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With coronavirus cases rising and global stocks’ worst week in over a decade taking them into correction territory, we have seen some echoes of what Sir John Templeton famously called the four costliest words in investing: “This time it’s different.” Pundits acknowledge past outbreaks didn’t drive global bear markets or recessions, but they argue past experience is irrelevant due to unique unknowns about the novel virus. But the specifics of any market downturn are always somewhat different. How markets react, though, rarely is—and that is the point of Templeton’s sage statement. In our view, stocks are very likely to once again prove his wisdom timeless.
The this time is different claims stem from detailed analyses of fatality rates, transmission speed, geographic spread and the like. We think these deep dives miss the point, which is about how human emotions affect markets. New diseases spur worries of pandemics slashing global commerce. In response, sentiment often swoons briefly, knocking stocks. But as we wrote, markets soon move on as they realize pandemics, though tragic, are temporary. They rarely pack enough economic punch to cause even local, much less global, recession. Factory shutdowns aren’t permanent. Companies work to keep goods flowing—perhaps by drawing on inventories or shifting production to still-operating factories elsewhere—and keep taking orders in the meantime. When the scare passes, they work through those orders. Output is delayed, but doesn’t disappear. Moreover, services—which comprise the bulk of developed-world GDP—are less affected. Sure, more visible services activities like tourism, dining out and shopping at brick-and-mortar stores likely dip initially. But activities that don’t require milling about in crowded spaces—like online shopping, insurance, finance, and countless forms of digital consumption and tech-related services—needn’t suffer. Some may even gain as consumers and businesses substitute them for potentially more infectious activities.
While stocks may react sharply at first, they soon realize commerce won’t crater for long and bounce before data recover—hard to fathom directly after stocks’ plunge, but normal. Hence, we think the key historical lesson is how sentiment can swing sharply in response to disease speculation—and recognizing recent volatility as sentiment-driven. Sentiment temporarily undershooting reality in response to a false fear isn’t different—it is a story as old as markets.
Super Tuesday is in the books, and it will forever be known as the day an underperforming candidate broke through: Yes, Representative Tulsi Gabbard finally won her first delegate. She remains in the race. Michael Bloomberg, who at last count won 12 yesterday, does not. Senator Elizabeth Warren, who so far can claim 26 of the 1,357 delegates on offer yesterday, is taking time to consider her future, according to her staffers. So while four candidates officially remain in the race as we write, this looks like a two-horse contest between former Vice President Joe Biden and Senator Bernie Sanders. We don’t know who has the inside track. We don’t know whether either will reach the convention with a majority of delegates. We don’t know who the nominee will be. And we certainly don’t know what will happen in November. Neither do markets, which means we may be in for more wobbles as uncertainty ebbs and flows over the next few months. However, once we have a nominee and markets can start handicapping November’s outcome, falling uncertainty should provide stocks a tailwind, resulting in a typically back-end loaded, positive election year.
Like every election year, 2020 has unique quirks and details, but in many ways it is a typical election year. It has started off with disappointing returns and increased volatility amid political uncertainty (with a side of infectious disease). If it continues behaving like a typical election year, we should see returns improve as the race narrows and markets can weigh probabilities instead of fear-inducing policy possibilities. That day may be hard to see now, with theatrics still dominating the headlines, but give it time. Even chaotic races eventually come into focus as the conventions wind down.
At a sociological level, Super Tuesday yielded a number of juicy stories. There was Biden’s back-from-the-dead win in 10 of 14 states, including mighty Texas. There was the “Stop Bernie” weekend dropout wave, in which Pete Buttigieg and Amy Klobuchar quit the race to endorse Biden. There was Bloomberg’s expensive flop, which amounted to an estimated $800 million of privately funded fiscal stimulus for Super Tuesday states. There was Warren placing a distant third in the state she represents in the Senate. There was the underperformance of House primary challengers funded by Alexandria Ocasio-Cortez’s PAC. There was the low turnout among young Sanders supporters which, surprisingly, we haven’t seen anyone tie to the coronavirus. There was the mystifying fact that Gabbard has not yet dropped out. There was the widespread call for do-overs from early voters frustrated over casting their ballot for someone who dropped out at the last minute. These are all fascinating. But we do market commentary, not sociology, so we won’t discuss them.
The Fed made its first “emergency” rate cut since 2008’s financial crisis this morning, slashing 50 basis points off the fed-funds target range to bring it to 1.0% – 1.25%. In his accompanying press conference, Fed head Jay Powell deemed the coronavirus a “new risk” to the economic outlook and said the central bank decided to ease monetary policy in response. He also left the door open for another move at the Fed’s next meeting in two weeks. The public reaction seemed divided. Some cheered the move as a positive step in bolstering the economy. Others saw it as a fearful sign superhuman rate-setters saw big trouble ahead. Finally, some bemoaned the fact the Fed didn’t do or promise more. We won’t wade into that debate, as there is little the Fed can do to combat coronavirus-related headwinds. However, Tuesday’s move does address one key factor getting less attention—America’s inverted yield curve—which may be a minor benefit.
