HCR Wealth Advisors and the COVID Economy: Where We’ve Been and Where We’re Going
Carl Aschenbrenner, CFA
Portfolio Manager
It’s hard to say anyone could be adequately prepared for the world we now have. COVID-19 is arguably a quintessential black swan, once-in-hundred-year event, and something that has little relation to human behavior or activity but can disrupt economies and leave an indelible effect on modern life.
The history of pandemics includes a respiratory or influenza virus about once every decade. Often such viruses originate in Asia where wet animal markets keep live and dead animals in close contact with humans, allowing the viruses to comingle or mutate in the animals and easily spread to humans. Usually, the virus is not that deadly (2009 H1N1, 2006 bird flu, 1968 Hong Kong flu, 1957 flu), or if it is, it causes incapacitating symptoms in the host that prevent wide-spread (2003 SARS, 2012 MERS). What’s different about COVID-19 is that it’s a little more deadly than average but can have up to a 14-day incubation period (although it may not be as transmittable during this period as people initially believed) and many people who get sick do not have serious incapacitating illness quickly or at all, which allows it to be spread more easily to vulnerable and elderly people.
The most comparable pandemic is the 1918 flu, which was spread by large numbers of soldiers moving around the world as World War I concluded. The difference between then and now is that 100 years ago medical technology was nascent, people didn’t know what the disease was, weren’t sure if it was caused by bacteria or a virus. Communication was not as good. Today, we have modern news media and rapid communication that allows for countries to respond quickly. Arguably, the resulting economic effects of putting countries into lockdown have been more significant that if we didn’t know what was happening and didn’t do anything. Some have said that today, the real virus is the news media, and perhaps some states in the worst fiscal condition are the ones most reluctant to reopen since they would benefit from federal bailouts or maybe require them. However, as COVID-19 spread to western countries, physicians discovered more dangerous symptoms like small strokes, cardiovascular and circulatory problems, and more serious illness in younger people than previously thought. It does seem like a disease to avoid contracting even if for those healthy and unlikely to die from it.
Despite the difference in the world a hundred years can make, so far comparisons made between 1918 and 2020 have been pretty good as far as financial markets are concerned . While the S&P 500 did not exist in 1918, the Dow Jones Industrial Average declined 38% as the pandemic began but slowly began to recover and rally as cases increased and deaths peaked. So far in 2020, the S&P 500 (which is our preferred more diversified equity market benchmark today) declined 35% and has behaved similarly, recovering even as cases and deaths increased.
Much of this recovery has been a result of quick, impressive stimulus to the tune of 30% of GDP and maybe more. The federal government responded in March with the $2 trillion CARES Act, and at the same time, the Federal Reserve expanded its balance sheet by $2.5 trillion to buy treasuries, stabilizing the bond market, and taking unprecedented action in buying corporate bonds. They even went so far as to buy corporate bond ETFs. An additional $3 trillion HEROES Act is working its way through Congress. Indeed, this response has been heroic. Being an election year, politicians are eager to get the economy as dressed up as they can for the elections in the fall. The lockdown isolation and unemployment does seem to be weighing on the public psyche as riots rage in response to George Floyd’s death at the knee of a police officer.
It’s important for our national mental health to get back to normal life, but that will be different now.
Well, my friends, the time has come
To raise the roof and have some fun
Throw away the work to be done
Everybody sing, everybody dance
Lose yourself in wild romance
People dancing all in the street
See the rhythm all in their feet
Feel it in your heart and feel it in your soul
Let the music take control
Yeah, once you get started you can't sit down
Come join the fun, it's a merry-go-round
Everyone's dancing their troubles away
Come join our party, See how we play!
-Lionel Richie, “All Night Long”
While the government response has largely stabilized the bond market and brought the equity market back up to about where it began the year, corporate earnings are expected to decline about 20% this year, largely due to declines in energy, retail, restaurants, airlines, REITS (particularly mall), and travel industries like hotels and cruise lines. This has left the S&P 500 at a 23 P/E, the highest valuation since May 2001, as the economy has suffered its worst decline ever (could be 30-50% annualized decline in GDP in 2Q 2020 by some estimates). There is a lot of uncertainty and earnings estimates are still a moving target. Some, like folks at GMO, have pointed to this dichotomy as extreme. Even Warren Buffett has been reluctant to deploy Berkshire Hathaway’s cash hoard and spoke repentantly at the May 2020 shareholder’s meeting of exiting their positions in airlines. People who watch money flow or volume-weighted price action have noted that this has been weak and getting weaker during this rally over the last two months. The buying seems to be dominated by the speculative, dumb money, retail crowd, while the smart money institutional crowd is not chasing it. Retail, speculative buying in small lots of options has been the highest ever. The market seems stretched and pricing in a lot of optimism around reopening the economy as many stocks in the hardest-hit industries have started to rebound, particularly so after May’s surprise increase in jobs. When trading at this valuation level, returns in the past have often been zero or negative over the next few years. COVID cases have been on the rise in many states that have reopened, perhaps prematurely. We’ll see if there is an increase in three weeks to a month as a result of the riots. There doesn’t have to be a second wave of infections in fall, according to Anthony Fauci, but this is an unknown and it’s possible. It’s happened with prior flu pandemics since viruses generally transmit better in cold weather—there is less sunlight to destroy them and people spend more time indoors, close to each other, without much ventilation.
