At the midpoint of an already momentous year for financial markets, investors are both encouraged by the rebound in equities and nervous about a potential "second wave" of the COVID-19 pandemic. There are still many unknowns, but one thing is certain — it will not be a surprise if we see a resurgence of COVID-19 cases later this year. The fact that investors are prepared, from a sentiment standpoint, is just one reason we believe that a second wave will not cause a meaningful pullback in equity markets.
"The fact that investors are prepared is just one reason we believe that a second wave will not cause a meaningful pullback in equity markets."
The possible scenariosObviously, the most encouraging scenario — for public health and for financial markets — would be the absence of a second wave. It is worth noting that not all pandemics experience a second wave, by which we mean a resurgence that is as bad as or worse than the initial outbreak. One example is the 1968 influenza A (H3N2) pandemic, which caused an estimated 1 million deaths worldwide and about 100,000 deaths in the United States. This pandemic did not have a second wave, but rather experienced a slight uptick in cases in the form of a seasonal influenza. Today, the mean expectation appears to be that we will experience a second wave. Therefore, having no resurgence in cases could result in a market rally.
Another possibility is that we experience a second wave, but it is less severe than the first. For a number of reasons, we believe a milder resurgence is more likely. We are better prepared from a medical, technological, and social standpoint. Our testing and tracing capabilities are vastly improved. We've advanced from 100 tests per day in early March to 600,000 per day and rising. Far more people are taking precautions such as mask wearing, frequent hand washing, and social distancing. We've seen advances in contact tracing technology to identify and warn people who have been in contact with an infected person. And it is likely that crowds will continue to be limited, with no large-scale gatherings such as sporting events or concerts.
Preparing for a worst-case resurgenceWhat if the second wave is worse than the first outbreak? In our view, this is less likely, but we also believe the markets will be able to withstand the shock. One reason is the willingness of the Federal Reserve and Congress to provide support in the form of massive stimulus measures. This is likely to continue if we are forced into another severe lockdown scenario. It also doesn't hurt that this is a presidential election year, making politicians on both sides of the aisle more likely to advocate for further government stimulus measures.
Businesses are also better prepared in the event of a severe second wave. Companies are not only adapting to a COVID-19 environment, they are innovating in ways they hadn't considered before the pandemic arrived. With the whole world focused on this challenge, we're seeing ingenuity and creative solutions that should help many businesses generate healthy earnings and profits over the longer term.
"Companies are not only adapting, they are innovating in ways they hadn't considered before the pandemic arrived."
Markets have shrugged off second wavesAlso important from an investing perspective is the fact that, historically, equity markets have tended to shrug off second waves of pandemics. Typically, bad news must be unexpected in order to severely impact markets. Investors will not be surprised if COVID-19 cases spike again, and as a result, we may see indifference rather than a steep fall in equity prices.
Some investors have been tempted to compare this virus-related downturn to the global financial crisis of 2008/2009, which had massive ripple effects and called into question the foundation of the global financial system. Today, the financials sector, the epicenter of the earlier crisis, has been able to withstand the pressures. Today's crisis has had a greater impact on consumer and energy companies, resulting in a number of high-profile bankruptcies, such as Neiman Marcus, J.C. Penney, and Hertz. However, the market has been largely unfazed by them.
"A worse-than-expected second wave could be dwarfed by positive news related to a vaccine or other new medications."
Innovation in virus studiesIn addition to the progress we've already seen, there are a number of promising new developments for tracking and possibly combatting COVID-19. For example, municipal wastewater studies may offer an effective solution for containing the virus. This analysis can detect the genetic material of the virus in wastewater, providing "advanced notice" of regions or populations that might be prone to an outbreak. Also encouraging is a recent study that found virus-fighting T cells in people who have not been exposed to COVID-19, meaning they may already have immunity due to exposure to other coronaviruses.
For investors, a worse-than-expected second wave could be dwarfed by positive news related to a vaccine or other new medications that could lessen the impact of the virus. We expect more data from the biopharmaceutical industry over the summer months and into the fall.
1999: Eliminating the worst-case scenarioLooking back 20 years ago, we have an example of the equity markets' reaction when a worst-case-scenario does not materialize. As the year 2000 approached, programmers realized that computers might interpret 00 as 1900 rather than 2000. This led to widespread fears about damaged or malfunctioning computer systems.
The greatest concerns centered around system failures for airlines, nuclear power plants, and telecommunications. Markets were volatile, but rallied in late 1999 as investors became confident that the issues had been resolved.
- In 1999, the CBOE Volatility Index averaged between 20 and 30, similar to current levels.
- In the fourth quarter of 1999, the S&P 500 gained 15%, and it ended 1999 with an annual return of 21%.
- Following an uneventful January 1, equities had a massive rally for most of the 2000 first quarter, including a near-25% jump in the Nasdaq until the stock market peak in mid-March.