Stocks fell sharply once again amid more negative Coronavirus related news and rising fear of both recession and disinflation. The 10-year Treasury yield sank to below 90 basis points, and this morning is now below 80 basis points. While the downward trend in yield may simply be attached to the emotional state of the moment, it may also be a harbinger of a pending recession, much lower inflation, or both.
The question we are all asking is “What’s going on?” Intraday moves are now in the range of 4% or more. 1000-point days are followed by next day reversals of almost equal size. Yesterday was a perfect example. As of Wednesday’s close, we had recovered over 60% of the losses through last Friday morning. Now we are back once again in correction mode.
The issues we face seem obvious. There is a virus scaring us all. Democratic primary action added some confusion, but a strong Biden showing Tuesday has reduced that. The Fed got into the act this week with an unexpected 50-basis point cut in Fed Funds rates. Normally easier monetary conditions are good for stocks, But not when central bank actions happen out of sharply escalating concern. That usually occurs at the start of financial troubles.
I think the problems we face stem from two contradictions. First, markets are forward looking. The stock market has already discounted what it expects to happen over the next 6-9 months. Six to Nine months from now, I think the consensus expectation is that the medical impact of the virus will be largely over. The epidemic will have run its course. On the surface, that suggests the lows of last Friday have a good chance of holding. But the Fed rate action, intended to be therapeutic to markets, may end up having an opposite effect. Besides elevating confusion, there is a reality that one longer term impact of the virus will be a build up of inventories caused by a sharp cut in demand. Those inventory buildups will lower prices and lengthen the time for a world already awash with excess capacity to normalize. I have stated countless times over the past several years that the main problem the world faces is one of excess capacity, not insufficient demand. Low rates might stimulate some extra demand (e.g. the spike in mortgage refinance activity), but they also stimulate an unwise further buildup of capacity. Offer the world free money, and the world will do stupid things.
There is a second factor dominating markets, one that works against the logic that stocks look ahead, and that centers on our emotions. In the stock market, emotions get in the way. We are human. We can’t stop how we feel. Right now, we feel scared. We know this virus is spreading and a lot of people are getting sick. Some are getting very sick. The media clearly stirs the pot, escalating the fears. That is a hazard of a 24/7 news cycle. Just a few weeks ago, it was a story about illness in China. We understood the risks at an intellectual level. But until the first cases showed up at our doorsteps, our emotions didn’t really kick in. Now they are starting to erupt. They are only starting. Meetings are being canceled. People are flying less. But we are not yet at the point where we know anyone personally who has Covid-19. That could change any day. If it is going to happen, it will do so over the next couple of weeks. That will only intensify our emotional response. Thus, March is probably going to be the worst month, as far as the virus headlines are concerned.
Wednesday, stocks rose because there wasn’t a lot of new Coronavirus news and investors liked the idea that Joe Biden had a big night on Super Tuesday. But yesterday was different. There is another cruise ship quarantined, this time off the coast of California. Multiple deaths are being reported. The Fed cut rates by 50 basis points and markets are now pricing in 2-3 more cuts by June. The bond market reacted negatively to the rate cut. The last time the Fed moved so boldly was October 2008. The Fed doesn’t react to a virus; it reacts to changing economics. Does the Fed know something we don’t? Is it reacting, or maybe even overreacting, to markets? Or was the Fed simply wrong, panicking at a time when it should have held onto its dry powder. Wednesday, while stocks rose over 1100 Dow points, the yield on the 10-year Treasury barely budged. Normally, rates rise when equity investors are optimistic. Yesterday, yields fell sharply and the declines continued overnight. 10-year Treasury yields have now fallen about 90 basis points since mid-February and the declines show no sign of abating. Negative interest rates aren’t that far away. If the Fed follows market predictions and persists with three more rate cuts by mid-year, negative rates could become a reality
Thus, we are confused, emotional, and scared. The VIX index, which measures volatility via changes in option premiums, is back up but not quite to the panic 50 level of last Friday morning.
There is little doubt the virus-related news over the next two weeks is going to be bad. There will be an explosion of new cases worldwide. We don’t know how long that will last but the first cases in China were reported right after the beginning of the year and today, two months later, the number of new cases reported daily in China is down to a mere handful. If that pattern repeats, by May the worst should be over. But, in its wake, Covid-19 will leave a lot of damage. When companies report first quarter results, we will learn the extent. It’s a bit like a hurricane. We know approximately where a big storm will land, we know there will be a lot of damage, but we don’t know until afterwards just how bad it was.