One of our biggest challenges throughout the COVID crisis is that we have not been testing people at the rate to determine how many cases there really are, so it has been impossible to aggressively also quarantine an infected person’s social contacts as has been done in other countries like South Korea, Taiwan, and even China where they seemed to get quick control of their outbreak. America’s freedom has been our Achilles’ heel during this pandemic; there is little anyone can do to prevent interstate travel, particularly by ground. American authorities are not going to quarantine entire cities by blocking freeway access with the military or lock people in their buildings or homes by welding the doors shut like the Chinese did in some harrowing images from January. We probably won’t drive disinfectant mist cannons along our streets either.
Companies serving the stay-at-home economy have seen their growth accelerate in the wake of COVID, companies like Amazon and Zoom. Sell-side analysts following Zoom said the latest quarter’s results were the largest surprising beat of their careers, yet the stock sold off following since it had run up so much in advance. Zoom trades at 150x earnings and 30x sales, which seems to exhibit extreme enthusiasm for its prospects. It’s a good example of sentiment in the short-term being a better indicator of how a stock trades than fundamentals or valuation, and the same is true for the market as a whole. Its valuation can range from 10x earnings to 25+x earnings depending on interest rates, expected earnings growth, and the sentiment, positive or negative, and how extreme that could be toward equity investing.
Therapeutic and vaccine makers working on solutions for COVID have seen their stocks rally, like Gilead Sciences and Moderna. Industrial companies making thermal scanners like FLIR Systems will also be beneficiaries as people will need to have their temperatures scanned before entering stadiums, planes, and theaters until there is a vaccine or effective therapy. Despite the gradual reopening of many states, people will be reluctant to resume their pre-COVID activities until there is wide vaccination or an effective therapy, especially if they are in a high-risk population or in contact with such people. So, while the COVID recession may end up being the shortest and sharpest on record, the recovery is likely to be muted, slow, and exacerbated by high debt levels among government and corporations. The recent stimulus efforts added even more to the accumulated debt from a decade of low-interest rates, and will probably lead to announcements of further QE and yield curve operations by the Fed to suppress intermediate and longer-term yields. Boeing is probably the most notable company saved by efforts to support the bond market. They were seeking a government bailout in March, but once the bond market stabilized, they were able to issue bonds instead. It makes you appreciate how fragile economies and markets are when the nature and speed of policy responses can affect the fate of companies and perhaps even countries.
When battling COVID is compared to being at war, remember that the U.S. never repaid the debt from World War II, but merely grew out of it by suppressing interest rates. The path forward will probably be similar now. While some inflation could help, it’s unlikely it will occur if the economy is in a more muted posture, debt levels are high, people are saving more as a result. The absence of inflation had been a key theme of the post-2008 financial crisis recovery because money velocity declined much more than money supply increased. An important feature of the recovery ahead will be how much the lost jobs come back. Even though the Paycheck Protection Program and additional unemployment payments last a couple of months, many jobs may not exist any longer. I know of a 40-year old buffet restaurant that is not coming back and neither are its 5,000 jobs. It makes you wonder to what extent will businesses where crowds of people closely gather ever come back and when.
America’s freedom has a high cost. When you think of all the trillions being spent to support our economy, you might wonder if we could have done more to prevent being the country with the most COVID cases. Iceland serves as a good example. When their first case was reported at the end of February, it was not from China--they stopped all travel from China--it was from an Icelandic skier returning from the Italian Alps. They tested and quarantined all of the person’s social contacts, began random testing throughout the country to identify cases, which admittedly is easier in a country with only 360,000 people. They didn’t just temperature screen international travelers but quarantined all of them for two weeks no matter where they came from, so people stopped visiting. They banned gatherings of more than 20 people. Iceland only has had 1,800 cases and 10 deaths.
Some have said that COVID hasn’t really changed the world so much as mainly accelerating trends already in place. Sure, some businesses may not come back. The trend toward a work-at-home economy, already going strong, will accelerate now, and there could be fewer uses for commercial and retail space as more people work and shop from home. Likewise, the nationalist political wave around the world will probably strengthen as people fear international travel and trade while countries dig in to protect their public health and economies. Maybe we’ll look back at this event as the cause of a globalization backlash. As the pandemic has more acutely affected lower-wage workers in service industries, there likely will be heightened anger around wealth polarization, which could appear in the election year political dialogue this fall.
The range of outcomes for investors is wider now than usual, so more caution than usual is warranted. At least our government agencies are willing to do whatever it takes.
This is article is provided for informational purposes only and should not be interpreted as investment advice. HCR Wealth Advisors is not affiliated with this website.
