Once in a Hundred Year
Like many university students from around the world, for the past month, I have found myself confined, attending remote lectures and working from home. While I admit that I am not the most social person and have the tendency to be inside, I am increasingly finding the ongoing isolation unbearable. Being able to meet friends and attend various events, etc. make up a very important part of the university life. However, we are dealing with the so-called once-in-a-hundred year event and like many others, I just want things to go back to normal.
But will things really return back to what they once were before the COVID-19 crisis? This pandemic is affecting our lives, but it is also shaking up the economy like we have never seen before.
For the past few months, we have witnessed the sharpest decline in the stock market and ironically, we are also currently having the best monthly rally in history. The S&P 500 is only 14% down from its all-time high matching Jun 2019 level while the economic data is deteriorating. Citi is projecting Q1 US GDP plunged by 4.8% annualised with an unemployment number heading towards 13.4% exceeding any recession history. In the meantime, 73% of the S&P 500 companies have reported 1Q earnings with results missing the market expectation and 20% of them have missed consensus by 1 standard deviation. The discrepancy between the market performance and the economic reality is obvious, but what is causing the surge in the market?
What fuels the current market optimism…
Firstly, the “recovery” that we are seeing is unbalanced, led by a small portion of companies. The five largest companies (Facebook, Apple, Amazon, Microsoft and Google, or FAAMG) collectively make up 20% of the S&P 500 market cap, the highest concentration in 30 years and only 23% of the S&P 500 companies are trading above their 50-day moving averages. The divergence between the top 5 companies’ performance and rest is staggering (Figure 1). Therefore, it’s likely the rally is not a broad market recovery, and we’ll see either the rest “catch-up” in the case of improving economic fundamentals or the top 5 “catch-down” if earnings proved below expectations.
Secondly, central banks from around the world have acted fast and injected a large amount of money into the market and the economy. The Fed alone has pumped $US2.3 Trillion into the system and even (many would argue) crossed the red-line by buying up the high yields. (Read Sam’s excellent article on the Fed’s response.) This essentially has improved market liquidity and reduced the left tailed risk. JP Morgan has estimated that an additional $2.3 trillion (Figure 3.) cash in the system created by Fed’s policies is likely to pump up equity and bond prices going forward.
Thirdly, the anatomy of the current recession is different from any previous recessions. We are dealing with a mandatory government shutdown that halts economic activity. The anatomy of the recession is clearer in the sense that we know what is holding the economy back and once the shutdown ends, economic activities should go back to normal. Therefore, the market is pricing in a significant decline in the current year GDP and followed by a significant increase in the following year. By comparing Figure 4 and 5, we can observe the swing in the GDP expectations.
Therefore, given these reasons, investors are largely willing to ignore the current quarter’s numbers and instead place a larger weight in the future outlook. Terms such as cash-burn and liquidity analysis have been the focus and with even Citi forecasting an almost 50% reduction in EPS this year, the equity market is holding up well and pushing the P/E ratio back to February’s level. Additionally, with declining COVID-19 cases and the hope of early reopening, the market has rallied. We are seeing a declining VIX, positive fund flow into the markets (Table 1.), improving spread and reducing short-covering ratios (Figure 6.).
However, many things that could still go wrong. No one holds the crystal ball and the shape of the recovery is still a mystery.
Fed’s support provides liquidity to the system, but we are dealing with a healthcare crisis and the US has been struggling to keep its daily confirmed COVID-19 cases below 20,000. Dr Fauci, the face of the White House’s coronavirus response team has also warned of a likely resurgence of coronavirus cases in Fall and a vaccine unlikely to become available until 18 months later. All these elements will weigh on the shape and the speed of the recovery.
The fragile part of the economy…
We entered into this crisis with close to 25~30% of the global debt trading with negative yield and 1-in-14 US-listed companies are dysfunctional “zombie companies” (Read Louis’ great analysis on the Zombie companies). By buying into “junk”, the Fed has entered the uncharted territory and potentially keeping dysfunctional companies afloat, pumping the debt bubble and possibly doing more harm to the economy in the long-term. Moreover, liquidity alone cannot fix solvency issues. Despite the Fed’s support, Goldman Sachs has forecasted a 13% default rate in the high yield bonds at a number slightly higher than the GFC level. While the troubled companies can lever up with more loans, it would make no economic sense for them to do so if the foreseeable revenue in future is not substantial enough to create economic benefits for the additional debt that they take on.
The potential red pill…
The truth is that some businesses will never return. Some of the revenue that was lost during the lockdown will never come back, and just because people are allowed to go back to restaurants does they will dine out at a higher frequency to make up for meals missed during the quarantine. The oil companies that operate on high debt and cruise liners were once the hotspot of the virus transmission, and they would be scarred permanently. Some of the industries will likely see longer and more painful recovery than others. The current crisis is likely to speed up and create changes in various industries. For example, it’s easy to point out retailers were in trouble before the COVID-19 crisis, due to the increasing trend of online shopping. The quarantine will likely accelerate this transition, improve logistic assets and increase online exposure.
Additionally, will the current crisis reshape how we utilise office space? James Gorman, the CEO of Morgan Stanley, has stated the firm can “operate with no footprint”, hence what does that imply for the future of the workspace and how would it impact the office space demand? Moreover, opening up international borders will only be the last step of the end of quarantine, but how long will it take for people to feel comfortable to travel again? A year? Two years? How will it affect the travel industry? The airliners? The hotels and casinos? What about the disruption of the global supply chain? and companies that relied on this would have seen their balance sheet obliterated beyond repair. This crisis could be seen as intensifying the mistrust and geopolitical tension between the US and China, so how would it affect the trade deal that has been negotiated, the geopolitical structure and the global supply chain going forward?
To a certain degree, I’d imagine things will not go back to “normal” after this crisis.
Now we look back to the rally that we have seen. What is the narrative that has been pumping the stock? You cannot fight the Fed? Sharp GDP rebound? Early reopening? Given the economic uncertainties that we are facing and the fact that part of our world will not go to “back”, do you reconsider the recovery that we are seeing is justifiable? Is the market way ahead of itself?
While I cannot decide the answer for you, all I hope for is to present two sides of the factors for you to consider.
Disclaimer: The views expressed in this article are solely that of the author’s, and do not necessarily reflect the position of UNIT nor the University of Melbourne. The advice given is general in nature and does not consider an individual’s personal financial circumstance. Transacting off this information is done so at one’s own risk, and individuals are encouraged to consult a finance professional before making investment decisions based off of this article.