Like many other investors, I rapidly became overwhelmed with the uncertainty in the future. Consequently I decided to focus in on what we know now with high probability. Essentially this is assuming all fiscal / monetary policies as currently enacted and consensus estimates on COVID-19 mitigation (i.e. gradual resumption of normal commerce after mid to late Q2). See more detailed assumptions later.
Some facts going into the analysis:
- 2019 saw a ~30% gain in the S&P 500, however corporate earnings were nearly flat. Consequently, the 30% rise in the S&P 500 was due almost entirely to increases in valuation, i.e. stock investors paying more for future earnings
- The OECD had projected in September 2019 3.0% Global GDP growth and 2.0% for the US. This was already a deceleration of global growth from 3.6% worldwide in 2018 and 2.9% in the US.
- US Manufacturing, according to the ISM and IHS Markit surveys, weakened through most of 2019 (although showed a slight rebound near the end of year)
- US Business investment also declined through much of 2019, potentially due to the “trade war” between the China & the US
- US Consumer spending remained robust throughout 2019, although also appeared to decelerate near the end of 2019 / early 2020.
- US households had modestly de-leveraged as a % of GDP since 2008, and the debt servicing costs (due to lower interest rates) were at historic lows at the end of 2019. It’s worth noting the changing composition of household debt, with strong increases in student loan and auto debt while mortgage debt decreased. Housing debt peaked at ~$10 trillion in 2008, compared to slightly less than ~$10 trillion at the end of 2019. However, non-housing debt peaked at ~$2.7 trillion in 2008, while by 2019 non-housing debt stood at $4.2 trillion
- US Corporate debt stood at record levels as compared to GDP: ~75%. This debt had also deteriorated in ratings with the largest percentage in history rated as slightly above junk (BBB)
- The US deficit for fiscal year 2019 was estimated at ~$1 trillion pre-COVID
- The bulk of net inflows from 2016-2019 into US equities have been driven by stock buybacks. Since 2009, companies have spent ~$5 trillion in share buybacks
In short, my analysis is that the US economy entered 2020 with modest to low growth prospects. While consumer spending and household debt servicing costs remained bright spots, modest wage gains coupled with high housing, education, and healthcare costs presented a mixed picture. Both business investment and manufacturing activity were subdued, although hopes for a “Phase 1” trade war seemed cause for modest optimism.
With those facts as background, here are my baked in assumptions for the following analysis:
- The OECD nations + major developing countries (China, etc.) modestly resume normal economic activity in mid to late Q2
- There is no vaccine or “miracle drug” until late 2020 / 2021
- Stimulus from major central banks globally prevents an immediate financial crisis or severe market distortions (e.g. the corporate credit market seizing up)
- Additional fiscal stimulus measures, while substantial, do not exceed the original stimulus bills (e.g. the $2.2 trillion US bill)
- The COVID-19 lockdown contributes to a severe recession in Q1/Q2 2020 in most countries, but the easing of lockdown measures + stimulus leads to modest to substantial recovery in Q3 2020.
Alright, onto the main event. Here is what I think is “baked” into the future assuming the above events:
- Dramatic increases in sovereign debt levels. The US alone is estimated to run a deficit of ~$3-4 trillion depending on the severity and duration of the recession. With global debt levels already at records highs, it is unclear what effect these substantial debt levels will have (deflation, inflation, stagflation, no effect?)
- Severe budget deficits in US state & local governments. Increased spending on unemployment insurance and healthcare expenditures coupled with decreased revenues will force states to significantly cut their budgets. These cuts will include layoffs of non-essential employees.
- Increased pressure on Euro zone economies, particularly Italy. Italian economic growth remained anemic in 2019 at 0.3%. With the complete lockdown of the Italian economy (which began in the economic engine of Northern Italy), Italy will likely face dramatic declines in GDP and correspondingly large government deficits. Northern Eurozone countries will be faced yet again with difficult choices with regards to Italian debt. Pressure from northern Eurozone countries on Italy risk furthering inflaming public opinion and leading to a separatist backlash.
- Negative to zero growth in US consumer spending in 2020. Despite the enhanced unemployment insurance, stimulus checks, and corporate / small biz loans I believe it is unlikely that consumer spending will rebound in 2020. Consumers will prioritize on paying off debts, rebuilding savings, etc. due to the economic uncertainty. Furthermore there is permanent demand destruction in certain sectors, e.g. consumers are unlikely to replace all of their canceled vacations, restaurant visits, shopping excursions, etc. The “wealth effect” will work in reverse as many high income households see drops in both their investments accounts as well as variable compensation: bonuses, pay raises, RSUs, stock options, etc.
- Unemployment will remain substantially elevated over its early 2020 low of ~3.5% through 2020. As in 2009, many corporations will “do more with less” in lieu of hiring during uncertain times. Small and medium sized businesses will face substantial revenue losses in 2020 and will focus on cutting costs to remain solvent.
