Valuentum Exclusive Analysis for the Discerning Investor

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Image: We think a rather modest sell-off in the market to the target range of 2,350-2,750 on the S&P 500 is rather reasonable in the wake of one of the biggest economic shocks since the Global Financial Crisis. The chart above shows how far markets have advanced since 2011, and an adjustment lower to the target range of 2,350-2,750 is rather modest in such a context and would only bring markets to late 2018 levels (note red box as the target range). The range reflects ~16x S&P 500 12-month forward earnings estimates, as of February 14, adjusted down 10% due to COVID-19. When companies like Visa talk about a couple percentage points taken off of growth rates, one knows that the decrease in spending is very real, and we’ve yet to see the brunt of the impact yet.

By The Valuentum Team

This is our sixth update on the 2019 Wuhan 2019 Novel Coronavirus, now named COVID-19. Our prior updates can be found here (Mar 1), here (Feb 26), here (Feb 22), here (Feb 7), and here (Jan 31).

According to the World Heath Organization, as of Situation Report – 44, dated March 4, there are over 93,000 confirmed cases of COVID-19 across the globe, with nearly 13,000 confirmed outside of China (FXI, KWEB, MCHI) in nearly 80 countries. The WHO Risk Assessment for China, Regional Level and Global Level remains ‘Very High.’ The WHO now believes that the death rate of COVID-19 is much higher than previously, estimated at 3.4% globally.

As we have reiterated, the illness is materially more deadly than the seasonal flu, and by some estimates, the death rate of those aged 70 and older is 8%+, and those with cardiovascular disease is 10%+. COVID-19 is a serious illness. China, South Korea (EWY), Italy (EWI), Iran, and soon to be the United States, Japan (EWJ) France (EWQ) and Germany (EWG) are key hotspots of COVID-19.

In addition to community spread in Seattle (with some saying the city is a ‘ghost town’), Chicagoland, California (which is in a state of emergency), there are now cases of “unknown origin” (community transmission) in New York, New Jersey, Tennessee, and Nevada, among other states. We believe there are hundreds more cases of community transmission in the United States that have yet to be documented.

In the case of coronavirus, absence of evidence that community spread is not accelerating asymptomatically is not evidence of absence. Quite frankly, there are not enough testing kits to truly get a feel for community spread in the United States. How similar does that sound to the problems with “evidence-based” and “empirical” finance today? [Quant finance is not testing for the right things, using realized data, instead of expectations, realized or not.] Nassim Nicholas Taleb, of Black Swan fame, has noted, “Those who mistake absence of evidence for evidence of absence…end up leaving the gene pool…except that here they endanger others.”

We have written extensively about our valuation expectations and target on the S&P 500 in the past, so please don’t mistake this reference as the extent of our thinking. We do not think a sell-off on the S&P 500 to the range is 2,350-2,750 is too far-fetched, as it really only gets the broader markets back to late 2018 levels (a mere year ago or so), and reflects a reasonable 16x forward expected earnings, as of February 14, hair cut by 10% as a result of the impact of COVID-19. The Fed put may not matter much anymore in the wake of this “biological” crisis, and increased fiscal spending may not be enough to offset what could be sustained weakness across the global economy.

With that said, we sat down with Matthew Warren, our Global Financials and Economics Contributor, to assess his thoughts on the evolving situation. Matthew Warren has spent a number of years managing money oversees in South Africa, and he worked as the Head of Financials at Morningstar during the Global Financial Crisis. We asked him for his take on how COVID-19 could become an all-out financial crisis. Here is what he had to say:

Initial Economic Conditions

A key to this question is what are the ‘Initial Conditions’ in the economy and markets? This is quite a Rorschach test. It is true that unemployment rates are at multi-decade lows, real wages are rising, and people are spending. At the same time, the US economy (SPY) is barely ticking over at 2% growth in the wake of a massive tax cut and a very accommodative Federal Reserve. Inflation is too low in the United States and around much of the world. Interest rates are at multi-decade lows and have been going lower. We would summarize the global economy as slow growth and fragile. Let’s zero in on the fragilities.

Capital investment has been low for many months as key decision makers like CEOs have been flummoxed by tariffs and potential trade wars. Where should they be investing in and or moving their supply chains? How transitory or not are these anti-globalization forces? Which trading partners will be spared if any? While the USMCA (the revised version of NAFTA) and partial reversal of trade tensions with China are somewhat encouraging, there simply no green light on this front.

The manufacturing economy (XLI) has also been very flattish over very many months. This sector has also been impacted by the brewing trade wars. This slow growth means it is particularly susceptible to going backwards.

US consumer spending and the service sector have been the standout source of strength. There has been a virtuous circle of hiring, wage gains, and increased spending furthering growth in the economy, which is so dependent on the consumer in the first place. It has been a long cycle and this virtuous circle is based on confidence--something that can easily reverse due to an outside force coming along.

China has been suffering from a debt and real estate bubble for so many years that people don’t even speak about it bursting anymore, but it is a clear and present danger in our opinion.

European banks (EUFN) are suffering from overcapacity against a weak economic backdrop. Negative rates pressure earnings even further. European sovereign debt remains a problem, though one wouldn’t know that by looking at the sovereign spreads, which are incredibly tight to any benchmark such as the long German bunds. The nexus between a weak banking system and overleveraged country balance sheets can be a toxic soup, like we have seen in the past 10-15 years, as pressure has mounted several times. The ECB forced down sovereign rates, but how many bullets do they have left?

