1 April 2020

The investor in the photgraph above can almost be forgiven for putting his head in his hands — a lapse of proper hygiene. The first quater of 2020 tested the nerve of even the most hardened market professionals. Following the recent equity market bounce, the commencement of Q2 2020 and the US and European earnings season provides a good opportunity to consider the staying power of the rally.

For the financial markets’ recovery to be sustainable, several questions must be answered. First of all, what will be the impact of the unprecedented economic lockdown on global GDP and earnings growth? Also, has the global policy response been adequate? Furthermore, in addition to the supply and demand shocks, the pandemic has shaken the confidence of investors, businesses, and the general public (most importantly). Restoring confidence is likely to require a considerable degree of certainty that the Coronavirus has been contained, and that a vaccine will soon become available. I will turn attention to each of these issues.

Covid-19’s Progression: When Will the Curve Flatten?

Let me be clear at the outset, I am obviously not a scientist. However, a sustainable economic (and market) recovery will require confidence that the pandemic has been contained. So, we need to monitor the disease’s progression, and determine when and under what conditions the contagion will be controlled. The experts provide assurance that like previous pandemics, the Covid-19 crisis will eventually run its course (if the public strictly adhere to their guidance). The Chart above illustrates the SARS epidemic took 3-4 months to tame.

The Chart above maps the progression of the spread of Coronavirus. (The graph is in logarithmic form to allow easy comparison across countries.) The slope of each line is critical, as it reflects the pace of the virus’s spread. Covid-19 hit Korea first, as the steeper slope of the grey line illustrates that reported cases accelerated more quickly than in Europe and the USA. However, Korea learned valuable lessons from its experience with the 2003 SARS outbreak. Widespread testing, aggressive contact indentification, and deployment of technology to ensure compliance with quarantine guidelines (amongst other measures) dramatically slowed the increase in reported cases within two months. To be sure, Korea is not out of the woods yet, but they managed to “flatten the curve” without the draconian measures implemented in Hubei province.

At the end of February, Europe became the epicentre of the pandemic. And, the still-steep slope of Europe’s curve illustrates that the month-long lockdown in many countries is only just beginning to have an effect (if at all yet). Italy will be of critical importance. And, in the search of optimistic signals, perhaps Italy’s curve is flattening a touch (Chart above). However, the following graph illustrates the continued large-scale increases in daily cases in large, hard-hit European nations. Eventually, Europe’s intense social distancing measures will work. However, I do not expect this to happen before June.

Perhaps most worrisome, the earlier Chart illustrates that since early March the USA has become the centre of the outbreak. As a result of delayed testing and belated social distancing, the slope of the US curve is now steeper than both Italy’s and Europe’s! Consequently, I do not expect the US curve the begin to flatten before July/August, e.g. into Q3 2020. Of course, what matters most is the loss of life. The following Chart illustrates that so far the number of deaths in the USA is one-tenth that in Europe, but growing exponentially.

The following Chart illustrates the number of American deaths per million population is a fraction that of most European countries (except Germany). Unfortunately, however, this will change, reflecting the later spread of the outbreak in the USA. The CDC and President Trump both projected this week that American fatalities could approach a staggering 200,000 in coming weeks, which would dwarf even Italy and Spain as a percent of the population.

Fiscal Stimulus: Exceeds Global Financial Crisis

In response, central banks worldwide have slashed interest rates, restored aggressive quantitative easing measures, and pledged again to “do whatever it takes”.

However, with monetary policy already extremely accommodative, fiscal policy will need to be the key source of stimulus in this crisis. The Chart above illustrates that in many countries the budgetary support will exceed that of the Global Financial Crisis. The USA has delivered an impressive plan, despite its debt burden rising well above 100% of GDP. Europe’s post-GFC austerity campaign has provided many countries ample room to maneuver. Finally, Germany is leading the way. The UK, Sweden, the Netherlands amongst offers are boosting spending sharply. More modest stimulus in hard-hit Italy, Spain, and France may reflect rising debt levels. I anticipate further stimulus in Europe soon, perhaps including EU-wide efforts to support cash-strapped southern European nations.

Low levels of public sector debt in many EM nations give ample scope for action. Singapore has announced a plan worth 10% of GDP. Korea, Thailand, Malaysia, Poland, Brazil, India and others have also contributed 1% of GDP or more. China, so far, has been more cautious, perhaps reflecting its higher debt ratio following its spending spree following the GFC. However, an infrastructure plan amounting to 3% of GDP is being discussed. China will be under international pressure to deliver soon.

Covid Forecast: Don’t Suffer a Lack of Imagination

In an earlier blog entitled “Don’t Suffer a Lack of Imagination” (which is available on my site), I outlined the key features of my economic forecast. First, the looming recession will be deeper than following the GFC. For example, I anticipate a peak-to-trough GDP contraction of nearly 6% in the USA, compared to 4% in 2008/09. At the time, these projections were worse than the consensus. Now, Goldman Sachs and Morgan Stanley project that Q2 GDP may decline up to 30% (annual rate). In reality, no one really knows, but Q2 will be horrific.

