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On Bear Watch

EV9 7899 2000 Bull Above Bear

After brushing off most of the initial coronavirus news, global equity markets finally reacted in force during the last week of February. While many of the early moves China made to contain the virus bought other countries time, it is becoming evident that most, if not all, countries around the world will have to deal with the coronavirus on their soil. To what extent, we don’t know, but the impact will be global. With U.S. equity markets down more than 10% from the peak, could this be our first bear market (a decline of 20%+) since the global financial crisis of 2008?

Equity Market Reaction

Historically, significant stock market declines have occurred rather orderly, though not always.  This past week’s decline was the fastest decline from an all-time high to market correction (down 10%) in history. Even so, there was no panic selling, no large gaps down, just steady selling. While this is somewhat comforting, it may be unrealistic to think there won’t be a moment of panic before the reaction is over. In fact, we expect there might be panic selling if news headlines continue to worsen. 

However, none of this should be surprising. Over the last decade, markets have endured long periods of very little volatility sprinkled with short and fierce bursts of declines. You may not remember other times the market reacted this way over the last ten years. But, it did, and this time is no different. We expect to see market pullbacks of 10-20% about once per year.

In other words, the market’s reaction has largely been rational so far. Equity markets were at all-time highs, valuations were stretched, and economic growth was slowing. We anticipated any decline in earnings expectations to create a market sell-off. But just because the reaction is rational doesn’t mean we should ignore it. What really matters to us is how this will impact economic activity. 

Economic Impact

To date, the economic impact is mostly tied to China. Factories closed, people stayed home, and entire cities shut down for business. This has a significant impact on economic activity and should be very evident in China’s 1st quarter GDP report.

In contrast, the U.S. impact so far has been mild. However, we expect that impact will grow for the following reasons:

First, assuming the best-case scenario that the U.S. is successful in containing the coronavirus spread within our borders, we will still experience some negative impacts. We live in an interconnected global economy. Like it or not, an economic shutdown in China means goods that drive our economy are not being produced. And, it’s not only China, we are highly dependent on many other Asian countries as well. The U.S. can absorb short-term impacts quite well by drawing down inventories, but the longer the disruption lasts the more we will feel real economic impacts.

This is already evident in corporate earnings reports. Global supply chains are being disrupted. One-by-one companies are announcing negative impacts on their businesses. We expect this will continue. Whether it is only a one-quarter event or not, earnings for the year will most likely be lower.

While corporations are taking the first hit, consumers may start to see that goods are not available. Electronics, apparel, and other goods produced in China may start to disappear from shelves for a period of time. This would be temporary until production resumes, but it is not without real economic effects. 

As if these impacts aren’t enough, if the U.S. is not able to halt the spread of the virus within our borders the domestic economic impact will be greater. Under this second scenario, the U.S. could easily see a couple quarters of negative GDP growth pushing us into a mild recession. Any short-term decline would most likely be followed by a short-term acceleration to rebuild inventories. This means if a recession hits it would most likely be mild and short.

This is not to say any of this will actually happen. The global response to contain the spread could be working and the worst could be behind us. But, understanding the risks associated with further spread of the virus helps explain why the market’s reaction is rather rational to date. We just don’t know how widespread the virus will be and how long it will last. 

Fed to the Rescue?

With equity markets taking a significant hit and economic impacts likely to follow, the Federal Reserve is on watch. Shortly after signifying they would most likely be on hold for the year the pressure is now building for the Fed to cut interest rates once again. A Federal Funds Rate cut would signify to investors that the Fed is going to help. However, the economic impact of a cut may not be significant. With interest rates near zero, there is less economic impact with each cut.

All Eyes on the Allegiant Economic Dashboard

The economic impacts of the coronavirus outbreak are still uncertain. As the virus spreads around the world the impact will grow. The story is developing real-time on a day-to-day basis. As such, we remain committed to looking at the real economic data instead of focusing on the rational or irrational reactions in the media and markets. 

Allegiant’s Economic Dashboard shows a very cloudy picture, as I mentioned in February’s commentary. March is no different. Currently, two of our six indicators are red, three yellow, and only one remains green. However, many of these indicators are hovering near transitional levels, meaning they could easily turn in either direction. 

AllegiantPA Economic Dashboard Portrait March 2020

We are monitoring the economic impacts and diving deep into the data to look for signs that this could cause the next recession. While the economy may currently be in its most vulnerable state in years, clear signs of a recession are still not evident. As the story develops, we will continue to be vigilant and ready to take action as the Allegiant team remains disciplined investors of your resources, sticking to our methodology and acting in your best interests throughout the turbulence.

If you would like to see more data and charts about the economy and various financial markets, please click here to view our Monthly Insights book.

Benjamin W. Jones, CFP®, AIF®
President, Chief Investment Officer, Principal

The Allegiant team will continue providing updates about new developments in future commentaries and Features. This commentary was written on February 29th, prior to the 0.5% Federal Funds Rate cut initiated by the Federal Reserve on March 3rd in response to rising economic risks. We will share insights about the rate cut in a subsequent update.

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