The Bright Side

As we continue to endure the uncertainty and market volatility associated with the coronavirus, we thought it would be helpful to point out some of the factors working in favor of not only the economy but also the markets. Please understand that we are by no means calling a bottom for stocks. We recognize that the scale of this market shock will cause some enduring market dislocations. The uncertainly is likely to recede only when the rate of infection comes close to a peak. However, there are some considerations that, following a period of time that likely won’t exceed a few months, should put a floor under the economy as well as financial asset prices.

Let me first start with a few qualitative factors that I think are imperative to remember. First, just about everyone in the medical community believes that the impact of the outbreak will be transitory with a limited duration. In other words, whether it takes six weeks or six months, there is already light at the end of the tunnel. We know this because life in China is beginning to resume as usual now that the crisis has become manageable both inside and outside of Hubei province. It is true that in order to beat this disease the Chinese government had to implement some pretty draconian measures. But if that’s what it takes, that’s what we must do.

Second, we need to remember that this year is an election year, and one that could change the political landscape in the United States for the foreseeable future. The president and his party appear poised to use the full weight of the US government to fight this affliction, and in doing so they stand to secure the presidency for another four years and maintain control of the Senate. The Democrats, for their part, are hopeful about maintaining control of the House, gaining control of the Senate and bringing home the grand prize, the Oval Office. Everyone knows that the best way to gain power is through strong leadership and successful management of this crisis. Everyone knows the stakes; failure is not an option.

And finally, we must keep in mind that unlike the Global Financial Crisis, nobody is at fault for our current predicament. This is a very important consideration because there will be no concerns about bailouts and other support for those deemed to be responsible for the crisis. Furthermore, our leadership, to include the presidential administration, Congress, and the Fed, is unlikely to face much backlash for implementing draconian and very costly measures to successfully defeat the virus. The public will be much more amenable to sacrifice in response to an uncontrollable force rather than an identifiable villain. A virus cannot be vilified or punished by the press or at the ballot box. And when faced with external threats, the American people have shown repeatedly throughout history that they have the grit and determination necessary to prevail.

We also believe there are more tangible reasons that the economy, after suffering an almost certain recession, should be relatively resilient and quicker to bounce back. Among these factors are the following:

  • Notwithstanding our continuing concerns about economic inequality, the consumer’s financial health is relatively strong.  The consumer Debt Service Ratio, which measures how much of the consumer’s disposable income goes to household debt service payments, is at multi-decade lows.  In addition, savings rates are currently quite high, which means the average consumer has some rainy-day money.
  • The consumer is receiving an effective tax cut in the form of mortgage refinancing and very low gas prices.
  • Business investment remains quite depressed.  While relatively low business investment has been a perennial drag on GDP in recent years, that is actually a good thing as it relates to the depth of any downturn.
  • Residential investment’s share of GDP also remains below long-term averages.
  • The trade skirmishes with China, Europe, Canada and Mexico have held back exports as a share of GDP compared to the levels we expect once trade agreements are firmly in place.
  • Business inventories are currently fairly low, which limits the impact of possible inventory drawdowns as a response to the crisis.  However, there is good reason to believe companies will actually be building inventories, in many cases, as supply chains are affected by the virus.
  • In the near term, the economy will be supported by consumer spending on goods and services (think health care) to protect against the virus or its worst effects.
  • Perhaps most obvious, the government is going to go much further into deficits as a result of tax rebates and spending related to the coronavirus.  Though the magnitude is not yet known with certainly, we may be looking at annualized deficits of between $2 and $3 trillion in the initial stages of the response.  A deficit of $2.5 trillion would equate to about 11%-12% of GDP, an amount that would make Keynes blush.  However, these deficits will be required to support the economy in order to prevent a rapid increase in unemployment.  The current super-low level of interest rates should allow the federal government to fund these deficits at a very low cost.  There will be ramifications later for running up this debt, but now is not the time to worry about that.
With regard to stock prices, we think there may be more pain ahead before it gets better.  However, we also need to acknowledge that a lot of damage has been done to valuations, and interest rates are very close to zero.  There will come a point when investors accept the risk of owning stocks rather than buying bonds that will result in an almost certain loss of purchasing power (because bond yields are below the current rate of inflation).  The current estimate for S&P 500 earnings next year (2021) is still about $190, which puts the current price-to-earnings multiple at just 12.6x.  Everyone knows at this point that that estimate is highly unrealistic.  If we apply a rather aggressive 30% haircut to those estimates, which will clearly be revised down in the coming weeks, the multiple goes to 18x.  Given that we know the effects of the virus will be transitory and that leadership is ready and willing to bring out the economic bazooka, at what level will investors step up en masse to take advantage of the mayhem given the backdrop of zero interest rates?  It’s anyone’s guess at this point, but we are likely getting pretty close.  And importantly, underinvested young people are finally getting an opportunity to start saving at lower valuations, which, over time, will result in higher returns.  Investing at lower valuations lowers the cost of saving for retirement, which is one of the consumer’s largest expenses – just one more hopeful sign.
Hang in there, keep your wits about you, and stay safe!   We will get through this together. Please let us know if there is anything we can do for you in these tumultuous times.