After what could be described as a devastating first quarter for equity markets, stocks rebounded somewhat at the start of the second quarter. The S&P 500 Index experienced its biggest one-week percentage gain since 1974, and by the end of April, year-to-date losses were a lot less painful than they had been in mid-March. This is not to say all is well in global equity markets. We are in the midst of an unprecedented demand shock, and a contraction of this suddenness and magnitude could bring lasting damage to many segments of the economy, with small businesses being especially vulnerable. Providing an outlook is challenging as the situation remains highly fluid and markets are still working to assess the economic impact of this public health crisis. Beyond COVID-19, many other layers of uncertainty remain, including severely pressured oil prices.
"History has shown us that stock markets typically hit their bottom before the worst news arrives."
Equities versus economiesIn this environment, many investors were surprised that equity markets had any type of rebound so soon. Market observers often conflate the economy with the stock market. While the two are synchronized to some degree, it is important to understand the differences. The economy is largely a reflection of what we see happening on the ground today, while the stock market is a forward indicator. Even if we continue to see discouraging data — dismal corporate earnings and GDP numbers, sharply rising unemployment rates and claims, and increasing COVID-19 cases — the stock market may still begin to recover. History has shown us that stock markets typically hit their bottom before the worst news arrives and the peak economic pain is upon us.
What shape could a recovery take?With global economies already in recession, it is clear that the impact of the COVID-19 pandemic will be deep. The debate now is around how long it will last. For the economy, we believe the recovery will not be V-shaped. A U-shaped scenario is more likely. We expect a severe downturn in GDP growth in the second quarter and although some recovery is possible in the third quarter, we expect it to be well below prior trends. Therefore, it could be a gradual U-shaped recovery, with the recession lasting 12 months, followed by a multiyear healing before returning to 2019 economic activity levels.
"High valuations will be vulnerable to sharp pullbacks when investors digest the magnitude of damage to the global economy."
The speed of this downturn was unprecedented, and if we see significant progress in fighting the virus, the speed of the recovery could be faster than that of the 2008/09 global financial crisis. As a forward-looking indicator, the stock market should recover faster than the economy. There will likely be a time when index valuations seem unreasonably high as the market prices in expectations for better earnings in a few years, while current profit levels remain depressed. This all points to higher volatility in stock prices than we've experienced in most of the past decade. The high valuations will be vulnerable to sharp pullbacks when the recovery scenario assumed by the market is tested, especially as contradictory data points emerge and investors digest the magnitude of the damage to the global economy.
Reasons for optimismThere are reasons for optimism. For equity markets, it is worth noting that the sharpest recent plunge occurred in March at a time when fixed-income markets were dealing with severe liquidity challenges. That was potentially very damaging to equities, as they are subordinate to fixed income in the capital structure. Since that time, central banks and governments worldwide have enacted measures to inject liquidity and repair the damage to fixed-income markets. Moreover, government stimulus is massive. In the United States, it already exceeds the amount spent during the 2008/09 global financial crisis, and it is focused on getting small businesses and challenged sectors back on their feet.
"Trying to call a market bottom misses the point of long-term investment strategies."
In terms of the pandemic, we should not lose sight of how far we've come. On January 1, the world was completely unprepared for this virus. Since then, we have caught up rapidly in our understanding of COVID-19, how it spreads, who is susceptible, and what equipment and resources are needed. Given the amount of resources globally that are focused on this problem, we should begin to see promising pharmaceutical solutions, including antiviral medications that can mitigate symptoms and reduce or limit hospital stays.
A strategy for all markets: Stay investedWe are often asked if we have seen the market bottom yet. It is very difficult to call market bottoms, and it misses the point of long-term investment strategies where it's critical to stay invested to reap the rewards of compounding.
That said, there is a high likelihood that the market bottom is behind us. Fixed-income markets are functioning, companies that need it can raise capital, government stimulus is massive, and capitulation selling took place in March. Most importantly, the COVID-19 crisis, however painful, will likely prove temporary, and the market will want to look past it. The S&P 500 Index is still nearly 15% below its previous high. This downturn, like every market decline, brings opportunity. As active managers, we hope to capitalize on it as some companies emerge from this crisis stronger than before.