Are Markets Getting the COVID-19 Recovery Wrong?

Various earnings reports, data releases and the IMF’s World Economic Outlook have served investors notice not to get ahead of themselves.  Truly, global risk assets have moved lower this week in response to historically disappointing corporate earnings and economic reports.  It’s certain that the stay-at-home orders in 42 states have essentially shut down the national economy.

And so, markets shouldn’t be surprised by the weak data, right?  In other words, this week’s bad news should have been taken in stride.  Well, market moves are typically about expectations.  And the market response to this week’s data suggest that investors’ expectations of a post-COVID19 economic recovery may have been wrong.

Figure 1: March industrial production drop worst since 2008

Source: Broadview Macro Research

Misplaced expectations?

Indeed, market expectations in recent weeks have shifted from panic selling in March on COVID-19 related uncertainties to renewed optimism on policymakers’ fiscal and monetary responses in April.  Large cap stocks being up well over 20% from March lows is one indicator of this change in sentiment.  And a rise in the price of riskier assets like small cap and emerging market equities proved the renewed optimism as well.

One reason for the recent market bounce is that some market participants expect the negative effects from the quarantine to be short-lived.  This goes back to the u-shared vs. v-shared recovery debate that we’ve written about before.  To be certain, various wire house strategists are already calling a bottom in this year’s market lows.  And some are even advocating that people add risk to their investment portfolios right now as headline coronavirus concerns dissipate.

But, this market view assumes that a few things need to go right in order for a v-shaped recovery to take place.  This includes a rapid end to quarantine efforts, a back-to-normal mentality for households and businesses operating pre-coronavirus capacity.  Market moves lower this week suggests that such assumptions could in fact not hold out in the near term.

Coronavirus: NYC seeing progress, national response still lagging

To the first point, in order to have a v-shared recovery you need the U.S. economy to reopen quickly.  Some policymakers and pundits are certainly pulling for this outcome, setting May 1st as a soft deadline to begin allowing non-essential businesses to restart.  This assumes, however, that “flattening the curve” efforts have been effective enough to prevent a renewed surge in COVID-19 infections.

For instance, some people are looking at the positive developments in New York as a litmus test for the broader U.S. economy. And this could be a problem.  With a key reason being that many other states are just now beginning to see a rise in new COVID-19 cases weeks after New York started its quarantine efforts.

Other issues come up as well.  Like state-level coordination and the ability to test the U.S. population for the coronavirus broadly, frequently and consistently with states at varying outbreak phases. Therefore, looking at what’s happening in one state may not be the best measure of how the COVID-19 outbreak will play out nationally.  Put differently, other state economies could remain closed even as New York reopens for business.   The longer people stay at home, the fewer businesses they will frequent. This increases the likelihood that more businesses may simply remain shutter and not reopen.

Figure 2: Behavior changes post 9/11

Source: Broadview Macro Research

Expect a change in consumer behavior

Another argument being made for a rapid economic recovery is the concept of pent up demand.  Proponents of this belief suggest that once the stay-at-home orders are lifted, people will simply flock to non-essential businesses after having been cooped up at home for weeks. While intuitive, such a view assumes that a large part of the U.S. population will frequent businesses that still exist and consume in a manner consistent with how they had at the end of 2019.

Some may certainly go out and spend on the things they have long wanted.  Yet, back to normal consumption is likely to take some time to return.  More specifically, we expect the COVID-19 outbreak to change the way people interact with each other and businesses once the threat is gone.

One example of how consumer behavior can change is found in the aftermath of the 9/11 World Trade Center attacks.  At the time, air travel in the U.S. was halted until leaders were certain that the terrorist threats were contained.  While the grounding lasted only two days, we find that flights getting back to normal took even longer.  For instance, government data show that it took well over a year for people to begin flying at pre-crisis levels again.

