3 paths ahead
Volatility looks like a mainstay for the coming months. We see three paths forward from here.
Our Top Market Takeaways for March 11, 2020.
A quick market recap
We’re getting whiplash
Yesterday, the S&P 500 lost almost -4% from 10:15 a.m. to 11:45 a.m., only to later gain over +5.3% from 11:45 a.m. to 4:00 pm. The index closed -15% below the all-time highs reached…just 14 trading days ago.
U.S. 10-year Treasury yields, meanwhile, rose by 26 basis points (bps), which is the third-highest moving daily leg since 2000. Just Monday, 10-year yields hit an intra-day all-time low, ultimately falling by 22 bps for their eighth-largest daily decline since 2000. As of this morning, the S&P 500 is down -3.5%, and there is also weakness in markets abroad.
Suffice it to say that markets don’t seem to have clarity on their future paths. The proverbial dust doesn’t seem close to settling, and we should prepare for more volatility ahead. It’d be helpful to have a map…
Drawing the map
Let’s recap. How did we even get to wherever we are?
There are three key dynamics at play:
- A negative supply shock. As the virus spread in Wuhan and other parts of mainland China, containment efforts shut down production and disrupted supply chains.
- A negative demand shock. No one wants the virus to spread, so they stop going out and spending money (or policymakers have told them they can’t go out and spend money).
- An oil shock. There are two sides to this one. The good news: More supply lowers prices, which increases consumers’ disposable income. The bad news: Energy producers have lower revenues, and are more likely to lose market share, decrease spending, lay off workers, and default on debt.
So where do we go from here? The recent market volatility is an indication that markets don’t really know, even if they are trying to figure it out. We see three broad paths forward.
- Path 1: A quick recovery with little lasting damage. In this scenario, the spread of the virus and associated social and economic disruption continue to escalate for a while longer, but peaks in the spring (say, in April or May). We’ll likely have to deal with weaker global trade, below-trend Chinese growth for the year, and very weak growth levels in the United States, Europe and Japan throughout the second quarter. But into the summer, the virus will be contained, and the benefits of the fall in oil prices, lower interest rates and possible policy action (like tax cuts and bridge loans) would likely cushion consumer and corporate balance sheets and lead to a swift rebound back toward trend.
In this scenario, equities would likely recover their losses, high yield spreads would tighten, sovereign bond yields would rise, gold could fall, but oil would be at the mercy of the fight for market share (in all three scenarios).
- Path 2: Prolonged weakness and a sluggish recovery. Here, the virus persists and reduces consumer spending and economic output well into the summer. The oil shock adds to global demand weakness (from oil producers) and increases credit stresses. Activity in China begins to normalize, but exporters face weak external demand. Global growth is flat in the first half of the year due to the shutdown in China and containment in other regions (think Italy). For context, global growth has not been below 2% since the global financial crisis. Extended disruption brings the risk of damage to corporate profitability and a rise in corporate credit risks, which are exacerbated by lower oil prices. Governments and central banks respond with stimulus, but risk aversion and supply disruption limit the effectiveness.
Markets seem to be pricing something similar to this scenario right now. If this continues, we would expect choppy equity and credit markets, low sovereign yields, and gold prices to remain elevated.
- Path 3: Global recession. In the worst-case scenario, virus disruption and the oil price shock cause a sharp downturn in demand and rise in corporate defaults. This leads to a negative spiral of lower capex, weak consumer confidence, and eventually layoffs and rising unemployment in most developed economies (even the United States). Deflation risk is prominent. Governments lack coordination or willingness to respond with appropriate fiscal measures, and the major central banks pursue more unconventional stimulus measures.
In this scenario, equities and credit would likely sell off more, sovereign yields would head lower still (yep, they can), and gold would likely rally.
As we mentioned, markets seem to be expecting something similar to Path 2 (prolonged weakness and sluggish recovery). To benchmark where we are, we examined the average peak to trough change in asset prices in prior U.S. recessions, and then compared it to what has happened so far this time. The results are shown in the chart below.
According to this simple methodology, risk-free Treasury bonds are already pricing in a recession, while risk markets (credit and equities) are between half and three-quarters of the way there. This repricing has been rapid. Just two weeks ago, the probabilities were negligible (grey bars). If the blue bars move higher in the coming days and weeks (i.e., risk assets lose more value from here, or Treasury yields fall further), then it is a sign to us that markets are moving from expecting Path 2 to Path 3 (global recession).
The bar graph shows the % of move during past recessions for equities, IG credit, HY credit and the 5-year U.S. Treasury. It shows the difference between March 9 and two weeks ago.
So how will we track which path we are on?
We believe the most important indicators to watch are daily new infection rates for the virus outside of China, high-frequency consumption indicators in the most exposed sectors (such as movie ticket sales, airline seat miles and same-store retail sales), and specific policy responses from governments and central banks around the world.
The line chart shows the millions of movie box office receipts for each week of the year. It has two lines: one showing the average from 2017 to 2019, and one showing 2020 through March 5. It shows that, thus far, 2020 has been below average but has followed the same trends.
Then, we have to monitor the extent to which the disruption in the most exposed sectors ripples through to other areas of the economy. We can track this by watching unemployment claims, business confidence surveys, and borrowing activity from both households and corporates.
Only time will tell which path we are on, but it’s our sense that anything better than acute disruption through the first half of the year would be positively received by markets.
As volatility is expected to be a mainstay of the months ahead, the best thing you can do is have a plan to ensure you are on the right path to meet your goals.
ll market and economic data as of March 2020 and sourced from Bloomberg, FactSet and Gavekal unless otherwise stated.
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