Economic forecasts for 2020 have been upended as public health concerns prompted the shutdown of large parts of the U.S. economy in order to prevent rapid transmission of COVID-19. 2019 had concluded on a very healthy note as GDP grew at a 2.1% pace in the final quarter and 2.3% for the year.1 A continuation of moderate growth seemed probable in 2020. If you recall, January and February economic data were solid, characterized by strong employment and a robust housing sector.
By late March, however, it was apparent the stay-at-home orders instituted throughout most of the country had triggered a deep recession. In just the last two weeks of the month, nearly 10 million workers had filed for unemployment insurance and even deeper job losses are likely on the way, underscoring the deterioration of a once vibrant labor market.2 The official unemployment rate which had been hovering around 50-year-lows had jumped from 0.9% in March to 4.4%.3 Estimates now call for unemployment to potentially peak anywhere from the mid-teens to 30% by late spring.4
GDP growth will plummet as well. It is now presumed that Q1 GDP has dropped from low to mid-single digits, and that second quarter GDP is likely to contract 15% or more5. Across the world, governments are deliberately creating a recession to deal with the coronavirus. These dire U.S. numbers are mirrored globally, although East Asia is showing some resilience, which is a hopeful sign. This region, having been the first to experience the coronavirus, is likely to be the first to emerge from the pandemic. The situation in poorer emerging markets, however, is especially worrisome.
The hope, of course, is that while damage to the economy will be severe, it will be temporary. Governments and central banks around the globe have responded with massive programs to prevent the economy from going into freefall and appear to have succeeded. In the U.S., Congress approved a $2 trillion spending package, while the Federal Reserve cut the Fed Funds rate by 1.5% and resumed large scale asset purchases to support markets. It is estimated the total support for the economy could exceed $4 trillion.
COVID-19 will eventually run its course and many are questioning the shape and extent of the recovery. We expect a strong rebound towards the second half of this year, but it would be naïve to think that an all-clear will sound and things will snap back to prior levels in an instantaneous fashion. COVID-19 caseloads in a number of states may not peak until late May, while many businesses will never recover lost sales. A sharp recovery would seem unlikely before mid-summer. Medical concerns including availability of widespread testing and adequate supplies of equipment will also need to be resolved.
Unfortunately, it now appears the U.S. economy will likely experience negative growth for the full year, most probably in the low single digits. While the labor market should begin to heal quickly, a return to a 3.5% unemployment rate is likely to be years rather than months away. Capital spending which was already limping along prior to the COVID-19 outbreak will likely be even slower to recover. However, despite the current pain, our forecast is for a return to sustainable growth in 2021.6
U.S. financial markets largely ignored the pandemic over the first six or seven weeks of the year. Despite the carnage experienced in China, the S&P 500 Index hit a record high on February 19th. The burgeoning number of COVID-19 cases in Europe, however, quickly made clear that the relatively few cases in the U.S. would compound exponentially. The only means to slow the spread of the disease and prevent the healthcare system from being overwhelmed would be extreme “social distancing” which would entail significant economic disruption. Markets went into a tailspin.
Not only did the S&P 500 Index lose more than 30% from its February peak to its March 23rd low, credit markets also plummeted and were on the verge of seizing. The yield differential between high-yield bonds and Treasuries, which had fallen to a cycle low of 3.15% on January 13th, spiked to 11% by March 23rd.7 All the while, prices of Treasury securities were screaming higher in a flight to quality and as the Federal Reserve swiftly lowered the Fed Funds rate towards the zero lower bound. At one point, even the yield on the 30-year Treasury bond plunged below 1% for the first time ever, while the yield on the benchmark 10-year Treasury has fallen below 1% and remained there.
While the velocity of the market decline was remarkable, markets just as quickly recouped much of their losses. Describing the scope and scale of the Government response, particularly that of the Federal Reserve “as unprecedented” is an understatement. Federal Reserve officials have long boasted of having an arsenal of tools to address extreme economic and market turmoil. In addition to slashing interest rates, the Federal Reserve initiated massive asset purchases in nearly every corner of the debt market, including municipal securities, and, for the first time ever, junk bonds. Lending facilities were also established to provide liquidity to a range of borrowers. With the Federal Reserve serving as a backstop, market participants regained the fortitude to return to the fray.