It’s also worth noting that it wasn’t just a fear of renewed terrorist attacks that changed people’s behavior and ability to fly.  Before 9/11, TSA checkpoints didn’t exist like they do today.  In fact, the early days of its operations were hampered by fits and starts, and long lines made flying simply unbearable.  Certainly, we’ve adapted, but it didn’t happen overnight.  As reports from China show, the COVID-19 outbreak could have lingering effects on our daily lives once the stay-at-home restrictions are lifted.

Figure 3: COVID-19 downturn worse than Great Recession

Source: Broadview Macro Research

Business coming back online will take time

There’s also this expectation that businesses will simply pick up where they left off before the stay-at-home orders took hold.  Indeed, the IMF reported this week that the global economy is likely to face prolonged sluggishness due to the COVID-19 containment efforts.  Analysts at the Fund expect the global economy to contract sharply this year, experiencing its worst decline in over a century.  The dour forecasts represent more than people simply not shopping or visiting restaurants.  Consider supply shock.

Stories abound of growers upending crops and chicken farmers destroying thousands of eggs because of demand and logistic challenges.  Truly, the supply shock issue shows that it’s hard to flip a switch and bring back lost produce and livestock overnight.  Also consider the way downstream processors, distributors and wholesalers depended on agricultural supply available to them that is now gone.

Quote: While timing the market bottom is interesting, what should be of more concern for investors right now is whether market prices accurately reflect risk expectations.

This concept can also be applied to restaurants, retail spaces and the myriad support businesses that will struggle to restart once the U.S. economy broadly reopens.  Adding insult to injury, there is a real risk of a renewed COVID-19 outbreak so long as we do not have a vaccine for the virus.  Even then, getting a vaccine produced and distributed throughout the U.S. and globally will yet take even more time.  Certainly, there is a strong argument to be made that getting back to normal won’t happen overnight.

Reframing expectations

While timing the market bottom is interesting, what should be of more concern for investors right now is whether market prices accurately reflect outstanding risks.  We believe that this may not be the case today.  Indeed, all of the knock-on effects from the global economic shutdown are still not fully understood.  And this could open the door for more downward market moves as data releases, like those from this week, surprise in the months ahead.  We’ll take just one more example from history to crystalize our point.

The 1906 San Francisco earthquake nearly decimated the city.  While the earthquake took only minutes, the fire that ensued lasted for days and destroyed thousands of buildings.  Now imagine local leaders back then having discussions about how much of the city would need to be rebuilt just hours into the inferno breaking out – well before it was even contained.  We believe that, right now, we’re still in the early days of trying to understand the present and future consequences of the COVID-19 pandemic.

Figure 4: Market sentiment still in risk-off territory

Source: Broadview Macro Research

Positioning for more market uncertainty

Therefore, making high conviction calls in one direction or another at the present time could be a setup for investor disappointment.  Make no mistake, we will get a handle on this outbreak. Our economy and markets will recover.  The challenge for market participants right now is whether their expectations are misplaced.  So, what should investors be doing right now during this time of uncertainty?

For now, we believe that the best course of action is for investors to remain disciplined and committed to their long-term investment process.  Stick with your systematic investment savings contributions and allocate new capital in a manner consistent with your long-term asset allocation framework.  It certainly is tempting to look for deep value opportunities in the markets today.  For sure, use this time to create a wish list of high-quality names that you would like to own, but give it time.

Our risk-on/risk-off indicator shows that we remain well into risk off territory.  Using the October 2008 lows in risk sentiment as our guide, it wasn’t until March 2009 that the markets broadly bottomed and a new bull market took hold.

Volatility may increase in the coming weeks as market participants begin repricing the likelihood of a longer, deeper protracted recovery.  Therefore, we believe that investors should hold off on taking unnecessary risk in their portfolio.  From this vantage point, we will likely need the balance of news to lean net positive in the coming weeks before we gain further conviction on shifting more favorably towards value/cyclical opportunities.  Until then, stay focused on the long-term opportunities.