As of June 30, 2020
The COVID-19 pandemic has plunged the economy into a deep recession that ended the longest global expansion in the post-war era as governments in major economies imposed lockdowns and shelter-in-place orders. While the lockdowns have generally been successful in “flattening the virus curve,” these measures crushed economic activity, leading to a stunningly large decline in global GDP. While global economic activity started off the year on a strong footing, the supply and demand shock stemming from COVID-19 caused sharp declines in GDP beginning in March, which put quarterly annualized GDP numbers for the major economies deep into the red for the first quarter. The second-quarter numbers, which spanned a long period under lockdown, are expected to be truly shocking, especially in the United States and Europe.
We expect global GDP growth to recover in the second half of the year as the apparent success in flattening the virus curve has led to a rollback of the lockdown measures and a reopening of major economies to varying degrees. The global policy response to the pandemic has been truly massive. It’s completely dwarfed the policy response in the aftermath of the global financial crisis and also arrived in a much timelier manner. This has helped stave off total economic collapse, reduced collateral damage, and hopefully provided the necessary support that will sustain the economic recovery. A variety of indicators suggest economic activity bottomed in Q2, and a rebound has begun.
The United States has led the way in delivering a surge of liquidity from monetary and fiscal stimulus. The US Federal Reserve (the Fed) has unleashed an extraordinary array of measures, restarting many of the liquidity facilities from a decade ago but also expanding them to new areas, including municipal and corporate bond markets. The central bank even launched a Main Street lending facility to support credit for small and mid-sized businesses. The collective impact of these measures has resulted in the Fed’s balance sheet growing from $3 trillion in March to $7 trillion in June, and it is on track to continue increasing. As a percentage of GDP, the Fed’s balance sheet has expanded by 15% to date during this crisis, versus 9% during the entirety of the global financial crisis. At the June 2020 meeting, the Fed reassured markets that policy rates would stay at zero through the end of 2022 and large-scale asset purchases would continue as needed.
On the fiscal side, the US government has delivered nearly $3 trillion in fiscal stimulus to support individuals and impacted businesses, and more is likely on the way in a presidential election year. Additional measures expected in July are likely to raise the annual budget deficit to nearly 25% of GDP, a level unseen in recent decades and on par with levels last seen during the Second World War.
While the US government has delivered the most aggressive stimulus program to stave off depression, the rest of the world has also risen to the occasion. The European Central Bank, the Bank of Japan, and the Bank of England have all followed the Fed in ramping up or restarting asset purchases and rolling out various liquidity facilities. In Europe, several countries have launched fiscal stimulus programs individually, and the European Union created a recovery fund that will offer grants to sectors and regions most impacted by the pandemic. This is a game changer for Europe, not only in terms of its ability to jointly tackle the COVID-19 crisis, but also as an important sign of European solidarity and of a willingness to deploy a new type of support from European institutions to assist member states. Meanwhile, emerging market governments are also contributing, with China’s aggressive fiscal and monetary policy leading the way.
Despite all the stimulus, we’ve dug ourselves into a sizable economic hole, and global economic activity is unlikely to reach pre-pandemic levels for an extended period. Even with the second-half rebound and 2021 recovery embedded in consensus economic forecasts, activity levels are still foreseen to be below pre-pandemic levels 18 months from now. It’s possible that the current economic consensus is too pessimistic and that quicker-than-expected medical breakthroughs might allow the economy to recover the lost ground more quickly than we foresee. However, it’s also possible that a variety of risks could act to delay/derail the long climb back to pre-pandemic levels, including a second-wave spike in COVID-19 infections, adverse economic and legislative outcomes stemming from the US presidential election, and rising geopolitical risks.
