 45% bonds.
- Valuations matter. For long-term investors, even given a social distancing recession, market moves have probably enhanced prospective long-term returns from equities while reducing them for bonds. In addition, both emerging markets and developed markets stocks appear to have a valuation advantage over U.S. stocks, particularly given a still over-valued U.S. dollar.
- The plunge in interest rates, both at the short and long end, increases the importance of finding sources of income elsewhere, including dividend-paying stocks and alternatives such as real estate and infrastructure.
- Finally, the dislocation to the economy and markets from a social distancing recession should provide plenty of opportunities for active managers. The companies that will succeed are those that have the financial stability to survive the downturn and the products and services to thrive in the somewhat altered economy that will emerge following the social distancing recession.