One place where it is bad is the oil patch. WTI oil prices this morning are down to $43 per barrel and falling sharply. Worldwide demand fell about 3.5 million barrels per day in the first quarter. They could fall at a similar pace in the second quarter. OPEC is talking of a production cut of up to 1.5 million barrels daily. You can do the math. If demand falls faster than supply, inventories increase and prices fall. They will keep falling until production finally slows sufficiently. It would seem likely that prices will have to fall to $35 per barrel or lower to finally stop new exploration and production. Rebalancing oil inventories will extend far beyond the end of the Coronavirus. It may now be years before oil prices of $50 per barrel can be sustained.
It’s time for a conclusion. First, once the number of new cases start to decline, especially in the U.S., the emotions will subside. Markets assess the damage months ahead. That is what has been happening over the past few weeks. Those in the eye of the storm (e.g. travel companies) get hit the worst. Others have taken a hit in anticipation of some lost business, but they should bounce back rather quickly. At least as far as the virus is concerned, a rational argument can be made that most of the damage in the stock market has been done, assuming May isn’t worse than March.
But there are a few caveats. Markets will have to adjust as damage expectations change. There is a risk that the economic damage is so much worse than we currently anticipate. The impact of the virus itself could trigger a recession. The bond market at the moment suggests much lower inflation as well as low demand currently leaves huge supply excesses. It isn’t just oil. It extends to all commodities. It further extends to manufacturing inventories, excess retail space, and even too many planes in service. If supply chains get so disrupted and travel so disturbed that companies need to resize and lay off workers, consumer confidence will weaken rapidly. We can’t forget that it has been consumer spending that has been the engine of worldwide economic growth for several years. I am not, repeat not, predicting a recession, at least not yet. But clearly, the odds are higher today than they were just a few weeks ago. I am more concerned about the impact of much lower inflation in the months ahead, both good and bad, than I am about a lasting recession. Realtime U.S. data so far shows virtually no measurable economic impact outside of the travel and manufacturing sectors. Housing is actually accelerating thanks to low interest rates. That’s at least a partial offset.
Lower inflation means lower interest rates and higher bond prices. Logically, that should also mean higher stock prices. But if lower rates and recent Fed action are a sign of economic weakness, the impact of lower future earnings will offset the advantages associated with lower rates. Stocks generally return 6% plus the rate of inflation over long periods of time. If growth remains around 2%, excluding the near-term impact of Covid-19, but inflation falls toward 1%, nominal growth will fall by a full percentage point. The offset will be a requirement for higher dividend yields. Normally, when dividend yields are well above the interest rate on 10-year Treasuries, it is a good time to buy stocks. That has been generally true over the years. But that also assumes that nominal earnings growth can be sustained and isn’t decelerating. The virus itself will play out fairly quickly from a medical standpoint. But the economic impact will linger until excess inventories, built up in times of weakened demand, are worked off.
As investors, the decline to date has discounted about a 10-13% haircut to 2020 earnings with most of the decline concentrated in the first two quarters. While earnings are still expected to rise in 2021, they will rise from a lower base and be less than previously anticipated. Equity values are a function of interest rates as well as earnings. The impact of lower earnings should be offset by the sharp decline in rates. Rationally, that suggests that despite the current high volatility, stocks today are within a range of fair value assuming a short 2-3 quarter recession and interest rates well below prior expectations. The damage, as noted earlier, will not be evenly distributed. It will take time to restore supply chains, work off excess inventories caused by lack of demand, and restore the confidence to travel again. The market has been punishing the energy, industrial, financial and leisure travel sectors for good reason. They will suffer the most damage and take the longest time to recover. If you want to bottom fish in those areas, it could be rewarding. But jumping in too early is like entering a hurricane a few hours before it ends. Don’t be a hero. Let the market tell you when it’s all clear. One day rallies are sucker rallies. You don’t have to catch the exact bottom to make money.
Today, Shaquille O’Neal is 48.
James M. Meyer, CFA 610-260-2220