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In early March, consensus expectations for 2020 global GDP growth were +3%. Now they are -3%. That is a 6% swing in one month – unprecedented. You have to go back more than 40 years to find a similar decline in GDP. Even then, it took 12 months. Generally, such a decline takes 3 to 4 years. Nevertheless, the current recession did not come about from fundamental or structural problems, it should be short, even if the recovery takes time.
The dollar started to weaken at the end of last year before the aggressive flight to quality pushed it sharply higher. We expect improving global growth will put downward pressure on the dollar in the second half of this year. Massive U.S. deficits will also act as a drag.
Valuing the S&P 500
At the start of the year, we expected economic growth to pick up modestly. The unanticipated coronavirus pandemic truncated an otherwise reasonably positive year.
Then you think about the market and how it’s priced, there is no better place to look than earnings. At the start of the year, the bottom-up consensus for S&P 500 earnings per share was around $175, which put the index around $3,300. That was approximately 20x earnings on forward earnings. Now, complicating things a bit, the market sell-off started on February 20th and gave up some 33%. It was natural for investors to buy at these discounted levels. The question is, were they really discounted? Regardless, equity prices have climbed a wall of worry in recent weeks – gaining nearly half of what was lost in the sell-off. Now we are getting a look at expected earnings for 2020 – down to $144 per share. Now, if price/earnings remain at a multiple of 20, you would expect the S&P 500 to be priced at approximately $2,800. Well, guess where it is? On that basis, we think the market is just as overvalued here as it was in February.
Our short-term perspective is limited upside, at least for the next quarter or two. A steeper decline in earnings will likely be seen in the 2nd quarter. That could set the stage for another volatile period for stocks. Perhaps an even better buying opportunity. Then, a sharp snap-back in earnings as we get into the last quarter of 2020 where we should experience rising stock prices on a weaker dollar.
It probably breaks down something like this: Our best guess is earnings will be down 15% in the first quarter and down 50% in the second quarter. The third quarter should not be as bad, maybe down around 20%. But we’d expect earnings to improve to flat in the fourth quarter. Much will depend on how quickly we see the virus come under control.
Yield
The yield on the 10-year Treasury plummeted to record lows amid the heart of the crisis in March and now remains comfortably below 1%. For the moment, Inflation remains low but we could see that (finally) change as economic growth starts to recover amid record-low interest rates. As economic growth starts to improve and as investors move back into risk assets, we think bond yields will rise modestly. Should the yield on the 10-year climb over 1%, it would be a sign the economy is accelerating.
We continue to think financials, technology, and health care have attractive fundamentals, and wouldn’t be surprised to see this one finish strong by year-end.
Oil
Oil prices turned negative in recent days – that means oil producers are paying buyers to take the commodity off their hands over fears storage capacity could run out in May. Demand for oil has all but dried up as lockdowns across the world have kept people inside. As a result, oil firms have resorted to renting tankers to store the surplus supply which has forced the price of US oil into negative territory. The price of a barrel of West Texas Intermediate (WTI), the benchmark for US oil, fell as low as minus $37.63 a barrel. Earlier this month, OPEC (Organization of Petroleum Exporting Countries) members and its allies finally agreed on a record deal to slash global output by ~ 10% – the largest cut ever in oil production. Unfortunately, it has done very little avert the incredible sell-off.
Active Equity Managers Outperform Their Indexes for the First Time in A Decade
It may surprise some, but 59% of large-cap U.S. managers beat their indexes in the first quarter despite (or perhaps because of) all of the volatility. We think opportunities for active management from here are relatively high. We believe active managers will have a tailwind given a backdrop where small stocks are beating big stocks, non-U.S. stocks outperform, equity returns are relatively low, value beats growth, economic growth improves and interest rates rise.
Election Year
There is no question political division has increased, even when agendas should be sidelined. Coming into 2020, it seemed President Trump would benefit from a lack of a recession and the fact he didn’t have a significant challenger from within his party. The “no recession” aspect didn’t happen, and at this point, the political environment is tough to handicap. What does seem apparent is Joe Biden doesn’t seem like a particularly strong candidate. Regardless of the election outcome, the economy was on solid footing before COVID-19 and we believe the current recession will be short-lived.
The Housing Market
A major pillar of solid U.S. economic growth in recent years — is starting to falter due to the pandemic. Building permits, which are a leading indicator, peaked in January at 1.55 million units and are now down 13% (data through March) and likely headed lower. New home sales were down 4% month-to-month in February, though they were still up 14% year-over-year. Prices have not fallen, yet. Nevertheless, inventory levels are getting tighter: currently, there is a 3.1-month supply of existing homes for sale (the average range is 3.5-5.5 months), according to the National Association of Realtors. We think on the other side of the pandemic, demand for homes — with space between neighbors and back yards — will quickly regain strength and listings will improve the limited inventory.
Similarly, getting a fragile small business back up and running requires a plethora of simultaneous re-starts. For a restaurant, suppliers who were left with spoiled produce have to be willing to extend new credit. Waiters who are called back may have gone off to work at Walmart. Electric, rent, insurance, and other bills that have piled up are coming due. In short, all the sweat and hours behind the multiyear effort to build a business will have to be replicated, but within an extremely compressed period. Multiple businesses won’t make it back. If the bottom of the pyramid is full of holes, the entire edifice can be unstable. This leads to the conversation of recent government intervention – PPP, EIDL, and more.
The recovery will be hard and possibly as painful as the pandemic. Fortunately, we live in a capitalist democracy. Rebuilding will call up human resources we didn’t know we had, and capital resources determined necessary to win this war. The multiyear process of rebuilding after 9/11 resulted in a downtown New York has never been more vital. Now, we are in the early stages of 1st quarter earnings reports – some of this news will help quantify economic challenges to come for the remainder of 2020. We encourage our listeners, clients, and prospective clients to let this be a reminder while the general stock market outlook is more positive than the broader economic outlook, the two are inextricably linked.
Is the market blast-off mostly due to the historic government monetary and fiscal stimulus (liquidity) and less about the potential for a strong economic rebound? That’s hard to say. What we do know is it is generally not wise to fight the Fed, the Treasury, and the full force of the U.S. government.
