In response to concerns about slowing global economic growth resulting from the spread of the coronavirus, the U.S. Federal Reserve Board (the Fed) announced a rate cut of 0.50% to the target fed funds rate. The intra-meeting rate cut announcement lowered the target rate to 1.00-1.25% in an effort to buffer the economy, which is showing signs of a slowdown driven by the spreading coronavirus epidemic.
Yesterday, the market was up sharply in anticipation of Fed action; today, the market is giving back those gains in spite of the Fed’s action. 10 Year Treasury yields also declined today, hovering just over 1%, a signal that many in the market continue to be concerned about the longer-term impact of the coronavirus epidemic on global growth.
The Federal Reserve’s actions are likely to have a limited impact on the market or global economy. There is little that the Fed can do to offset a global health crisis. Making capital cheaper is not likely to boost growth. To understand why the market is behaving the way it is and why the Fed’s action might not work, it is important to understand the context of the current economy.
Impact on the Economy
Global markets are highly integrated, and China is both a key member of the supply chain and a growing piece of the consumer spending puzzle. Even if the coronavirus were limited to mainland China, its impact would disrupt supply chains and likely reduce consumer spending. On the supply chain sign, there are already indications that the virus is negatively impacting global supply chains; these disruptions will take a long time to solve as companies wait for China to stabilize or look to switch their supply chain to other countries.
On the consumption side, there is evidence that the spread of the coronavirus is impacting demand as individuals and businesses cut back on their activity levels. While some of this pullback may “catch-up” in a future period, it is reasonable to assume that some of the lost consumption will not be fulfilled even when the epidemic slows down. Many businesses are curtailing their travel, canceling industry conferences, or implementing travel restrictions on their employees. This economic activity is not likely to get pent up, returning at a higher than normal rate when things stabilize; instead, it is likely missed for good, hurting near term profitability for many industries.
Many Market Values Were Stretched Pre-coronavirus
When the coronavirus struck, U.S. equity market prices had grown dramatically. In 2019, the S&P 500 appreciated by more than 31%. That substantial growth had pushed the forward price-earnings (PE) measures to more than 19, meaning the cost of a presumed dollar of stock earnings in the index cost an investor more than $19. This metric is nearly 20% higher than the average cost of a dollar of earnings for the index over the last 20 years.
The global slowdown is likely to have a twofold effect on stock prices. First, to the extent the slowdown is widespread and prolonged, it will have a negative impact on corporate earnings; pushing down stock prices are earnings decline. Second, to the extent that the fear of epidemic continues to persist, it may cause valuation multiples (the price investors are willing to pay for a dollar of future earnings) to contract as well.
This Too Shall Pass
The spread of the coronavirus has been rapid, and it is clear to most that the ease with which the virus spreads will make it difficult to contain completely in the near-term. Absent new information, the virus will likely extract a toll both in casualties in at-risk communities and costs to governments worldwide to contain the spread.
There will also be a toll on economic activity and the correlated impact on earnings and stock prices, but none of these impacts should persist indefinitely. Like the health impact of the virus, the economic impacts will likely be most harmful to industries at-risk like travel and leisure and in countries where the virus is most concentrated and economies most fragile.
In the face of this uncertainty, how should investors react? For guidance and advice on how to respond to the current market environment, read this commentary we shared with our clients.
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