Yesterday was a nice little rally in shares on the back of good news about a virus trial and stimulus support in the US and Europe. That saw us get well over the 61.8% retracement level for the S&P500, where there had been a lot of resistance. Buy and hold is seeing a lot of investors through this worst recession in ninety years, even as the likes of Warren Buffett are selling. I think it’s a bear market rally. But, it’s been a powerful rally nonetheless.
So where are we now?
Let me take a roundhouse view both on some of my prior forecasts and on sectors of the economy. I can’t escape the virus here as the biggest wildcard. But I do want to shape the contours of the economy without being forced to become a armchair epidemiologist. And so, I am going to frame the economy in terms of best and worst case outcomes, as well as in terms of beating or missing expectations.
Policy Response
More than anything else, the rally in risk assets has been driven by the aggressive monetary and fiscal policy response. Just yesterday, we saw this on display. At the weekend, US Federal Reserve Chair Jerome Powell spoke of continuing to do whatever it takes on the monetary side and exhorted Congress to keep the fiscal taps on full bore. We also saw the Franco-German alliance on full display with a promise of a 500 billion euro stimulus package that would not burden EU member states.
The initial policy response in March as we all headed into lockdown was to arrest a burgeoning liquidity crisis. Once that was under control, policy makers moved to support household incomes and businesses as we continued through lockdown. Even so, we have seen the most severe economic hit to the global economy since the Great Depression. And so, the policy response, while overwhelming, even in comparison to the Great Financial Crisis, is merely preventing worst case outcomes at this point.
The economic numbers for Q1 were worse than expected all around. And the Q2 numbers will be worse still, an annualized drop of 20-30% of output in Europe and North America. But, then we will see a sharp snapback because we are now coming out of lockdowns. In retrospect, we will see this as the shortest and sharpest recession on record. And therefore, it will look V-shaped initially as we exit lockdowns. The downside risk comes later.
Lockdowns
As for lockdowns, I think we have done better in getting out of the lockdowns than we should have expected. And so, that makes me see hope for upside. Looking back to mid-March, I wrote the following:
If you take the Chinese timeline as a best case outcome, front to back would be 15 May 2020 when the US economy slowly reemerges. If you compare the lockdowns, the US is just about two months behind China. And that would also point to mid-May as the re-emergence date from the epidemic. That’s two months of excruciating economic pain, followed by recovery.
Is that a recession? Probably, yes. Look at the Chinese data; China’s industrial output contracted at the sharpest pace in 30 years in the first two months of the year. Auto sales plunged 79% in February. Exports fell 17%.
We are pretty much bang on that estimate of a mid-May release from lockdowns, a little ahead of it actually. From an epidemiological perspective that could be significant in terms of a second wave. But, I don’t want to talk about that since I don’t know anymore than you do on this front. It is a worry in the background for me. But, in terms of economic damage, we are looking at best case scenarios in the US until a potential second wave hits.
That’s true for Europe as well as the US, especially as Europe has been open for longer than the US. Danish schools have been open for over a month now for example. And the hardest hit laggards in Spain and Italy are finally re-opening. Only Britain remains behind, a testament to how having a slow crisis response can lead to worse economic outcomes.
Equities
With that backdrop in policy and lockdown release, we are seeing best case outcomes for shares. Let me do a mini-timeline here.
Back in early March when I asked if we were in a recession already, I talked of a 40% move down for shares. Subsequently, we got to about 35% before the Fed arrested the financial crisis with blanket liquidity support on March 23.
But it was on that very same day, March 23, that I wrote my most pessimistic forecast, talking interchangeably of a Depression with a Capital ‘D’ and a depression with a small ‘d’ and speaking of a slide of 60% in shares as a base case in that scenario. That tells you the Fed chose the right time to stop the rot and prevent a severe financial crisis turning into a Great Depression.
But I think the Fed merely took worst case scenarios off the table. For me, the risk, despite a 61.8% retracement, is still toward re-testing lows to the degree the recovery takes a long time and turns into a Depression with a Capital ‘D’.
On the other hand, if my base case now is for a depression with a small ‘d’, that could mean recovery and expansion without another relapse into recession. That’s the outcome for which shares are priced. And the assumption is that the policy support will continue to take worst case outcomes off the table every step of the way until we are completely out of the woods.
How likely is that? I don’t know, especially given the overhang that a second or third wave of viral infection creates. But, we are seeing a very different policy response now than we saw during the Great Depression. And so, I do think worst case outcomes are mitigated as a result. Nevertheless, to achieve the ‘stimulus to expansion’ nirvana after 25% unemployment, you would have to see fiscal deficits and monetary policy easing for years to come. After all, in 1937, we saw US policy support fade after 4 years of expansion. And the US economy lapsed right back into a depression. Historians give the Fed much of the blame. But fiscal policy was also a factor.
