- The big questions are when will the growth rate of new COVID-19 cases peak and will the fiscal and monetary policy response be enough?
- The significant drop in the stock market has been made significantly worse by the oil price war between Saudi Arabia and Russia, as well as forced deleveraging and a soaring dollar.
- Earnings estimates for the next few quarters tumbled last week, and will likely fall further in the coming weeks.
- While further US stock market declines are quite possible or even likely, my technical work suggests that the momentum of this decline may diminish in the weeks ahead.
As financial markets continue to come to terms with the sudden devastating demand shock across much of the world, made systemically worse by a massive liquidation among leveraged investors, we continue to look for answers to the following questions: When will the growth rate in COVID-19 cases level off, and will the fiscal and monetary policy response that is now underway be enough to help people and markets navigate to the other side of this crisis?
We know things are bad and getting worse, as evidenced by the now incoming economic and earnings data, but what we don't yet know is how long it will remain bad and how quickly (or slowly) the world can recover once the pandemic has been contained. Only when we get a handle on this can the markets start to stabilize and can volatility and inter-market correlations start to come down. It's at that point that we can start pricing in a recovery.
The next 3 weeks may well seem like an eternity
About the expert
Jurrien Timmer is the director of global macro in Fidelity's Global Asset Allocation Division, specializing in global macro strategy and active asset allocation. He joined Fidelity in 1995 as a technical research analyst.
With Italy now presumably (hopefully) nearing the peak of the COVID bell curve, and the US possibly 2 to 3 weeks behind Italy, hopefully by mid-April the growth rate in new cases in the US will start coming down. However, even if that best-case scenario comes to pass, these next 3 weeks may well seem like an eternity. My daughter, an ICU nurse, just told me that her ICU has now been designated as the COVID ICU at her hospital. For her, the next 3 weeks are bound to seem even longer.
Oil, deleveraging, and the dollar put more stress on markets
Making matters exponentially worse for the markets was the massive de-risking by hedge funds and other leveraged players, as well as the collapse in oil prices resulting from the Saudi-Russian price war. This has led to a contagion among all asset classes not seen since the Great Financial Crisis (GFC) of 2007–2008, with cash (in dollars) being the only asset class left unscathed. High-yield credit spreads are now at distressed levels (above 1,000 bps), and the high-yield energy credit spread is at 2,260 bps. At these levels, we may see casualties in the oil patch.
A soaring dollar was also a big part of the stress on markets last week, as were sharply rising real rates. High demand for dollars caused supply to dry up, and the lack of liquidity threw markets into disarray. In times of crisis, all correlations go to one, (the asset classes move in the same direction) and that certainly has been true this time around. For some form of calm to return to the markets, the dollar needs to weaken, real rates need to come down, and credit spreads need to stabilize. It wasn't happening last week, but hopefully it will happen this week.
Significant stimulus coming from the Fed, Congress close behind
You can tell from the price action that the stock market's plumbing is distressed. Fortunately, the Fed is throwing everything it has at the problem, and doing so much faster than it did in 2008 (back then it still had to come up with the programs that it now can rapidly re-deploy). The Fed's balance sheet has now risen to $4.67 trillion, up from $4.31 trillion just a week ago and $4.16 trillion 3 weeks ago.
And now things are moving on the fiscal side as well, with talk of up to $2 trillion of fiscal stimulus coming out of Washington. That's about 9% of GDP which, added to the already-large budget deficit (4.5% of GDP), will put a hole in the budget of about 14% of GDP.
Between the Treasury and the Fed, there are now estimates that the total monetary/fiscal policy response will be on the order of $4 trillion. Those are eye-popping numbers and hopefully they will be enough.
Earnings estimates take a hit
As of last week the S&P 500 had declined 32.8% from intraday high to intraday low, and 29% from February's close to last Friday's close.
On the earnings front, last week brought the first sizable hit to estimates for companies in the S&P 500. It surely won't be the last. It looks like Q2 is where the fastest declines are likely to be.
For the S&P 500, the forward P/E ratio has come down to 13x–14x and the equity risk premium (the difference in valuation between stocks and government bonds) is near 700 bps. Whether this valuation haircut has discounted enough bad news is unknowable in real time, but at this point I would say that a lot of bad news is priced in.
A technical look under the hood
To say that the stock market is now extremely oversold would be the understatement of the year, in my view. Analyzing technical indicators to compare recent events to previous dramatic downturns may yield some clues about what's to come.
A measure of market breadth (i.e., measuring the number of stocks going up against those going down) in the S&P 500 shows that last week's new highs minus new lows (−80%) was the third lowest in history, after 2008 (−82%) and the 1930s (which includes the 1929–1932 and the 1937–1938 periods). This means more stocks have been hitting new lows, compared to those hitting new highs—and not only that, last week's number is absolutely stunning given that the S&P 500 is "only" down 33%. In 2008 when this number hit −82% the S&P 500 was already down 47%. This puts some context around the declines that have been taking place in the markets these past few weeks. The index-level data don't do it justice.
With the exception of the 1930s (which produced an 86% decline followed by the Great Depression), by the time the market became this extreme, most (but not always all) of the downside was complete. The 1930s were different because the Fed committed a policy error by tightening reserve requirements, and there were no fiscal circuit breakers. This time we are getting an overwhelming policy response of up to $4 trillion.
1987, 2008, and 2020
How does 2020 compare to 1987 and 2008? The 1987 crash was a one-off price and valuation reset that was not associated with an economic downturn (although plenty of people back then thought a depression was coming). The GFC was a massive balance sheet recession, which by its very nature (de-leveraging) took many months to unfold.
Which one will it be this time? Clearly the current downturn is an economic event, which leaves the 1987 analog as a less-than-desirable one. But there are also many differences between now and 2008, the current market contagion notwithstanding. The GFC was a trifecta of financial excesses (banks, households, corporates), which took a long time to unwind. Plus, the policy response was much slower. My guess is that we are somewhere in between these 2 analogs.
My conclusion from all these indicators is that, unless we are heading into another Great Depression (unlikely in my view with $4 trillion of helicopter money on the way), these extremely negative breadth readings are more consistent with a market in which the bulk of the declines have already occurred, as opposed to one where they are yet to come. That doesn't mean the lows are in by any means.
We are likely at least several weeks away from the peak rate of change in either COVID-19 cases or the resulting economic distress. But the market has moved very quickly to discount this shock. Some lower lows may well lie ahead in the coming weeks, but my expectation based on the above is that the momentum of the decline is probably peaking.
My glass-half-full assessment is further supported by the potentially large rebalancing that is coming our way over the next week. My back-of-the-envelope calculation shows that a 60/40 stock/bond portfolio in mid-February has now become a 51/49 portfolio, entirely on the basis of market action. This is very large drift in a very short time. Given the many trillions of dollars in assets that follow some sort of multi-asset class approach, the coming rebalance could well be in the range of a few hundred billion.