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Macroeconomic & Geopolitical

Darkness Before the Dawn

3 April 2020 - 3 min read

What we need to see before the long recovery begins.

Market conversations these days wrestle with a hundred versions of a single question: How bad will it get? Most end with a vague consensus that things will get worse before they get better, but there is still little agreement about how much worse and when markets will start to see through to the other side. 

Obviously, the depth and breadth of the crisis depends primarily on how quickly the virus is contained and how soon we will comfortably board a plane once again. Even as we all struggle to catch the first glimpse of sunrise, much will depend on how quickly markets navigate the darkness before the dawn.

Five darker developments will have to play out before we gauge how quickly a recovery takes hold.

  1. Earnings Revisions: If there is little in nature more fearsome than a herd of thundering wildebeest, there is nothing in financial markets more harmful than a herd of sell-side analysts downgrading earnings estimates. While the number of analyst downgrades of S&P 500 stocks now exceeds the levels of 2008, the size of their second quarter downgrades remains relatively modest at around 10%. This time, it's not just because analysts are almost always behind the curve, it’s mainly due to the level of uncertainty remains exceptionally high. Companies themselves have stopped issuing guidance, which makes stocks still look much cheaper than they actually are.
     
  2. Ratings Downgrades: Credit analysts have been furiously reassessing debt sustainability of all borrowers large and small. Investment grade firms set a monthly record in March raising $260.7 billion in fresh debt anticipating tough times ahead, but some will be knocked into a “high yield” rating that forces some investors to sell. There have always been ample pools of high yield capital to pick up these "fallen angels," but they themselves will be under some stress. Downgrades also trigger covenants that force early repayment of some debts or redirect cash flows to more senior creditors. It will be a bumpy ride as these cascade through markets.
     
  3. Bankruptcies: The lucky firms will merely suffer downgrades, but others face bankruptcy or even liquidation. Savvy investors manage to avoid most of these, but there will surely be land mines that explode unexpectedly. It's hard to imagine a crisis of this magnitude not claiming some large and beloved retailing victims that were already on the ropes. There will also be sovereign debts to restructure across the emerging world as capital retreats at an unprecedented pace. Argentina and Lebanon were basket cases before we had heard of the coronavirus, but others will now join the list.
     
  4. Oil Chaos: It’s hard to imagine a durable recovery without Russia and Saudi Arabia coming to a lasting arrangement on oil prices. There seems to be a deal in the works that would limit supply and provide a floor on global prices to save large sections of the industry from collapse. Still, financial markets will not fully embrace the recovery until there is confidence that oil has returned to a predictable range. Commodities prices more generally may need to stabilize to signal that global demand has bottomed out.
     
  5. Government Follow Through: After weeks of denial and delay, world leaders and central banks finally swung into action, but there is much more to do. The $2 trillion package the U.S. Congress approved is more emergency assistance than recovery stimulus. Even so, much will depend on how quickly it can be distributed to small businesses and households. The Fed has been fast and creative in unblocking credit markets, but banks will face further stress as their loan books turn bad. Few have even begun to think about the blow that will soon hit developing countries and their additional needs for aid and debt forgiveness. Durable recovery will also require much more international cooperation. If the G-20 does little more than issue bland statements, investors will have to see more concrete bilateral cooperation on expanding trade, stabilizing markets and boosting investment.

Investors don’t need answers to all of these questions for the recovery to begin, but they will find it difficult to get back to the business of assessing risk-adjusted returns without a clearer picture. A reliable flattening of the curve of coronavirus victims will deliver a crucial breakthrough for public health and a return to normalcy, but there will be more darkness for markets until we get a little light on the economic wreckage that will need repair.
 

MSCI ACWI INDEX

Source: Bloomberg. As of April 2, 2020.
 

U.S. BENCHMARK BOND YIELD—10 YR. 

Source: Factset. As of April 2, 2020.

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