- Manufacturing and business investment will remain weak in 2020. Manufacturing will continue to stagnant due to sluggish demand for automobiles, aircraft, and other durable goods. Businesses will focus on preserving cash, paying down / refinancing debts, etc. due to weak global demand
- The US Federal Reserve will continue to support markets with QE and other monetary policy measures.
- Increased likelihood of a change in US presidential administrations. In early 2020 the Democratic party appeared poised to nominate a progressive, divisive candidate in Bernie Sanders. By April 2020 Joe Biden, a center-left candidate, had secured the nomination. At the same time, the US economic outlook had substantially deteriorated. While the economy is likely to improve in the June-November timeline, it is unclear if this recovery will be substantial enough to allow President Trump to run on a message of economic recovery. The increased likelihood of a Democratic presidential administration is a corresponding decreased likelihood of further US corporate tax cuts.
- Dramatic decrease in stock buybacks in 2020. Companies will focus on preserving cash and reducing debt levels.
- Significant deployment of “dry powder” from cash rich corporates and private equity firms (which have ~$2+ trillion in unallocated funds). These funds will look for opportunities in distressed credit, M&A, and other opportunistic areas
- Continued low oil prices in 2020. While a modest recovery is possible, the magnitude of demand destruction for oil, the unraveling of Opec+, and the continuing impact of American shale drillers will contain price growth.
- Continued China – US tension. There is little sign of a thaw in relations, and a hard line against China is one of the few popular bi-partisan issues in US domestic politics. Initial discussions to suspend Chinese tariffs during the crisis seem to have stalled.
- Emphasis on supply chain resiliency / diversification. Between the US – China trade war and the COVID-19 outbreak, OECD companies will face both investor and political pressure to diversify their supply chain away from China. This will bolster the slow and gradual shift that was already underway due to increasing Chinese labor costs and the perception of an opaque, unfair legal regime. In the short term this will drive up costs (China is a manufacturing hub for many reasons beyond cheap labor) which will either compress corporate profits or raise consumer prices.
- Unlike 2009, there does not appear to be a new global engine of growth. China seems justifiably concerned about exacerbating their debt situation with massive fiscal stimulus. India was already experiencing a recession, and other major economies like Nigeria, Indonesia, etc. do not have the per capita purchasing power to stimulate global growth. Many of these countries are also suffering from the collapse in commodity prices and the flight from emerging market bonds / equities.
I hesitate to forecast the future, because obviously there is significant uncertainty. However, my personal base case is that an immediate “V-shaped” recovery in asset prices is unlikely. For asset prices to reach or exceed 2020 levels would require corporates to either substantially increase earnings in mid to late 2020 AND investors to value future earnings at the same high levels of 2020. However, it is worth noting that the record low interest rates (and corresponding bond yields) and monetary easing could in theory drive investors into equities, real estates, private equity, etc. as the only option for positive returns. My personal base case is a sluggish recovery in mid to late 2020 with asset prices remaining volatile to shifts in sentiment. With the Fed stabilizing markets, a widespread global depression seems unlikely but could occur if high global debt levels trigger widespread corporate bankruptcies or some form of “stagflation”. Another unlikely, but possible case is that the world emulates Japan after the early 1990s and experiences a long period of slow asset price decline as corporates deleverage, credit availability declines modestly, and no new global engines of growth emerge.
One thing that occurred to me is that since this analysis is slightly bearish, I should proactively offer some data points that would indicate I’m wrong / overly pessimistic:
- Rapid recovery in US consumer spending in Q3 / Q4 2020 to pre-COVID levels
- Rapid return to pre-COVID employment, ~3.5%, by Q4 2020
- Increased US business investment / manufacturing activity in Q3 / Q4 to supplement or replace consumer spending
- The rapid return of the US corporate debt market which enables large stock buybacks in Q4 2020 onward
- Corporate earnings growth compared to late 2019 (i.e. not simply quarter on quarter comparisons against the likely awful Q1 / Q2 numbers)
- Massive US government infrastructure projects / other stimulus programs that generate demand and boost US household incomes
- Business Investment: fred.stlouisfed.org/series/W790RC1Q027SBEA
- Consumer spending: www.bea.gov/system/files/2020-03/pi0220_hist.pdf
- US Debt: www.newyorkfed.org/microeconomics/hhdc.html
- $400 expense: www.bloomberg.com/opinion/articles/2019-06-04/the-400-emergency-expense-story-is-wrong
- Corporate Debt: www.blackrock.com/institutions/en-us/insights/investment-actions/assessing-risks-in-bbb-corporate-bonds
- Corporate Deb #2: www.bloomberg.com/news/articles/2020-03-13/for-battered-junk-bond-market-an-old-risk-grows-louder-each-day
- Stock buybacks: www.cnbc.com/2019/10/29/goldman-says-there-are-three-big-stock-buyers-that-will-keep-the-record-rally-going.html
Disclaimer: This information is only for educational purposes. Do not make any investment decisions based on the information in this article. Do you own due diligence.