Current Thoughts On The Market with S&P500 Down -16% Versus Wed 2/19 High

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Apart from the fact that 26mm Americans are filing for unemployment benefits, things are not that bad from a market perspective. Thanks to the massive and relatively rapid monetary and fiscal policy response, COVID has not taken the S&P 500 down as much as the 2008 Financial Crisis did. At this point in the 2008 experience (start the sequence with 9/29/08, the first -5% move for the S&P), the index was down -17.6%. Now, (start with 3/9/20, the first -5% “crash” day), the S&P 500 is actually up +3.3%. So, based on the valuation for U.S. large cap stocks, this indicates a market view that the worst outcomes are off the table.

As such, the stock market believes the US economy will not be shut down again as testing, contact tracing and social distancing successfully contain COVID until better therapeutics and a vaccine arrive. This is underpinned by a view that monetary and fiscal authorities will remain on guard, ready to allocate fresh capital to keep consumers and businesses relatively whole until the US economy restarts. In all this, it is important for investors to understand that big businesses stand to benefit as smaller firms struggle, a real tailwind for the fundamentals of large public companies.

The stock market’s belief that current policy measures are sufficient to support a share price recovery underscores the outlook that the U.S. economy will stage a recovery as we move later into 2020. Over the weekend, Treasury Secretary Mnuchin stated his view that 3Q20 would see strong growth. Summer generally sees a seasonal peak in energy consumption, so demand recovery will be the main driver to clear the current record oil inventories.

Looking out further, though, it is harder to forecast a vigorous economic recovery. Recent experience from countries in Europe who are re-opening see consumer activity remaining subdued, a sign that stronger public health measures need to be in place and seen as effective before consumers will trade away the safety of staying at home. Consequently, economic growth is likely to be fairly modest and the path of economic recovery “W-shaped” with slowdowns and restarts around potential subsequent COVID outbreaks. Using the Fed Funds Futures (FFF) curve as a market-based forecast for economic growth, it currently discounts essentially 100% that the Fed maintains its current 0–25 bp interest rate policy through at least November 2021. While not as actively traded, the FFF’s 2022 prices show it is not before June 2022 that the odds of a Fed interest rate increase go above 50%.

GOOGL Results Show Revenue Growth Deceleration (+14% y/y vs. 1Q19 +18%), But Beat Forecasts; Worse Lies Ahead

Alphabet (GOOGL) 1Q20 net revenues of $33.7bn were up +14% with non-search-ad-related segments posting solid growth (i.e. YouTube +34%, Google Cloud +52%). In management’s words, 1Q20 was a “tale of two quarters” as the impact of COVID-19 caused online advertising to contract dramatically in March with travel bookings vanishing as sector activity ground to a halt in the face of the pandemic. Specifically, search and display ad revenue dropped more than -10% in March. The 2Q20 outlook is that Alphabet’s advertising business will be challenged.

Relative to consumer behaviour, management indicated that people have been searching more on Google, but many of those queries are not commercial in nature and likely linked to a surge in people looking online for COVID-19 information, limiting the company’s ability to show ads. Google is now seeing early signs of user behavior returning to normal, but stressed that it is unclear how durable the trend is for now.

FB 1Q20 Results Preview Sees It Harder Hit Than Alphabet By Online Ad Collapse

Facebook (FB) 1Q20 results will be out after the close this afternoon. Lacking the diversified operations that Alphabet has (i.e. cloud operations, in particular), it is likely FB will turn in a more disappointing report. Although activity on Facebook has leapt, thanks to housebound, news-hungry users, spending on advertising, its main revenue source, has shrivelled, as businesses cut costs to weather the pandemic.

Facebook will probably try to cheer investors by pointing to its recent $5.7bn investment in Jio Platforms, an Indian telecoms provider, which builds on its already dominant position in the world’s second-biggest internet market. Yet it will be hard to distract them from weak revenue: Facebook may report its first year-on-year quarterly decline. The fact that advertising inventory ad rates have crumbled over the course of 1Q20 is a clear indication of too much supply and not enough demand.

David Garrity, Chief Market Strategist for Laidlaw & Co discusses markets, bottom for tech, and changes to consumer behavior.

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1) Current Thoughts On The Market with S&P500 Down -24% Versus Wed 2/19 High:

In the spirit of the Chinese curse, “may you live in interesting times,” we are certainly in the thick of it at the moment as efforts to contain the COVID-19 coronavirus to China have failed. There are now 140 countries that have reported infections and the weekend has seen the announcement of radical steps such as major U.S. cities (e.g. Chicago, IL; Los Angeles, CA; New York, NY) taking steps to sharply curtail public activities as the U.S. Centers for Disease Control & Prevention (CDC) has issued guidance that events involving 50 people or more not be held for the next two months. Meanwhile, Trump administration officials on Sunday took to the TV talk shows to let Americans know that it will possibly take a few months before life returns to normal as part of an effort to “flatten the curve” of coronavirus infection to preserve healthcare system capacity in the face of the expected surge in cases, not a confidence-building move.

Clearly, economic activity is grinding to a standstill in the face of growing COVID-19 coronavirus quarantines. This is making it challenging to estimate global GDP growth and, of more immediate concern to investors, corporate EPS. A week ago, sources such as Bloomberg Economics estimate that economic fallout from the COVID-19 coronavirus could be as much as a $2.7 trillion hit to global GDP, a -3.1% decline from the 2019 level of $86.6 trillion. With China’s economic statistics for the first two months of 2020 (i.e. retail sales -20.5% y/y, industrial output -13.5% y/y, fixed-asset investment -24.5% y/y) indicate the likely COVID-19 coronavirus hit to the global economy will be worse than the -3.1% decline forecast previously. This in light of the uncertainty associated with expectations for the shape and pace of the eventual recovery.

