Not Out of the Woods Yet
Recent market reaction over the coronavirus is understandable, given the tragic loss of human life, the spread of the disease beyond mainland China, and concerns about its impact on the global economy. Still, we believe it is important as investors to make a distinction between temporary market reactions driven by uncertainty and the fundamentals that drive market performance over the long term. Though volatility feels uncomfortable, it is also normal, especially in times of high uncertainty.
While it’s too early to assess its full implications, the outbreak of coronavirus represents a massive global shock. There are now 73 countries with confirmed cases, and efforts by governments to contain the virus will likely have a temporary but considerable negative impact on economic growth around the world. Thankfully, responses from international health officials to halt the virus’s spread have improved, and better medical attention has resulted in a significantly lower fatality rate globally than initially seen inside the Chinese viral epicenter.
From this perspective, developments in China, which has been hardest hit, offer some encouragement for the path forward. With containment measures easing as the number of new coronavirus cases has slowed, many companies that were shuttered in February have started to reopen, employees are beginning to return to work and supply disruptions caused by factory shutdowns are slowly coming back online.
Mirroring what we have seen in other countries, the number of infections in the U.S. will likely continue to climb over the coming weeks. In a nation of more than 300 million people, thousands of eventual cases seems like a more than reasonable possibility. Nevertheless, the U.S. economic foundation appears strong enough for now to shoulder such a temporary shock, with consumer confidence and employment high, and low inflation and interest rates that could bolster future spending and investment.
Our best current analysis is that the impact to U.S. growth will be short-lived, lasting a quarter or two, before growth recovers as the rate of new virus infections slows, containment measures are lifted and policy easing gains traction. Indeed, in some ways, we think the U.S. economy is well-positioned to deal with a global pandemic. While manufacturing, air transportation, retail and arts, entertainment, recreation, accommodation and food services could all be hit hard in coming months, collectively these sectors/industries represent only about 25% of GDP (see Figure 1).
However, should public alarm rise as more and more cases are reported, consumer behavior and business operations may become more negatively affected than anticipated. In that event, we still believe the U.S. economy will manage to avoid recession, but it will likely take until the end of the year before economic activity normalizes. The Fed’s recent move to cut interest rates is reassuring in this regard. While policymakers can’t stop a supply shock, they can mitigate the fallout and also power a swift recovery in asset prices once the crisis has been brought under control.
Given this, we continue to believe that over time the stock market should eventually reconnect to the broader positive fundamentals. Encouragingly, credit markets, which we believe are more reliable indicators of forward economic activity, have been far more orderly over this correction. Still, the possibility of a more prolonged and higher magnitude disruption from coronavirus remains a risk to markets.
Up until recently market complacency had been elevated regarding the impact of coronavirus. Our guess is that consensus EPS estimates are still too high and that it will take more time before the market bottoming process is finished. As a result, we expect volatility will stay elevated in the near term, and further downside is possible, as investors continue to reassess the impact to economic and earnings growth. For historical context, over previous viral outbreaks, S&P 500 declines were in the range of 6 - 13% and lasted on average 62 days, before stock prices began to recover, gaining on average about 23% over the following 12 months.
It will likely be several more weeks at least before we have a clearer understanding of the cumulative economic impact from coronavirus, the extent of the human toll or the timeline for its containment. In the meantime, clients should rest assured our late-cycle playbook has constructed resilient portfolios of quality, durable assets designed to help weather storms such as these. By keeping our focus on U.S. dividend-paying equities and non-cyclical, secular growth companies, we have positioned our portfolios to help withstand current global uncertainty and minimize risk, yet participate in future gains ahead (see Figure 2).
In response to growing fears of the coronavirus, the Fed made an intermeeting interest rate cut. The Fed cut the federal funds rate by 50 basis points, bringing the median rate down to 1.125%.
The Fed sent an unambiguous and vital message to the financial markets: The Fed is early, the Fed is forceful and the Fed will not fight the markets. This move was a unanimous decision by all 10 members of the FOMC (Federal Open Market Committee, the group within the Fed that makes monetary policy decisions).
There are limits to what a rate cut will do. The Fed cannot fix all the problems by themselves — lower interest rates will not reduce the risk of infection of the coronavirus or get factories producing again. But, the Fed has the tools to overcome the fear in the markets and the economy. They need help from other sectors. The healthcare sector and other public and private sectors need to work to curb the spread of the virus. Other central banks can join in the global effort to improve financial market conditions. And, if severe enough, there may be a need for fiscal stimulus.
The federal funds futures market is expecting 25 to 50 bps in more cuts at the next FOMC meeting on March 18 (see Figure 3).
One consistent theme throughout this record-long expansion has been the low level of inflation. This is despite the near-record-low unemployment rate and record-high household wealth, both of which have historically ignited price pressures. Inflation, measured by one of the Fed’s preferred inflation gauges, Personal Consumption Core-Price Index, is currently at 1.6% and has averaged just 1.6% since January 2012, when the Fed started targeting inflation at 2.0%. There have been two times when inflation has moved above 2.0%, but it could not sustain that level (see Figure 6).
The Fed appears to be getting more aggressive in its pursuit of its 2.0% target. In its latest statement, it tweaked its inflation outlook: It is committed to getting core inflation back to the 2.0% target level. In the past, the Fed was more casual about this goal, stating that it planned to be “near” the target of 2.0%. In the press conference following the FOMC meeting, Fed Chair Powell made it clear that fellow members were “not satisfied” with inflation consistently coming in below target.
The Fed is undergoing a policy review. The results should be revealed later this year, and it is expected that the Fed will announce more policies in an attempt to move inflation higher (see Figure 4).