On the bright side, the Fed’s move does shore up confidence that the bank is ready and willing to act when things get tough. It shows decisiveness and perhaps boosts credibility—both fine things, in general. However, an interest rate cut doesn’t directly address the potential damage from the coronavirus.
Usually, rate cuts aim to stimulate demand. But the coronavirus isn’t a headwind against demand alone—rather, it hits supply harder. A Fed rate cut cannot end quarantines in China, Korea, Japan and Europe. It cannot get folks back to work. It cannot replace the auto parts and consumer goods that aren’t flowing from China at the moment. It cannot stand in for sick workers. We guess it could help tourism-reliant businesses get over the hump if they were to encounter a short-term cash crunch, but industry estimates peg travel and tourism at around 8% of GDP annually.[i] A short-term, localized hit to an industry that small isn’t going to move the needle much. To the extent it helps smaller businesses stay afloat and keep workers, great. But that is probably a local, micro benefit, not a macroeconomic boost.
Stocks took another beating Thursday, with the S&P 500 price index falling -4.4% and bringing this pullback officially into correction territory.[i] Considering stocks were at record highs last Wednesday, this is a jarring, sudden move. Investors’ emotions are likely running high, and understandably so. There is nothing fun about a -12.0% decline in six trading days.[ii] But sharp plunges have a way of stimulating market history buffs. In the last hour, we have seen a bunch of tweets and headlines showing stocks’ biggest-ever short drops, sliced and diced various ways. You may have seen them too. Please do yourself a favor and tune them out.
Any ranking of “worst” drops is one thing and one thing only: trivia. Especially when the time periods are so short. Trivia is not a market driver. Nor is past performance. Stocks don’t care one whit that this is the worst five-day stretch since the depths of the eurozone debt crisis in 2011. A panic is a panic. Does it really matter that folks are freaking out about a potential pandemic as much as they panicked over tiny Greece and a US credit-rating downgrade?
Trying to glean any sort of meaning from a five-day move seems fruitless. As Ben Graham legendarily observed, stocks are a voting machine in the short term and a weighing machine in the long term. In our view, that is all you need to know. Sentiment wins in the short term, but fundamentals matter most over more meaningful stretches. The “why” and “how much” behind sentiment swings strike us far less important. The emotional swing itself is what matters. Market fundamentals likely didn’t change on a dime seven days ago. That isn’t how these things work. As another old adage says: Bull markets end with a whimper, not a bang.
As market volatility persists, headlines declare that stocks are finally wising up to the coronavirus’s potential global damage. Flash (a.k.a., preliminary) purchasing managers’ indexes (PMIs) out of the developed world seem to bolster this notion, with firms around the developed world noting the outbreak has crimped business. Yet February’s numbers also show that, as recently as February 19/20, economic activity hadn’t plunged—important context for investors to keep in mind as they size up big stock swings since.
Exhibit 1 shows how IHS Markit’s February’s flash PMIs—which reflect 85% – 90% of total respondents—compare to January’s final numbers.
Exhibit 1: February ‘Flash’ Vs. January PMIs
Negotiations between the UK and EU on a post-Brexit trade agreement kick off next week, and both sides are already drawing their red lines. In a refreshing change of pace, most coverage points out that these tough statements are merely starting positions, with both sides likely to erase and redraw lines repeatedly in the name of compromise. Yet it all ends with the same underlying warning: Without a trade agreement that includes mutual recognition of regulatory standards, UK businesses selling goods into Europe are sure to suffer and may move production out of the UK. Trouble is, there is plenty of real-world evidence to the contrary, suggesting a no-deal Brexit on WTO terms wouldn’t be a disaster.
Those who fear a WTO Brexit acknowledge tariffs would be minimal. But they claim the real disadvantage would come from the lack of mutual regulatory recognition. If UK and EU standards differed, UK manufacturers allegedly wouldn’t be able to sell into the EU, cutting off their nearest and supposedly largest market. That seems logical enough on the surface, but there is a problem: The US and EU don’t have mutual regulatory recognition and still manage to trade a heck of a lot. America allows all sorts of things the EU frowns on, including chicken meat washed with chlorine and genetically modified agricultural products. Europe has much tougher data privacy regulations, and their standards for financial communication are so different that even basic educational articles require a good deal of revision for transatlantic use. Drug and medical device standards also differ.
