On 25 January, we asked “Is the party over?” and now it really is. It has long been assumed that coronavirus would be largely confined to China and that our healthcare systems would easily cope with contamination elsewhere. Equity markets kept on rising right up to the point where Italy announced a wave of infections and the US authorities issued a warning of their own. They then corrected violently: by 13% from their highs at the time of writing over just seven trading sessions. Declines of over 20% have historically forewarned of recession, although not infallibly. In the autumn of 2018, for example, central bank easing prevented a correction producing that result.
The biggest losers so far in the current crisis are energy stocks. They accounted for 13.5% of the MSCI World index before the 2008 financial crisis but amount to just 3.5% of the index now. Other casualties include tourism and travel (aviation, cruises, hotels, restaurants, casinos) and clothing. The auto sector was already sluggish and is exposed to supply bottlenecks even before risks of recession are factored in. The financial sector has corrected more than average because it is exposed to crisis-affected companies; in the oil sector, junk bond spreads have hit 10%. The worsening economic environment is already visible in layoffs at firms like Expedia.
As usual when recession beckons, investors have switched to safe havens such as gold and the Swiss franc. The autumn 2018 crisis started with successive Federal Reserve rate hikes, which the markets effectively succeeded in reversing. This resulted in soaring financial asset prices without any corresponding increase in wealth. The current crisis is different, as it has nothing to do with interest rates and everything to do with a real risk to economic activity. Companies that start to fail because of a lack of customers will not be revived with zero interest rates, especially as nobody is likely to lend them money. This time, conventional central bank liquidity injections will be of no help at all. Instead, cash should be given directly to those who need it to get through this crisis. Helicopter money, in other words, for consumers and businesses. The authorities in Hong Kong have already decided to issue HK,000 (US],283) to all residents aged 18 or over and are offering other direct support to both citizens and firms.
In a replay of 2018, the markets have put a good deal of faith in Fed easing. 30-year yields are down to a new low at 1.65% in America and are negative in the euro zone. The curve is pricing in three or four Fed cuts; the ECB is assessing what the long-term effects of coronavirus might be, but as we say we do not see what monetary policy can do in this situation. The supply chain is breaking in pharmaceuticals, with China unable to export the raw materials to India that end up as exported finished products. Apple, Japan and South Korea have signalled comparable problems. The chances of a rebound in corporate profits growth this year are waning fast, and the consensus estimate for US index EPS growth is down to just 5.6%. Our estimates are 1.5% without a recession and -14% with one. The American market’s CAGR implied in market prices is 0.5% with a 30-year at 1.68%, and our model is at 1.9%.
Our theoretical objective for the S&P 500 is 3,241 points, compared with 2,954 points at Friday’s close. That objective would drop to 2,992 points with a 30-year at 2%, and in a recession scenario with 1.5%, it would be 2,776 points. A long rate at 1.25% would lift it higher still. These considerations prompted us to return to the market, and we are looking to increase our equities exposure from 35% to 38% in a stepped operation: a fifth with the S&P 500 at 2,938 points (executed on Friday), two fifths at 2,850 points and the balance at 2,750 points. We are using the same strategy for Europe, using these same US thresholds.