March marked the beginning of big adjustments – certainly, at a personal level for those under lock down, those now working from home and those with no work at all. This was also the month in which China began to unlock its people and its industrial activity rate jumped. In addition, equities had their speedy descent, followed by a recovery of roughly half the equity losses1. Credit spreads were somewhat steadier although hardly functioning normally. Investors struggled to evaluate wide-ranging forecasts, and at times, security prices seemed to create their own narrative.
Uncertainty Now Driving Stock Prices More Than Fundamental Insights
Professional analysts are significantly less certain about the future than when we were at the brink of normal recessions. After all, the COVID-19 crisis is health driven whereas previous crises were rooted in economic or financial conditions. Due to twists in the path of the virus and the wide-ranging points of view, financial markets have become disjointed with incongruent expectations. In other words, the “legs” of the V-shaped outlook can be narrow or wide depending on whom one asks and may even approach more pessimistic shapes.
Let us look at the European auto industry as one example. Bottom-up revenue estimates for the STOXX600 Autos and Parts sub-index2 reflect a remarkably shallow V given the supply chain disruption and weak near-term demand; an overall -6.9% is expected for 2020 over 2019 followed by a 6.5% rebound in 20213 . In contrast to mild trims to revenue forecasts, investors were much more pessimistic and pushed the sub-index down nearly 25% reaching a bargain price-earnings ratio of 74.
US markets suffer similar contradictions, not only in the auto industry but also, for instance, in dividend expectations. Dividend futures for the S&P 500 are presently indicating a permanent cut from now through 2023. Specifically, the level of dividend drops from the pre-crisis annualized 65 index points to 37 in 2021 before rising to only 41.75 in calendar 2023. At today’s S&P 500 level this corresponds to a dividend yield of 1.4% to 1.5%!5 Yet, since 1970, the S&P 500 dividend yield has only briefly dipped down to this level – in the late 1990s when the tech bubble vastly inflated the denominator. The most vocal advocates of market efficiency would have a hard time reconciling the dividend futures pricing relative to equity market dynamics.
Wide Dispersion in Forecasts Means Fat Tails
We believe markets are struggling to price a wide range of potential outcomes, driven by several known unknowns. The first unknown being how the virus spread can be stopped without recontamination. Complete eradication is unlikely to have happened in any country, so an intense monitoring process must be introduced to pinpoint (and contain again) individuals or communities in which the virus spreads. Otherwise, the health system may very well be overwhelmed. The economic impact of this potential on-off process is very hard to forecast.
The second unknown is the shift in spending behavior and how long lasting it might be. After the Global Financial Crisis, both individuals and corporates hoarded liquidity and re-built balance sheets in the short term instead of increasing spending. We believe balance sheets were stronger going into the COVID-19 outbreak than in 2008 on average and that different spending behaviors might prevail. Further, corporations might see strong efficiency gains post COVID-19 as businesses re-evaluate their priorities. Even more importantly, government intervention has likely become somewhat embedded in social expectations.
The third unknown is what the landscape might look like in terms of government borrowing, bail-outs and bankruptcies (personal and corporate), and the housing markets. Politically, we might have passed some important thresholds, which will reset our thinking on deficits, bringing a new era of bigger government interventions in healthcare.
Lastly, the possibility of rapidly available treatments and eventual vaccine is a significant right-tail development, which would bring forward a confident end to containment.
Our Outlook Focuses on 2020 and Beyond
As long-term investors, we are marginally less interested in the weekly, or even quarterly, market gyrations. These short-term effects are crucial for liquidity and for communications to plan participants; yet, the medium- and longer-term views affect the ability of portfolios to meet spending expectations.
The most likely outcome is a sharp but brief fall in activity, revenues and profits followed by the end of containment and aided by a multi-year fiscal stimulus. As highlighted in our quarterly economic review, macroeconomic policy solutions in targeted fiscal and monetary actions are on the front line of the market response to the COVID-19 epidemic. Central banks have risen above and beyond in coordinating actions on rate cuts, commercial paper funding and other emergency liquidity facilities. In addition, the US $2 trillion spending package should mitigate the suffering of the vulnerable, the poor as well as the self-employed. Further, emerging economies in Africa, Asia and Latin America with lower GDP per capita, higher poverty rates and poorer health systems should also benefit from the speedy response of central banks and governments. This is good news for humanitarians as well as investors.
As such, we encourage investors to remember that this is temporary, and as long-term investors, we need to remember that the bulk of asset values lies in the years and not in the next several quarters. It is essential not to get swayed by extreme judgements that gloss over the difficulties or extrapolate challenges too far into the future. We have a degree of uncertainty over the period of lockdown and economic interruption, but it does have boundaries – foremost amongst them is the very high likelihood that vaccines will be produced in a reasonable timeframe. We believe ultimate containment efforts are a function of known science rather than an ambitious exploratory undertaking without a near-term benefit.