Our market strategists weigh in on what drove a recent market rally, how the shutdown will affect the economy and markets, and what additional government support may be coming.
Q. How does the recent market rally compare with past short-term market rallies? How have markets historically fared following sharp moves to the upside?
The 25% rally in the S&P 500 Index from the market bottom on March 23, 2020 through April 9, 2020, stands as the best 13-day period in the history of the index.1 The move surpassed the 13-day rallies that began on March 9, 2009; July 23, 2002; August 12, 1982; and October 4, 1974.2 Notably, each of the other top-5 best 13-day rallies on record began near the end of recession bear markets. In two of the instances, markets did fall toward (in 1974) or through (in 2002) the prior bottom.3 Today, we expect markets to be volatile in the near-term and to potentially retrace lower levels. In each of those past 13-day rallies, stocks were meaningfully higher one year later (March 2009-2010, +72%; July 2002-2003, +26%; August 1982-1983, +66%; and October 1974-1975, +44).4
Q. What’s been leading this recent rally? How do we square higher stock prices with weak economic data?
The S&P 500 Index rally has been driven by: 1) a massive policy response; 2) modestly better hospitalization and new cases numbers in many of the hardest-hit areas of the country; 3) hope for potential treatments; and 4) the reality that many of the large market-capitalization companies are reasonably well positioned for the current environment. Many of the mega-cap companies that led the rally are the same handful of companies that produced roughly 20% of the earnings of the S&P 500 Index in the fourth quarter of 2019.5 Nonetheless, the S&P 500 Index, even with the top 10 holdings excluded, returned 19% over the 17 trading days ended April 17, 2020.6
Q. What’s the near-term cost of the shutdown, and how did it likely impact U.S. Gross Domestic Product (GDP) in the first quarter of 2020?
The size of the U.S. economy is about $20 trillion,7 which equates to roughly $370 billion per week ($20 trillion/52). If half the economy was shut down for four weeks, that would imply a 10%-15% quarter-over-quarter drop in 1Q20 GDP, at an annualized rate. Eight weeks would imply a 25%-30% drop. Clearly, the shutdown becomes more costly with each passing week. Congress’s $2 trillion-plus package is roughly 10% of U.S. GDP, providing a cushion for the first weeks of the shutdown. More stimulus is likely in the offing.
Q. How does the coming decline in corporate earning compare with other recessions? How quickly does the market normally price it in? Will this be worse than a 15% decline?
At the end of 2019, U.S. earnings hit a record high of $157, up 3.6% compared with 2018.8 In recent months, however, the coronavirus-related shutdown has delivered significant shocks to the economy at a vulnerable stage of the business cycle. We judge that the stock market has priced in a 15% drop in earnings to roughly $134. That’s bad, but it could get much worse. By way of example, earnings during the 2008-2009 and 2001 recessions declined by as much as 30%-40%, a comparison that suggests markets have not yet priced in the full extent of the current earnings collapse.
(View a more Detailed Examination of the impact of COVID-19 on corporate earnings.)
Q. Why are U.S. oil prices plunging?
Oil prices globally had collapsed as a result of drastic decline in global demand for commodities, and the situation was aggravated by large global oil producers, such as Saudi Arabia, maintaining production to support cash flows. The OPEC+ countries have recently committed to cutting supply, but not by enough to offset the decline in demand. West Texas Intermediate (WTI) crude oil prices are now plunging and the gap between Brent crude and WTI has widened meaningfully, as the U.S. stock of crude oil, gasoline, and jet fuel have risen to record levels.9 While the first response for the U.S. oil producers was to pump oil and maintain cash flows, the number of rig counts (a measure of active drilling rigs) is now starting to fall,10 a development that should help to produce a floor for oil prices.
Q. What is the outlook for additional fiscal support being provided to the economy?
The White House and Congress appear poised to reach a deal to extend the Paycheck Protection Program. The plan will likely include a near doubling of the size of the small-business loan program ($300 billion), as well as providing additional funding for hospitals ($75 billion), disaster loans ($25 billion), and the federal coronavirus testing program ($25 billion). The fiscal spending, combined with the monetary stimulus, amounts to over 20% of U.S. GDP.11
Q. Are you worried about the deficit spending? Is this going to be massively inflationary?
The U.S. fiscal package is already equal to roughly 10% of U.S. GDP, and it is designed to provide support to small businesses, households, and the health care system during the elongated shutdown of large segments of the U.S. economy. The U.S. deficit will expand meaningfully in the next few years to provide a cushion for the U.S. economy and to provide support for an economic recovery. The government is currently borrowing money at very low rates, as there is strong demand for U.S. dollar assets. Near-term fears of inflation are misguided, in our view, given the extent of the ongoing demand destruction and the persistent risk of deflation. The market’s current forward five-year expectation for inflation is 1.5%12 below the U.S. Federal Reserve’s perceived comfort zone, and that is indicative of a bond market that is still gripped by fears of deflation.
Q. What is our outlook from here?
We put together a series of market bottom indicators that we released here. These indicators give us a detailed look at what we would need to see before we become more confident that a new cycle is beginning. We’re not there yet. While many of the indicators are starting to improve, inflation expectations remain weak, the U.S. dollar remains strong, and commodity prices are plummeting. As a result, short of a medical breakthrough, there does not appear to be a catalyst for markets to continue this advance. We would expect volatility to persist and markets to potentially retrace lower levels. That being said, we are still not suggesting investors should avoid, or reduce their positions in, equity markets for the long term. Ultimately, we believe that betting against equities over the long term is akin to betting against policy, science, and human ingenuity.