As of April 10th, the S&P 500 year-to-date loss had been reduced to 13.1%, although declines were significantly larger for smaller capitalization shares. Taking a longer-term perspective, the benchmark has only shed 3.1% from a year ago.8 Investors may well be wondering if we just experienced the shortest bear market in history. However, fundamentals are dismal. When the year began, Washington Trust forecast a mid-single digit gain in 2020 S&P 500 earnings to $173 per share. We have now slashed our estimate to $122.50, which results in a rather lofty forward P/E ratio of nearly 23x.9
Investors are clearly looking beyond 2020. A strong earnings recovery in 2021 is probable, but a return to peak levels of 2018/2019 would seem too much of a stretch. The damage done to the economy is real and changes to consumer behavior could be longer lasting than some expect. COVID-19 may not be completely be vanquished until a vaccine is successfully introduced which some experts indicate is likely to take at least another year. As interest rates are likely to remain near current depressed levels for the foreseeable future, higher equity valuation is not unreasonable but, in our view, P/E’s above 19x or 20x are unlikely to be sustained over time.
While Treasury yields are likely to stay “lower for longer”, investors may be able to locate fixed income investment opportunities given the substantial widening of credit spreads. As the credit picture has grown cloudier, new challenges have emerged, but diligent investors may now be able to reap some rewards. For example, a two-year Treasury is yielding just 0.2%, but a AAA tax-exempt municipal security of similar maturity could yield 1.75% or better. With this type of yield differential, the muni bond could be a sensible choice for any account regardless of tax status. Corporate spreads have also widened materially. We would focus on higher-quality investments given economic uncertainty.
The current economic environment is unlike anything experienced in our lifetime. There is no definitive roadmap for the progression of the disease or financial markets. While there were no visible financial bubbles preceding this crisis, we now recognize the fragility of our consumer economy, filled with great abundance, when so many live paycheck to paycheck. The closest analog is the 1918 influenza pandemic which took the lives of 675,000 Americans (over 1/2% of the population) and 50 million people worldwide and tended to afflict those in their working prime. Interestingly, the stock market steadily rose over its course.
Nobel Laureate Robert Shiller has speculated on three explanations. The bigger story at the time was, of course, the end of World War I. Further, there was confidence in the banking system in large part due to the creation of the Federal Reserve five years earlier. Lastly, the general public was far less involved in the stock market, and prices of financial assets were of less consequence to society. Shiller concludes with a truism, “Predicting the stock market at a time like this is hard. To do so well, we would have to predict the direct effects on the economy of the COVID-19 pandemic, as well as all the real and psychological effects of the pandemic of financial anxiety.”10 To that we would only add that the U.S. emerged from the pandemic of 1918 to a decade of great prosperity. While the current situation is disheartening and history does not necessarily repeat, investors should continue to think long-term and construct portfolios accordingly.
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The views expressed here are those of Washington Trust Wealth Management and are subject to change based on market and other conditions. Investment recommendations and opinions expressed in these reports may change without prior notice. All material has been obtained from sources believed to be reliable, but its accuracy is not guaranteed. Investing entails risk, including the possible loss of principal. Stock markets and investments in individual stocks are volatile and can decline significantly in response to issuer, market, economic, political, regulatory, geopolitical, and other conditions.
Investments in foreign markets through issuers or currencies can involve greater risk and volatility than U.S. investments because of adverse market, economic, political, regulatory, geopolitical, or other conditions. Emerging markets can have less market structure, depth, and regulatory oversight and greater political, social, and economic instability than developed markets. Fixed Income investments, including floating rate bonds, involve risks such as interest rate risk, credit risk and market risk, including the possible loss of principal. Interest rate risk is the risk that interest rates will rise, causing bond prices to fall. Past performance does not guarantee future results. The S&P 500 Index is an unmanaged index and is widely regarded as the standard for measuring large-cap U.S. stock-market performance. In addition, the S&P 500 Index cannot be invested in directly and does not reflect any fees, expenses or sales charges. Further, such index includes 400 industrial firms, 40 financial stocks, 40 utilities and 20 transportation stocks. The information we provide does not constitute investment or tax advice and it should not be relied on as such. It should not be considered a solicitation to buy or an offer to sell any security. It does not take into account any investor’s particular investment objectives, strategies, tax status or investment horizon. Please consult with your Portfolio Manager, financial counselor, attorney or tax professional regarding your specific investment, legal or tax situation.
1 Bureau of Economic Analysis
2 Bureau of Labor Statistics
3 Bureau of Labor Statistics
6 Washington Trust Wealth Management
9 Washington Trust Wealth Management
10 Robert J, Shiller, “The Two Pandemics”, Project Syndicate