Volatility across asset markets and the end of the 11-year bull market run in equity prices strongly implies that the current business cycle will soon come to an end, if it hasn’t already done so. The exogenous shock of coronavirus, which has triggered severe financial shock and profound second-order demand shocks across the economy, has now spilled over into the real economy.
The exogenous shock of coronavirus has now spilled over into the real economy.
This will require a much larger fiscal and monetary response than what is currently being considered. Until a series of policy responses commensurate with the shocks currently cascading throughout the real economy are implemented, investors, firm managers and policymakers should expect further volatility, declines in valuation, falling commodity prices and declining yields on government securities.
Equity markets as a predictor of recession
Research has shown that the U.S. economy tends to fall into a recession when two criteria have been met: (1) a decelerating rate of real GDP growth falls to about 1% or lower per year, which sets the stage for (2) the likelihood that an unforeseen event or monetary or fiscal policy error becomes the catalyst for pushing the economy into outright recession. The metaphor for thinking about this is the single drop of water falling into an ice-cold pond, which then becomes the catalyst for the pond turning into a sheet of ice.
The catalyst for turning sluggish slow economic growth into a recession can be anything from the start of a war, an oil crisis, or the bursting of a financial bubble. The adverse event then leads to a loss of confidence in the ability of the monetary and fiscal authorities to control the crisis or to create the climate for the restoration of normal economic behavior and growth, which is precisely where we find ourselves now. In this latest cycle, the focus of the world turned from the trade war with China and the pre-existing manufacturing recession to the coronavirus crisis and its implications for the whole of society.
The past 10 days have seen the single-worst decline in stock market history.
As the extent of the virus outbreak became apparent, and as it became clear that existing U.S. health infrastructure and government agencies and authorities were not prepared to address a pandemic, the global equity markets collapsed. The S&P 500 index declined 9.5% Thursday, March 12, having fallen 27% from its record high set just three weeks ago. The past 10 days have seen the single-worst decline in stock market history.
The first chart below illustrates the extent of this month’s collapse compared with prior declines. The second chart compares losses from earlier periods to recent developments, which is sort of like comparing NBA scoring before and after the creation of the 3-point shot.
Point-to-point yearly returns of the Dow Jones Industrial Average shows that a collapse of equity-market returns has typically preceded the economy falling into recession. There have also been episodes in the middle of the recovery periods when an equity collapse has not immediately turned into recession.
[Note: we are using the Dow-Jones Industrial Average here because of the public’s familiarity with the index. In the following charts and examples, we use the S&P 500 index as a benchmark because of its wider coverage of the tech and service sectors that have become essential components of U.S. economic activity.]
The stock market is not the economy
The stock market is not a perfect indicator of the direction or level of economic growth. There have been episodes during the modern economy when stock market returns outstripped economic growth, and vice versa. For example, after a disturbing drop in the stock market during the last quarter of 2018, which wiped out an entire year of profits – perhaps the first signal of a fragile economy and an impending economic downturn — the stock market rebounded in 2019 even as growth was decelerating.
The lack of a consistent relationship between stock returns and real GDP growth is likely due to factors such as the availability of alternate investment vehicles. During this regime of lower-for-longer interest rates — which was necessary to stimulate growth in the wake of the Great Recession and financial crisis — and in the midst of a re-ordering of manufacturing in developed economies, investors searching for yield have turned to stocks. Meanwhile, the 2018 corporate tax cuts resulted in equity buy-backs that further juiced stock market returns during a period of limited growth.
A shifting composition of economic activity
There have recently been dramatic shifts in the makeup of the economy, with manufacturing taking a backseat to the service and tech sectors. There is also the rise of oil extraction which has propelled the U.S. to one of the top three producers and exporters of oil.
Before 2008, the relationship between the rate of change of oil prices and the point-to-point yearly return from an investment in the S&P 500 was predominantly negative, with higher prices of oil a factor in decreased consumer spending and decreased business profits, all leading to lower GDP growth. After the 2008-09 recession, and with improvements in shale extraction technologies, the energy sector became a positive factor in U.S. economic growth, with higher prices of oil pushing up the value of gross domestic product, while lower prices — such as during the 2014-15 commodity price collapse — leading to lower values of GDP output.
That might explain the anxiety and equity sell-off caused by the price war between the two other top producers of oil, Russia and Saudi Arabia. The Saudis (OPEC) hoped to maintain the price of oil by cutting production, with the cut in supply offsetting the global drop in demand for oil brought on by the coronavirus health crisis and general economic slowdown.
When the Russians balked, the Saudis instead took the opportunity to increase production, with an oil glut causing prices to drop below the break-even level for Russian producers and the more expensive shale extraction in the U.S. and Canada.
The addition of an oil glut collapsing prices at the same time the coronavirus began to pick up steam in its global spread has further hampered economic activity.
There have been four major collapses in the stock market during the decade-long recovery from the Great Recession: 2012, in response to the European Sovereign Debt Crisis; 2016, in response to the oil glut and the collapse of commodity prices; 2018 as the impact of the trade war became apparent; and now 2020, as the impact of the global coronavirus health crisis and its impact on global economic activity is becoming apparent.
What’s next for the middle market?
Well, here we are. What’s next? Below are three five immediate considerations for middle market businesses amid the coronavirus supply disruption and economic shock.
1. Determine if you have enough cash to weather the storm and shore up liquidity: Responding to coronavirus challenges may require an additional infusion of cash. It’s critical for middle market companies to shore up short-term liquidity needs in the form of bridge loans, revolving credit and government assistance offered through special temporary lending facilities.
2. Evaluate your supply chain and determine if you can shift dependence away from China and Southeast Asia to North America: Shipment slowdowns have impacted every single port across North America. China exports in January and February declined 17.2 percent. Meanwhile, the California ports of Los Angeles and Long Beach, which account for about half of containerized goods report business dwindling. Expect the goods shortages to begin materializing within the next two weeks.
3. Evaluate how you ship your goods and consider alternative modes of transportation: The port slowdowns make it critical for companies to consider alternative modes of transportation, particularly those businesses that rely on ocean shipments. Can products be sent by train, truck, air?
4. Re-evaluate your remote work policies. Allow as many teams as possible the option to work remotely. Those who cannot, consider changing or staggering their working hours to minimize contact when they do come into the physical office. Employees with laptops should be required to take them home every day.
5. Stress test your IT infrastructure. Can you handle a larger virtual workforce? The stress test can be as simple as asking all your employees to log on to your VPN at 8pm (for example) and download documents from an intranet site. Have your IT department monitor performance during this test and scale your infrastructure as necessary.
