Second Quarter Outlook and Opinion

The coronavirus has thrown the world into chaos over the last quarter, and its impact on the economy was swift and devastating. It has been a health and financial crisis like no other, with substantial uncertainty and many unpredictable variables. The peak-to-trough decline in U.S. and European GDP is likely to be more than double the decline during the global financial crisis, or roughly -10%. The stock market slide experienced between February and
March was the steepest decline in the S&P 500 ever, even steeper than in 1929.

Since 1870, downturns of this magnitude have happened mostly because of either world wars or depressions, taking on average, five years for output to regain its peak. Out of the past 15 bear markets, only one has been “V” shaped, in 1987, which wasn’t a true recession but more of an event shock. Event driven bear markets typically rebound faster than normal recessions, but the current situation is fraught with uncertainty. The drama between public safety and putting economies back to work is manifesting unforeseen political tensions which then further increases uncertainty. In short, history would suggest a slow, multi-year recovery.

To make matters worse, Russia and Saudi Arabia entered into an oil price war in March that amounted to an economic war on the over-leveraged US shale oil industry, which was already suffering from COVID-19 related fall in both demand and oil prices, which have now dropped by nearly 80% since their January highs. As much as 16% of junk bonds are associated with the shale industry. Over $140 billion of debt issued by independent oil and gas producers, oilfield services providers and integrated energy companies has triple-B credit ratings from Moody's or S&P and is now at risk of falling to junk status. If the downturn in oil prices is prolonged, an additional $320 billion of triple-B rated energy industry debt could be downgraded. Since 2015, over 400 bankruptcies have already taken place in the shale oil and gas industry. We can now expect many more, as most U.S. shale operators need oil prices above $50 to remain viable. More recently, major oil producing nations including Saudi Arabia and Russia agreed to cut their output by 9.7 million barrels a day in May and June, but not enough to counter the destruction in demand for energy products caused by the pandemic.

Supply chains for manufacturing have been thrown into chaos worldwide. Nearly 75 percent of U.S. businesses have experienced supply chain disruption because of COVID-19, according to the Institute for Supply Management (ISM).

On April 9, the Federal Reserve announced a $2.3 trillion monetary stimulus program. This is about half of what the entire Federal government spends in a year. It will expand its Quantitative Easing (QE) programs to include municipal bonds, asset backed securities, investment grade corporate debt, junk corporate debt, and commercial paper (short-term corporate debt). It will begin buying junk bonds for the first time in history. The next step in terms of asset classes’ bought by the Fed could be equities. If this seems surprising to you, the Bank of Japan has been buying equities for years, as has the Swiss National Bank.

Simultaneously, the Federal Government announced measures of fiscal stimulus, called the CARES Act, which should cost around $2 trillion. This bill includes expanded unemployment insurance, $350 billion allocated to the paycheck protection program, rebates for individual taxpayers, a variety of business tax provisions, and $454 billion in emergency lending to businesses, states, and cities.

The stimulus programs are being funded with printed money. Since March 23rd, they have been effective at rallying the stock market considerably off its lows. There is evidence that the coronavirus will peak in the second quarter, but economists are issuing bleak forecasts; the IMF is projecting global growth to fall by 3% in 2020, a downgrade of 6.3% since January, making this recession the worst since the Great Depression as closed factories, quarantines and national lockdowns cause economic output to collapse.

Investors have no idea what the exit strategies of governments are from these unprecedented stimulus measures, because governments themselves don’t know.

The current crisis could take years to unfold. The answer to the problem lies only in a cure or a vaccine klgc so the economy can reopen, otherwise there will be permanent and long lasting damage.
A vaccine or cure for COVID-19 could take up to 12-18 months, according to experts. The amount of human effort and money devoted to developing that end is certainly staggering. The World Health Organization indicates that there are currently 62 drug companies and universities working on it. Less than half of one percent of Americans have been tested for COVID-19. Without a cure or vaccine, will consumers go back to restaurants, concerts, theaters and gyms? And will there be a never ending cycle of flare-ups and lockdowns?

The U.S. government expects the economic shutdown to last three months, and its fiscal and monetary measures are attempting to soften the negative impact in the second quarter and pave the way for a recovery in the third quarter.
If the economy continues to soften, or if there is a second wave of COVID-19 occurring after the lockdown ends, there appears to be no limit to the amount of government stimulus, provided with printed money. This is also true on a global scale. We may be entering into a period of permanent stimulus from global central banks.

Much media attention is being paid to “peak” COVID-19 growth, country by country, which leads to forecasts of when each economy will get back to work. When Dr. Anthony Fauci was asked recently when the U.S. quarantine will end, he suggested that the country could remain under quarantine until there are no more infections or deaths. Meanwhile, the Executive branch of the US government believes that the economic impact of a prolonged shutdown may cause more damage than the virus itself. It remains to be seen which way this will go. A premature re-opening of the economy will surely cause a “second wave” of COVID-19 cases. There is also the problem of Africa, which risks re-infecting the world after the contagion stops in the developed world. Even if the economy opens sooner than expected, consumers will remain cautious for some time, and possibly a long time.

At the time of this writing, the U.S. has 22 million unemployed, and the unemployment rate is approaching 18%.
It is not uncommon to hear talk of Great Depression-era levels of unemployment, which peaked at 24.9% in 1933.
We will probably not see 3.5% unemployment again anytime soon. Despite talk of “flattening the curve” and “seeing through to the other side” of this crisis, the stock market seems to be underestimating the severity of the problem.

If we examine three prior crashes, 1929, 2000, and 2008, there were two phases to each, a “plunge” stage, and then a persistent, choppy bear market phase. In all three cases, prices retraced upward 50% of the initial plunge, as we have
today, and then entered into a protracted bear market which brought prices much lower than the initial plunge. While the point of maximum panic might be over, the point of maximum pessimism has not arrived.

Europe is experiencing an economic crisis which may threaten its very foundations. Weaker nations in the south are experiencing debt shocks which Northern European nations no longer want to finance. This may lead to more sovereign debt crises, with Italy in focus as the eighth largest economy in the world. It may also lead to political crises, as the political classes are in favor of financing weaker economies with “Eurozone Bonds” while European voters seem to be against the idea.

The steady rise of stock buybacks which fueled the market between 2012 and 2020 is now over. Recall that stock buybacks helped to increase earnings per share over the last eight years, making corporate results look better than they
actually were. This was an important driver of the bull market, which now looks rather foolish as companies desperately draw down credit facilities. Going forward, they will be engaging in “balance sheet repair, meaning that they will focus on paying down debt. At the household level, spending will drop due to a negative wealth effect bringing a realization that assumptions about retirement need to be revised.

To conclude, the COVID-19 pandemic is likely to continue and likely to bring more social, healthcare-related, and economic pain. In the long run, it will provide an excellent buying opportunity in the stock market, but not yet. Gold has rallied 14% this year, and should continue to be well bid based on US dollar debasement (Fed printing), bond yields converging toward zero (no opportunity cost), and potential social disturbance as unemployment reaches Depression-era level

The Dow fell 23.2% in the first quarter, the S&P 500 was down 20%, and the Nasdaq fell 14.1%


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