Secondly, I believe that the recovery will be sharper than following the GFC. Specifically, I believe the lost US output will be recouped within 5 quarters compared to 8 following the GFC. Europe took 7 years to rebound from the combined impact of the GFC and Euro crises, but GDP will revert to pre-crisis levels by mid-2021. I don’t know if that V- or U-shaped, but its two years lost.

Even though the economic shock will be temporary, I differ from the consensus, as I think the US slump will continue into Q3 2020, reflecting the protracted fight against the Coronavirus. Others expect the restrictive measures to ease in May/June, rather than late summer. If Europe’s lockdown flattens the curve, the recovery in that region should begin by Q3 2020.

In addition to successful control of the virus, key differentiators in regional performance will include the size of the hard-hit consumer sector — the USA is vulnerable (Chart above). Tourism and hospitality, of course, are taking a big hit, and the following Chart indicates where the impact may be greatest (e.g. Asia and Europe).

Given the impact of China’s lockdown on global supply chains, the trade-oriented Asian economies are most vulnerable. Singapore’s recently reported Q1 GDP contraction indicates the recession is likely to mirror that of 2008/09.

Earnings Season: What am I Missing?

While economists appear to have made appropriately large adjustments to GDP forecasts, equity strategists and analysts have not! For example, Factset reports that top-down S&P 500 EPS estimates show a decline of 1% this year followed by a 14% rebound in 2021. Not only is that not a recession, it does not reflect the type of slump we will experience. Based on analysis of previous economic cycles, I project a 25% decline in US earnings this year followed by a 40% rebound next year.

What is the correct valuation multiple to attach to these earnings? During the GFC recession, the S&P 500 PE averaged under 13X. However, interest rates are now much lower than during the previous downturn. Therefore, using an equity risk premium approach (ERP) would be appropriate. The Chart above (provided by my former colleagues at Morgan Stanley) illustrates the ERP is high relative to the last recession (although it has been higher). Using a still-high ERP of 5% , an S&P 500 Forward PE ratio of 16.5 seems appropriate.

What does that imply for US equities? Valuing 2020 EPS with the trough PE of the 2008/09 recession produces a market level of 1,600. Thankfully, that’s not appropriate. Applying a 16.5 Forward PE to 2020 EPS projects the S&P 500 at 2,150. In establishing a market projection for 12-months ahead, however, we should use 2021 EPS projections. Accordingly, my new S&P 500 target is 2,850.

Achieving that goal will require sharp revisions in analysts EPS forecasts and confidence that Covid-19 has been contained and a vaccine has been developed. As the pandemic’s death toll mounts and EPS forecasts are slashed, however, the equity market could slump within the 2,150 to 2,850 range in coming months.

Europe’s story is similar. I project a 25% MSCI Europe EPS decline this year followed by a 35% rebound in 2021 — a pattern similar to past cycles. The following Chart illustrates Europe’s ERP is sky-high (again provided by MS). Attaching a 15X PE to 2020 and 2021 MSCI Europe EPS generates a market range of 1,100 to 1,575. I establish a base case target of 1,575, upside of 15-20% potentially. However, as with the USA, there is more than the usual uncertainty attached to this projection. And, until the pandemic curve flattens, declines within this range are likely.

Emerging Markets: When the Dust Settles

I will provide a detailed assessment of the Emerging Market outlook in the coming weeks. As I am cautious about the general market outlook in the near term, I do not expect investors to show much enthusiasm for emerging markets until later this year. Luckily, developing countries have not featured heavily in the outbreak so far. Sadly, however, I assume that low-income, densely-populated EM countries, especially those with weak health care ssytems, will experience sharply higher Covid-19 cases in the months ahead.

However, EM equities have dramatically underperformed this year, and many EM currencies have been crushed. The Chart above illustrates that many EM exchange rates are extremely undervalued. Opportunities will emerge, as the dust settles.

Strategic Implications

• Global equities will continue to trade in wide ranges in the coming year. I establish a 2,850 S&P 500 target. However, as the pandemic death toll mounts, we could revisit the lower portion of the range in coming months.
• The same is true in Europe. Equities are cheap, and should eventually produce attaractive returns. However, setbacks are likely until the Covid-19 curve flattens.
• Preconditions for sustainable market recovery include: sharp EPS revisions, control of the pandemic, and development of a vaccine.
• Emerging markets have underperformed. Volatile market conditions suggest it’s too early to get involved.
• At some stage, we will need to consider the impact of higher debt and new health concerns on labour supply, productivity and long-term growth prospects. That’s for tomorrow. Today, save lives!
• Stay home, stay healthy!!