Thinking about relative value
In terms of the near term, I had been thinking for a couple of weeks about relative value: things like investment grade bonds over high yield due to continued economic stress or like European shares over US due to the lockdown release dates and testing preparedness. But, a lot of the upside in shares has been in the same old growth over value dynamic that played out in the last bull market run. It’s not often you see the leaders of the last cycle outperform on the way out of a bear market in the next cycle. That leaves me worried about downside risk.
With that in mind, you could still play it safe and move into the sell the German bonds and buy the US/Spanish/Italian/Greek bond trade. Of those pair trades, I like the German-Spanish pair the most because it has the least downside risk. I see the Spanish economy as the closest to the core of periphery eurozone nations in terms of relative performance potential. And so, I think any scenario in which Europe frays will see much less downside in Spain than Italy or Greece. But, even in a convergence trade, I fear that the debt profiles for Italy and Greece are too far gone to benefit over the medium-term.
The long US and short Germany pair trade is really a convergence to zero trade. On the one had, it assumes the bid for German bonds will dissipate as stress on Europe diminishes. But then it also assumes the bid for US bonds will increase. But why? That can only happen if the dearth of safe assets drive US yields lower. And that’s a bearish economic scenario. I would much rather own Spanish bonds there.
Sector performance
While coronavirus is on the loose, anything that puts you into close proximity to dozens of strangers for an extended period is like your playing Russian roulette. If the virus sticks around for the long-term, as I am thinking it will, those activities will be shunned en masse. And that’s not a good outcome for companies in those sectors.
What are the sectors to shun for the long haul? Airlines, Leisure, Tourism, Casinos, Rental Cars, Amusement Parks, Live Events like music, theater, comedy, and Vegas shows.
And then there’s sports. We saw the German First Division Bundesliga come back and start playing at the weekend. The fans weren’t in the stands but that means more TV revenue. And maybe that’s bullish for companies leveraged to those events. The same might well be true of live events like music concerts or Vegas shows too. Let’s see what the new normal is.
Any way you look at it though, the roar of the crowd is gone for some time to come. No one will want to be cheek to jowl with 50,000 other strangers for months if not years. That’s bad for Disney. It’s bad for Carnival Cruises. It’s bad for the Airlines. It’s bad for Thomas Cook. It’s even bad for Marriott. But, via ESPN, it might well be good for Disney too.
Energy is one sector on the list of recent losers turned gainers where I think there could be more upside. Oil has traded to the highest levels since the lockdowns went in place – this despite the glut of storage. That’s not just because of the re-opening. Perhaps, we will see greater energy inefficient modes of travel going forward because of social distancing – less carpooling, more driving over public transport, etc. And that means the outlook for energy companies is uncertain.
Yes, there will be a decline in movement and less demand for jet fuel, for example. But, a lot of people will be using cars to get around, simply to avoid contact with other people. Let’s see how this shakes out as we re-open. I am not as bearish on the energy sector as the other sectors. Where the pain will come in the energy sector will be because of poor balance sheets. That may leave the remaining players like the US majors better off when the dust settles.
One last sector here: the banks. I saw that bank shares in Europe were trading at levels were price to book value was even lower than during the Great Financial Crisis. I don’t have a strong view on what this means yet. Just because something is cheap doesn’t mean it represents value. I will return to the banking sector in due course when I take a view.
My view
So, as the re-opening unfolds, it’s not all bad news. I think, worst case outcomes have been mitigated. And we are likely to see continued policy vigilance. That puts a floor under risk assets.
Nevertheless, it’s hard to square the real economy’s economic depression with the robust rebound in share prices, even if this is destined to be a short and sharp downturn. Not only do we have no idea how much impact the coronavirus will have in the months and years to come, we also have no idea what the long-term economic fallout is from this first wave. The bankruptcies have only just begun. And so the loss of income and output will continue.
One way to look at this rally is by thinking about the March 2009 lows in equities. The economy was weak and uneven afterwards. Nevertheless, we had the longest expansion in history afterwards. Apparently, many are expecting the same outcome now. And we can’t discount this.
Another way to look at this rally is as a bear market rally, sucking people in because of a false dawn just as all the bear market rallies between 1930 and 1932 did in the crash during the Great Depression in the United States. We can’t discount this outcome either.
And so, as both of these outcomes are plausible, it tells you a lot of the future hangs on the policy responses going forward. Politics and policy are driving the economy now more than at any other time in our lifetimes. For me, that means we are again at a point of maximum uncertainty.
The financial sector is where the rubber hits the road in all of this. For me, the bank stocks are the most important in some senses because that’s where we will see a durable recovery or a financial crisis made. My conclusion is that, until you get a view on bank stocks, it’s hard to have a forward-looking view overall.
So, if you get that call right, assess the opportunities, and make the right choices, it’s going to be the greatest macro environment of all time.
Caveat Emptor.