Over the past few weeks there have been several things worth worrying about—chief among them the impact of the coronavirus and growing uncertainty around U.S. electoral politics. For the first eight weeks of the year investors didn’t seem to care about either until, abruptly, they did. Now uncertainty has taken hold, sending global stock markets into the ditch.
Whatever the eventual outcome of the virus crisis, it will have already blown a large hole in Q1 GDP growth for China, with knock-on effects of varying degree across Asia. The impact in North America and Europe should be much smaller, in our view, but that can’t be quantified with any certainty at this point.
Management guidance accompanying Q4 2019 earnings releases in January and February mostly took the form of “too early to tell.” Q1 comments beginning in mid-April are likely to continue painting a cautionary and indeterminate picture. Even assuming the outbreak peaks and begins receding by early summer, clarity around the sales and earnings costs of this health catastrophe will be a long time coming.
What is likely to arrive sooner will be more fiscal stimulus from governments. From China first and foremost, but also from Japan where domestic demand was dealt a body blow by a Q4 sales tax hike that has been exacerbated by China’s abrupt slowdown. In the UK and Europe, plans were already afoot for additional government spending to offset trade concerns as the final Brexit deal is negotiated and weak exports into China take a further toll on the German economy. These efforts are likely to be advanced and probably entail greater-than-previously contemplated sums.
In North America, Canada has plenty of budgetary capacity to boost spending, while in the U.S., both the Republicans and Democrats will be eager to establish their bona fides as the “economy-friendly” choice in the lead-up to a hotly contested election in the fall.
As things stand today, we expect no recession in the U.S. or Canada in 2020, but with GDP growth rates hovering around two percent, an occasional negative quarter can’t be ruled out. It is also possible the coronavirus impact turns out to last longer and cut more deeply into the U.S. economy, pushing it into outright recession. That is not our base case, but the probability of this happening is certainly markedly higher than when the year began.
A weaker GDP profile could be expected to produce weaker-than-anticipated corporate earnings. And earnings estimates for 2020 have been falling, from a wildly optimistic $187 per share for the S&P 500 early last year all the way down to a recent $175 per share, which is still above the long-held, below-consensus call of RBC Capital Markets’ Head of U.S. Equity Strategy Lori Calvasina for $174.
Calvasina estimates the potential cost of the virus on earnings at $4 per share, which could bring her estimate down to $170. Her estimate would fall to $167 per share if the U.S. were to endure a mild recession. Clearly, even lower numbers are possible. So, at the very least, we expect Street conviction around what earnings figure to use to calculate forward price-to-earnings (P/E) ratios will be in flux for at least the next quarter, probably longer.
In the big and unsettling stock market retrenchment of late 2018, the S&P 500 slumped from a summer peak of better than 18x forward earnings in August down to something less than 15x at the Christmas Eve low. But that happened against a backdrop of (sharply) rising bond yields. The
10-year Treasury yield jumped from 1.50 percent in August to 1.90 percent in December that year, while corporate bond yields (BBB rated) rose by 120 basis points to 4.70 percent over the full year. Since those peaks, the Treasury yield has fallen to a new all-time low at 1.15 percent while BBB corporate yields have collapsed down to 2.70 percent.
Low and falling bond yields not only potentially stimulate growth, they also support P/E ratios. At the end of the day, we don’t expect the P/E damage of this correction will be as big as that endured in 2018. But we also think it will take some time to fully play out, probably months, conceivably quarters. The damage to all equity markets globally is likely to be directly related to the damage done to the U.S. economy in particular, in our view.
In the February edition of Global Insight, our parting thoughts in the “Global equity” commentary were:
“… concerns around the coronavirus outbreak will probably go on suppressing investor attitudes for some months to come. As well, American politics will likely deliver occasional market volatility from the start of the primary season in February through at least to the Democratic convention in mid-July.”
That volatility has driven share prices down further and more rapidly than we expected. If the U.S. economy avoids a recession in 2020, by year end, we expect most stock markets will have advanced meaningfully from today’s levels.