The COVID-19 pandemic has led to a tumultuous year for financial markets. Equity markets were crushed in the first quarter. The US stock market suffered the fastest-ever plunge into a bear market ever, just 16 days, eclipsing an earlier record of 44 days in 1929, according to Factset. From the February peak to the March low, the S&P 500 index fell 34% in the span of a month. During the global financial crisis, US equities experienced a deeper plunge of 57%, however, it occurred over a 17-month period. This time around both the decline and the subsequent rebound came at lighting speed. Since the trough in late March, the S&P 500 index surged 40% though early June. Should US stocks continue to rally and reach a new high this summer, the S&P 500 would have recovered its bear market losses in just a few months, compared to the more than four years it took to recover its losses in the aftermath of the global financial crisis. Most other risky assets have followed suit, making the second quarter of 2020 an extraordinary recovery period for global stocks, high yield bonds and emerging market debt.
While financial markets appear reasonably far along the path of a V-shaped recovery, economic activity and profits remain depressed, and the prospects for an economic recovery are still shrouded in a fog of uncertainty. Given the surge in stocks and the plunge in forecasted earnings, equities are trading at very elevated price/earnings (PE) ratios, suggesting the market is willing to look past the pandemic’s impact on near-term earnings. Global equities (MSCI ACWI) are trading at 19.6 times forward earnings, in the 94th percentile of its 20-year history. US equities (S&P 500) are trading at a forward PE of 22 and in the 98th percentile during the same time period. So why is the stock market trading at such high multiples given such high levels of uncertainty regarding the future path of the economy and corporate earnings?
The policy response to the pandemic has been overwhelming, as we chronicled in the previous section. Research by Cornerstone Macro (June 2020) estimates that the combined impact of central bank liquidity injections and additional fiscal spending has equaled 44% of GDP in the United States and 24% of GDP globally. This has provided a wave of liquidity that has driven financial markets higher despite the depth of the current economic valley. And, as we mentioned earlier, current activity has actually bottomed and is improving, despite the depth of the economic hole. Historically, equity markets have bottomed before the end of recession, anticipating and discounting the eventual recovery.
US rates have also moved substantially lower since the pandemic, joining other developed economies with yields on ten-year government bonds below 1%. It is possible that lower rates mean US equity markets could support higher multiples, as lower rates discount future cash flows at higher present value. Given the scale of the US Federal Reserve’s bond buying, 10-year Treasury yields are likely to stay low to support the return of GDP and corporate profits to pre-pandemic levels. The Fed is even openly debating yield curve control policies, which would involve targeting levels for longer-term yields, a move the Bank of Japan adopted several years ago and the Reserve Bank of Australia adopted very recently. From a global perspective, the earnings yield gap measure—the earnings yield on global equities minus the yield on global government bonds—which is considered a relative value measure for stocks versus bonds, is currently near the average level that has prevailed post financial crisis.
The stock market is also not the economy, especially in the United States. This is another factor at play in explaining the strength of the equity rally. The information technology, healthcare, and communication services sector make up 52% of the S&P 500 index but just 16 % of US GDP. These areas have been dubbed the “Work from Home” stocks whose businesses are generally more insulated from the lockdowns. Conversely, industrials, real estate, retail, and restaurants, which have been hit hard, make up a much larger share of the economy but a much smaller share of the stock market. Public equities also represent a small portion of total business and are generally the stronger and more successful firms. Thus, Wall Street has gained even in the midst of widespread Main Street pain. Finally, stocks have been supported by positive news flow related to COVID19 treatments and potential vaccines with several pharma companies announcing encouraging developments in clinical trials.
While the aforementioned drivers of the stock market rally are powerful, we remain somewhat skeptical of the stock market at current levels. It is unusual historically for stocks to experience a bear market drawdown and recession and then so quickly transition back to a bull market without setbacks along the way. Usually, bear market bottoms are a process and stocks tend to retest the prior low once or twice after the initial rebound. We think it’s unlikely that stocks will retest the March low this time around, given the comprehensiveness of the central bank backstop for financial markets. However, a correction from current levels or consolidation over the next few months seems likely before stocks experience another strong leg higher. This is especially true given the presence of a number of downside risks, including the potential for another spike in COVID-19 infection rates, US China trade tensions, risk of a hard Brexit, and headline risk as the presidential election kicks into a higher gear in the United States amidst social unrest due to race relations.
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