The Fed Acts, Volatility Continues, What’s Really Driving Investors – March 9, 2020
On Tuesday morning, the Federal Reserve slashed the fed funds rate by 0.5 percentage points to 1.00-1.25%. It was the first intra-meeting rate cut since the financial crisis. Investors weren’t surprised the Fed acted, as it had hinted that upcoming action was in the pipeline.
The half-point move may have been a little more aggressive than anticipated and may have spooked some investors. Do they know something we don’t know? In my view, the answer is, “No, they don’t.”
In an abbreviated press conference, Fed Chief Powell said, “The fundamentals of the U.S. economy remain strong,” but added, “The spread of the coronavirus has brought new challenges and risks….the risks to the U.S. outlook have changed materially.”
The key phrase here is “risks to the U.S. outlook.” Today, the economy is strong. But what about tomorrow? I agree with Powell’s remark about the fundamentals.
Released on March 6, the unemployment rate fell 0.1% to 3.5% in February, nonfarm payrolls surged by 273,000 in February, and January was revised up sharply to 273,000 (U.S BLS). Meanwhile, a key measure of the broad-based service sector hit a one-year high (ISM report), signaling growth accelerated last month.
And, the Atlanta Fed’s GDPNow model places Q3 growth at 3.1% as of March 6. Yes, the quarter isn’t over, and that number will likely change. Milder winter weather may be helping, but the economy appeared to be gaining steam as the spread of COVID-19 disrupted the news cycle.
Still, the Fed’s rate cut isn’t a cure-all, and Powell acknowledged such.
I believe the volatility we’re seeing can be traced to the enormous amount of uncertainty that has been injected into the economic outlook. You see, we don’t have a modern precedent that can be used to build economic forecasting models when such an event arises.
That said, models are, at best, adequate when it comes to forecasting during ‘normal’ times.
Potential outcomes
Let’s start with the darkest.
1. A recession that drives corporate profits lower. Businesses seek clarity, hitting the brakes on hiring while delaying projects. Consumers cutback on travel and spending; production falters and layoffs ensue. The Fed can cut rates, but industries dependent on person-to-person contact may not be helped by lower financing costs.
2. The economy stalls, avoids a recession, and re-accelerates in the summer or fall. It’s possible. We’re already seeing anecdotal signs of cancelled business conferences and individuals delaying travel. But modeling the impact is difficult.
3. A modest/temporary slowdown that delays the projected 2020 acceleration in corporate profits. This is probably the best outcome. So far, some folks are stocking up on staples, pulling spending forward and temporarily helping retailers. If the virus shows signs of peaking soon, there would likely be minimal disruption to our daily routine.
As you can see, there are a wide latitude of outcomes. While we’ve experienced a selloff in stocks, investors are not yet pricing in a recession (#1). But neither are investors pricing in a minor slowdown (#3). If that were to happen, we might see a quicker rebound.
Supply vs demand shock
These are terms used by economists.
A supply shock was the initial concern when the virus was contained to China. A supply shock simply means that there is a hit to supply.
For example, you might go to the store to upgrade your smartphone. You are told the model you want is on backorder because factories that manufacture components for the phone are temporarily closed. The model will eventually be available but with a delay.
A demand shock, as the term implies, simply means an outside, unexpected event hinders overall demand for goods and services.
During the winter of 2014, the polar vortex sent temperatures plummeting, which impeded economic activity. But we know that spring follows winter. Weakness was contained to Q1, and investors side-stepped the brief slowdown.
Today, investors are unsure how much a demand shock, if any, we might experience. Therefore, the volatility we’re seeing has its roots in the unknown, as investors try to discount future economic activity and the impact on corporate profits.
Perspective
Before I go on, I want you to understand that I’m not dismissing the human toll. Those who pass away have family and close friends who must deal with the tragic aftermath of the loss of a loved one.
The Centers for Disease Control and Prevention estimates that influenza caused 9 million–45 million illnesses, 140,000–810,000 hospitalizations, and sadly, 12,000–61,000 deaths annually since 2010. The mortality rate is 0.13%.
South Korea has been aggressively testing for COVID-19. It may be one reason we’ve seen a surge in cases – 6,593 as of March 6. China leads at 80,573 (Johns Hopkins CSSE), though new cases appear to have plateaued – good news.
South Korea’s mortality rate could rise if patients deemed critical pass away But 42 deaths in South Korea place the mortality rate at 0.64%, well below the 3% being disseminated..
Testing hasn’t been as widespread in the U.S. So, some may have the virus and not know it, especially if symptoms are mild (also encouraging if everyone who contracts COVID-19 doesn’t get very sick).
We’ll see the number of U.S. cases rise. But if there is a sense the epidemic is being controlled and the mortality rate is below 1%, a return to some semblance of normalcy (and less time devoted to the virus in media coverage) could be viewed favorably by investors.
No one can predict the final health consequences, nor can we say when stocks will bottom or if they have bottomed. At this point, we’re not in a bear market. However, we know that bear markets follow bull markets, and bull markets have historically followed bear markets.
I believe we will get passed this, we’ll be stronger for it, and the volatility that inevitably crops up from time to time will eventually pass, too.
Created 2020-03-09 15:22:59