Coronavirus Impact

The novel coronavirus (‘COVID-19’) impact has been widely discussed. What we do know is that China slammed the brakes on its economy with MASSIVE quarantines. They were actually soldiering some people into their houses according to news reports. The government also seems to be sending people back to work whether or not they would like to. This type of activity is unlikely in most free and democratic western countries such as the United States, so don’t expect centralized planning to slam on the brakes to the same extent in other countries and don’t expect any V-shaped recoveries that happen by mandate.

Instead, in the United States and in other democracies, decisions are being made by individual people and local authorities. Will the local basketball game be played and if so, will people show up? For example, there have already been instances of school closings in New York, and more and more school closings across the country may mean parents need to stay at home, with possibly negative implications across the economic sector. There is certainly mounting pressure to not put people at risk and of course there would be mounting pressure from insurers who don’t want to pay out on unnecessary risks.

It has been reported that individuals have been stocking up on household essentials, which suggest they are preparing to cocoon in place if they decide its necessary. Discretionary purchases for things like business travel, personal travel, and community-based group activities are being curtailed. Who would want to go on a cruise at this particular moment in time? Public companies have been warning about decreases in demand in real time. When companies like Visa Inc (V) talk about a couple percentage points taken off of growth rates, one knows that the decrease in spending is very real, and we’ve yet to see the brunt of the impact yet.

It appears like the ongoing COVID-19 epidemic is spreading rapidly across countries and is starting to spread in the community in many places. The key question is: Can the various health authorities in various countries quarantine infected individuals in time before they spread the disease? Can they curtail the spread and stamp it out in relatively short order, or will the spread continue and worsen for many months? We’re not sure even the experts know the answer to this question.

We do know that Bill Gates is concerned that this virus has the potential to act like the 1918 Spanish Flu, and that should give anyone pause before they downplay the possibilities of what might take place. People travel around the globe much more easily these days, while the healthcare authorities are also much more organized in their responses as compared to 1918. Only time will tell, and let’s hope that the authorities can bend down the infection curve in short order.

Countermeasures

There are obviously medical counter measures that are critically important, including developing a vaccine or treatment soon enough to bend the infection curve? Again, we will leave that discussion to the medical experts, but it seems clear this could very well take some time. According to some estimates, it may be 12-18 months before a vaccine is available.

So, let’s focus on economic countermeasures. The Federal Reserve just cut rates in an emergency session by 50 basis points. What can this accomplish? It cannot put a person on a cruise ship next week or next month. It doesn’t change the debate on whether the Olympics in Japan (EWJ) will proceed or not. It will not re-open closed schools--only the local authorities can and will do that based on their best judgment. The Fed rate cut really just ratifies what the Fed funds futures were calling for.

In fact, the markets are calling for additional rate cuts. One might argue that lower rates can help boost rate-sensitive parts of the market like home and auto sales, but auto sales are actually looking quite late cycle already and home prices exhibit affordability issues in many areas of the country. That said, both sectors will probably fare better than they would have without the rate cuts.

The other thing a rate cut might do is boost asset prices, but will the market actually put a higher P/E ratio on the market given the massive shadow of the ongoing COVID-19 epidemic and its potential negative impacts? The best we can hope for is that liquidity remains in the markets and new financing doesn’t get shut off out of panic.

It is quite clear that the Federal Reserve is running out of bullets with short rates, and that negative rates are actually quite counterproductive. Negative rates hurt savers, dent bank profitability, and hurts insurers and pension funds. Negative rates imply the probability of a deflationary bust are uncomfortably high.

The other possibility for economic countermeasures involves fiscal stimulus which Hong Kong (EWH) and Italy have already embarked upon. The US is quite paralyzed politically at the moment and with an election looming, we would suggest the bar will be quite high to get something passed that would be material enough to actually help the situation. Here we would like to stress that even if you put money in people’s pockets with tax cuts, if they are cocooning in their house, they very well might save rather than spend the money.

Concluding Thoughts

In our view, we need the health authorities to clean up the ongoing COVID-19 epidemic quite quickly in order to avoid a recession. The market was already overvalued as a starting point, which we outlined here, so a recession would imply a pretty substantial decline in the market indices.

As to the risk of a financial crisis, which would be much more severe, the future path of the epidemic is the key. How bad will it get and how long will it last? If it gets substantially worse and lasts multiple quarters, the risk of a financial crisis will mount in our opinion. The weak points are China which could easily go into a deflationary bust, and Europe (EZU) which is suffering from weak economic growth, a troubled banking sector, and poor sovereign situations in several cases.

To be more explicit, if China were to spiral into a deflationary bust, the country would likely export deflation around the globe, pressuring asset prices including real estate--the collateral for bank loans around the world. This could be a serious problem for global banks, especially those that are already weak as in Europe. In the event European banks were to come under pressure again, global market participants would start to worry about contagion and domino failures. The derivative markets are global in nature and counterparty risk could become very real very quickly in such a scenario.

If these scenarios were to come to fruition, we would expect financial conditions to tighten substantially both in the fixed income and bank lending markets. This type of activity feeds on itself, further pressuring collateral values and cutting off more borrowers from taking on or refinancing existing loans. The governments around the world would of course try to stem these pressures at every turn, but this would not be an easy task by any means.

Let us all hope that the epidemic comes under control, first and foremost for the health of the global population, and then also due to the economic and financial market consequences, where the dangers are high and mounting.

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