“There ain’t nothing you fear more than a bad headline, now, is there?”
The coronavirus hits the market hard
Until a few short weeks ago, most investors were aware of the outbreak of the coronavirus (more specifically named the Covid-19 virus) in China which started to take hold in December. Although the headlines were vaguely alarming to nearly anyone, investor sentiment didn’t change much in response to another faraway threat, and the markets were still regularly hitting all-time highs up until two weeks ago. More recently, the news of spreading infections across Italy, South Korea, Japan, Iran and the United States have made it clear that the damage was not going to be contained inside mainland China. In the final week of February, the markets finally succumbed. Since then, the markets have set several undesirable records – including the fastest stock market correction and the largest single-point decline ever.
As the virus continues to spread, the impacts of the coronavirus on global behavior and the markets have been repeatedly acknowledged. Every health organization, news outlet, political commentator, talk show host, and sizable financial institution has submitted a verbal commentary or written tract describing the damage and presenting their own perspective on the crisis.
The coronavirus’ impact on the market is now a subject for debate for investors and market analysts. Succinctly, the debate could be phrased as a multiple-choice question.
The negative market reaction due to the coronavirus outbreak is:
A: an undue overreaction
B: an appropriate reaction
C: Insufficiently negative reaction
How would you answer this multiple-choice question? Let’s consider each of these possibilities one by one.
The market decline is an overreaction
A market bull might look at the recent market pullback as the absorption of an unnecessarily pessimistic base case scenario by investors. The World Health Organization (WHO) recognizes the coronavirus has spread to 75 countries thus far, but it has also noted effective national and international actions to limit the virus’ spread through quarantine, institutional, and personal safety measures. The efforts to slow the virus and buy time is not a futile exercise in the face of the evitable. While there are no treatments for Covid19 today, that is projected to change over a period of months. Moreover, if the virus transmissions can be meaningfully suppressed for a long time, it is possible to have a viable vaccine which could deeply stifle the virus’ ability to cause damage. The current estimates suggest an 18-24 month delay before a vaccine might become available to the public.
Next, consider the math regarding how many people have been infected. There are approximately 100,000 verified infections thus far – most of which have occurred in China, although China has notably seen its rate of infection slow in the past few weeks. While 100,000 sounds like a lot of people, it isn’t in comparative terms – it’s about 0.001% of the world population. By way of comparison, the very worst flu season in the modern era – the 1918 Spanish Flu pandemic – is estimated to have hit 25% of the world’s population. Furthermore, while the rates of infection for coronavirus are higher than the seasonal flu, it isn’t as contagious as other headline diseases (e.g. the measles).
Most epidemiological models suggest that the virus will continue to spread, but if we were to take a snapshot of verified information and where things are today, the virus has not yet spread to meaningful numbers on a global scale. Therefore, a market optimist might look at a 14% stock market correction as an undue overreaction based on an unfounded fear of where things might get rather than what the evidence suggests is true today.
Let’s consider what we currently know, rather than theorize, about the economy thus far. Through February, there has not been any confirmed impact to US GDP, employment, or profitability. Assuredly, there will be damage, but if we act based upon publicly verified information, there is not yet sufficient evidence to suggest weakness in fundamentals. Moreover, the economy has repeatedly skated through potential catalysts for weakness without a scratch. Why should this crisis du jour be any different?
The market decline is appropriate and proportional
A more balanced investor might disagree with the market bull, reasoning that the coronavirus infection – even if it is contained – is already having a measurable negative effect on earnings and commerce. A balanced investor might conclude, even if the threat of the coronavirus was fully overwrought, that consumer behavior has changed enough to alter the calculus of economic activity in a materially negative way. Thus, the damaged earnings potential base case, which the market seems to expect, is supported by the evidence we’ve already seen.
The coronavirus’ direct impact on earnings have been dramatic. Many large conferences in the developed world have been shut down. Massive movie releases have been delayed. Large corporations (e.g. Amazon, Facebook, Microsoft) are telling employees to work from home in an effort to limit virus transmission. Travel and leisure businesses (airlines, hotels, cruise ships) are experiencing incredible stressors as a result of the virus. For instance, global airlines are projected to lose $113 billion in estimated revenues if the virus continues to spread. Some have already buckled under the pressure; Britain’s largest domestic airline collapsed in early March.
We have yet to fully comprehend the indirect impact of corporate earnings and GDP growth from the crisis. We can be sure that limited transit and greater incentives for consumers to stay at home will necessarily reduce overall economic circulation and its virtuous cycle of growth. We do not yet know how much the economy will slow as a result.
This pessimism is not merely speculative. On March 2nd, the Federal Reserve announced emergency interest rate cuts of 50 basis points and the Federal Reserve tends not to move preemptively on speculation. Investors interpreted the Fed’s actions of evidence for worsening economic data and the market fell sharply as a result.
The market decline has not fully begun yet.
There is an even gloomier argument which suggests the market fall we’ve experienced thus far is insufficient given the potential for equity market revaluation given anemic growth rates or an outright recession. For the past 10-years, while the markets may have been positive or negative, the actual US economy has predictably chugged along at a rate of 1.5% to 3.0% every year. Some quarters have seen short term boosts outside of that range due to tax-cuts or short term drags due to muted global growth, but the annual US GDP growth rates have been steady since the 2009 recovery.
The coronavirus may be the catalyst which lowers growth rates on a global scale, including the US. Consider what happened in China has a comparative example and harbinger of what’s to come. China, which has been dealing with coronavirus since December, is estimated to have experienced a 6% contraction in growth in the first quarter of 2020. There are direct effects to China’s slowdown – it is the 2nd largest economy in the world – including global supply chain shocks and price dislocations. Moreover, what happens if other countries undergo a similar shock to the system? The most pessimistic market-bears don’t expect the United States to undergo a 6% contraction as a result of the coronavirus, it would only take a 2% drag on growth to send the US into a recession. To achieve a 2% GDP drag, all it would really take is a negative hit on the (hitherto resilient) consumer sentiment which is currently near a 15-year high based on February data. We will just have to wait and see if things appear quite as rosy in March.
Equity markets are priced based upon assumptions of earnings and growth trajectories. Equity bulls would be hard pressed to say the market is fairly valued if the growth rate for the foreseeable future dips below 1% as a result of a coordinated global slowdown. In other words, if the coronavirus pandemic sparks a mild recession, the markets may be overvalued.
To be fair, market analysts predicting the odds for a recession aren’t calling for a cataclysmic event like 2009, but instead a moderate market correction based on sagging earnings. For instance, Canaccord’s analyst Tony Dwyer, simultaneously predicts a 2020 recession with corresponding market slump, and he has announced his intent to buy stocks bullishly during this slump. For long term market watchers and professional analysts, a recession is a periodic inevitability that any investor must absorb gracefully.
Uncertainty works both ways
Rational people could make a reasonable case for either of the three scenarios to play out.
Any discussion of the future is definitionally speculative. We do not know what is going to happen; nobody does. Collectively, investors are coping with the uncertainty and processing new information quickly. For example, it is not a coincidence that the single greatest market decline was followed up, almost immediately, with the single greatest market upswing ever. This sharp oscillation in the recent equity markets suggests investors are uncertain about the fair value of stocks, but they are willing to readjust their expectations based upon the information available. Only duly presented evidence disseminated over time will let us know which base case is closest to reality.