Yet the EU still manages to be the US’s largest trading partner. Total goods and services trade was nearly $1.3 trillion in 2018, according to the Office of the US Trade Representative. $575 billion of that was exports. If this transatlantic trade relationship can be so robust without synchronized regulations, it strains credulity to think the UK’s trade with the EU will all but cease on New Year’s Day if they default to WTO terms—especially since they will be starting with zero barriers. Any regulatory divergence would take time to materialize.
It is happening again. After the yield curve flirted with inversion in early February, last week’s broad fears over the coronavirus took 10-year yields back near historic lows—sending the gap between long and short-term interest rates further into negative territory. Accordingly, we are seeing a fresh round of articles warning the inverted curve is troubling for the US economy. Few, if any, bother mentioning that short-term volatility is normal for bonds as well as stocks. The curve’s near-term wiggles are impossible to predict, and it could be back in positive territory relatively soon—or not. Regardless, we thought it would be beneficial to explore how the lending landscape has evolved since the curve’s mid-2019 inversion so you can see why we don’t think this latest dip is a warning sign of imminent danger.
To catch everyone up, Exhibit 1 shows the spread between 10-year and 3-month Treasury yields since the beginning of last year.
Exhibit 1: The Yield Curve Spread’s Recent History
US and global stocks started this week on a sour note, as fears over the coronavirus’s spread into South Korea and Italy shook sentiment. The S&P 500 finished Monday down -3.4%, with most overseas markets similarly weak.[i] Coverage of the disease leads virtually every financial news website, which are also teeming with analyses from economists, politicians, analysts and pundits. Generally, their take is negative, operating on the assumption markets are just now catching on to the coronavirus’s potential fallout—and arguing more downside lies ahead. But this rocky Monday doesn’t change our view: Sentiment swings can always hit stocks short term, but the coronavirus is highly unlikely to upend this bull market.
First, some perspective seems in order. While Monday’s swings were large, it is worth remembering that the S&P 500 stood at all-time highs last Wednesday.[ii] Global stocks? Eight trading days ago (February 12).[iii] Since their respective high-water marks, US and world stocks are down a little over -4% each. That is the definition of a short-term dip—of which there have been dozens during the nearly 11-year old bull market that began in March 2009. For example: Last year had two nearly -6% downdrafts (April 30 – June 3 and July 24 – August 15) and one very similar to today’s size in September.[iv] We aren’t suggesting you should anticipate 2019’s hugely positive returns this year, just that even in great years, short-term volatility is normal.
As we often write, bull markets end one of two ways: Atop the wall of worry when widespread euphoria makes expectations impossible to meet; or when walloped by a huge, unseen negative. Neither of these seems likely today, in our view.
Among the myriad economic gauges and statistics out there, we think The Conference Board’s Leading Economic Index (LEI) stands out as one worth following. It is broad-based, mashing together 10 data points into a single figure. It is also a useful forward-looking indicator, given it has telegraphed every US recession since 1959. Hence, January’s 0.8% m/m rise—the largest since October 2017 and double expectations—seemingly bodes great for US growth.[i] Yet we think it primarily showcases the gauge’s calculation quirks and doesn’t necessarily mean a huge growth acceleration awaits.
Despite LEI’s history of accuracy, it isn’t a perfect economic forecasting tool. Over the years, it has given a fair few false signals—short-lived declines that didn’t precede an economic downturn. To separate potentially meaningful moves from noise, we recommend analyzing LEI’s components to see what produced a given result. Doing so last autumn led us to believe manufacturing weakness drove LEI’s decline—not an indication of broad economic weakness, as factory output accounts for just 11.5% of US GDP.[ii]
This time around, as Exhibit 1 shows, just one LEI component detracted.
For a long time now, we have held the opinion that political uncertainty over Brexit, rather than Brexit itself, was the chief headwind against the UK economy. Accordingly, once politicians stopped fighting and dithering and got on with it, we believed simply having clarity on the matter would enable businesses to stop waiting, stop stockpiling for deadlines that came and went, and start producing and investing as they normally would during an expansion. It is early days yet, but IHS Markit’s Purchasing Managers’ Indexes (PMIs) suggest this is coming to fruition.
PMIs are surveys measuring the percentage of businesses that report increased activity in a given month. Readings over 50 mean over half of businesses reported growth, which is a loose indication the economy overall grew. It isn’t exact, as it doesn’t measure how much activity rose or fell. But if the majority of businesses are growing, that is generally a good sign.
Last year, the composite PMI—which combines services, manufacturing and construction—spent a lot of time below 50. It dipped on the eve of each abandoned Brexit deadline and remained in contraction in November and December as the general election threw everything in limbo and businesses apparently entered wait-and-see mode. But in January, it jumped above 50—indicating expansion. The February flash estimate, released Friday, showed it stayed there.