Also, it is important to consider how COVID-19 coronavirus will have a lasting impact on consumer and business behavior, much as previous crises (e.g. Great Depression) have done. The likelihood is that the “stay-at-home, work-from-home” mentality will limit recovery for airlines and travel/leisure/tourism sectors and favor the technology providers that cater to the “stay-at-home, work-from-home” paradigm such as cloud computing (GOOGL, MSFT, AMZN), e-commerce (AMZN), distributed workforce productivity (WORK, ZM) and distance learning (TWOU) providers. The shifts here are significant as by some estimates approximately 10% of all workers are employed in the sectors experiencing a sharp, immediate reduction in demand from the spread of COVID-19 coronavirus.

In broader terms, COVID-19 coronavirus is having a negative effect to both supply (e.g. through supply chain disruption) and demand (e.g. consumers are hunkering down), so this is an economic shock that differs markedly from the 2009 Great Recession. Before addressing the question of the timing and shape of the expected recovery, it is best first to assess when the global spread of COVID-19 coronavirus might be expected to peak.

To that point, a RAND Corporation expert panel indicated that this is unlikely to occur until 2Q20 with the possibility of 3Q20 indicated. One important point from the panel is that the COVID-19 coronavirus may not abate seasonally and is likely to see multiple waves of infection. All this underscores the importance of developing a vaccine, a process likely to take until mid-2021. All this serves to highlight the vulnerable state the global economy will be in for 2020 and going into 2021.

2) Recent Economic Data Was Positive, But Does It Have Any Significant Meaning Now?:

On its own the recent February 2020 economic data was very encouraging, but it serves now only to set a baseline for how well the U.S. economy was performing before the containment efforts around the COVID-19 coronavirus failed. The Services PMI reading of 57.3 was a great number, historically consistent with 3% real GDP growth on an annualized basis. The U.S. Employment report of a +273,000 gain in jobs was very solid, coming well ahead of expectations. Nice economy we had here. Too bad COVID-19 coronavirus had to come ruin it.

3) Oil Price Collapse Should Serve To Stimulate Economic Activity, But Will It Now?:

Our thoughts in December 2019 when drafting the “Laidlaw Five” was that oil might reprise its exogenous shock role to the global economy with an upside spike stemming from hostilities in the Persian Gulf. That said, we did not anticipate that the production cooperation between OPEC and Russia would collapse. The ensuing moves by Saudi Arabia to seize market share from Russia now has WTI crude quoted at $29.05/bbl and Goldman Sachs is calling for crude prices to fall to the $20/bbl level.

Now, normally a collapse in oil prices would be seen as stimulative, but the demand environment with the COVID-19 coronavirus is quite different as consumers are hunkering down across the globe. Oil is historically a leading indicator commodity. With likelihood of oil breaking below $30/bbl, this price move does not bode well as it has negative implications for the high-yield bond market as well as for energy sector exposure for the banks. Also, with $45/bbl being the break-even level for the U.S. oil shale producers, look for U.S. employment in that sector to be cut back, something to add to the reductions noted above for the airline and travel/tourism/leisure sectors.

Meanwhile, away from the oil price move, there have been signs that China has been slowly ramping up production in an effort to restart global supply chains. This is based on weekday traffic volumes in major cities in China (Beijing, Shanghai, Shenzhen), but weekend traffic which reflects consumer activity remains depressed. These weekend traffic patterns are also becoming depressed in major European cities (Milan, Rome, Paris) and U.S. cities (Seattle, San Francisco, NYC). So, the takeaway from this data is that while China is trying to restart global supply chains, consumers are not buying but instead hunkering down. All we appear to be seeing from China is an effort to replenish inventory, but consumers are not drawing down due to the impact of the global spread of the COVID-19 coronavirus.

4) With All Of The Negative News Coming Out On Multiple Fronts, Are You Constructive On The Stockmarket?:

Mindful of historical performance that clearly favors equities, I consider myself to be a bull. However, with significant uncertainty around where 2020 earnings will come in, it is difficult to determine where a good entry point might be for long-term investors to step in front the current level of market volatility. With the global economy experiencing sudden retrenchment from COVID-19 coronavirus, it is challenging to determine where exactly corporate earnings might be thought to reach a trough level.

As chaotic as US equity markets may be, they are simply trying to discount normalized earnings power: the average of peak and trough bottom line results. A look at the last 2 recessions (2000 – 2002, 2017) shows the S&P 500 bottoms at an average of 13x prior peak earnings and 20x current trough. Assuming markets decide 2020 S&P 500 earnings will decline a not unreasonable -30% this year, that puts the floor on the S&P 500 at 2100, a level that represents a further -18% decline from current levels. Meanwhile, our 2020 S&P500 target level of 3,420 is essentially in line with the Goldman Sachs bull case of 3,400, all of which is highly dependent on how rapidly the global economy recovers from the COVID-19 coronavirus pandemic.

5) Other Topics Investors Should Focus On At Present?:

Earlier we discussed the challenge of determining the likely parameters around the global spread of the COVID-19 coronavirus, one important subsidiary consideration is to determine what is the available healthcare system capacity to address the epidemic. Capacity is measured by hospital beds and the medical staff necessary to provide adequate levels of care.

One of the challenges the U.S. faces is that among developed countries it has one of the lowest levels of hospital beds per citizen. That said, we have reviewed analyses that indicate that at current infection rates, the available U.S. healthcare system capacity will be fully used up by May 2020. Clearly, there will need to be a significant U.S. government-led effort to increase the supply of hospital beds and medical staff.

Note that the draw on U.S. healthcare system capacity from addressing the COVID-19 coronavirus may crowd out patients with other ailments from receiving care. Stay healthy.