COVID-19 crisis - back to basics

As a research team, we are reading as much as we can about the COVID-19 virus in order to understand more about the potential economic consequences of the crisis. Following our guidance note posted on 16 March 2020, we offer some further thoughts below.

The virus itself

The Imperial College report (“Impact of non-pharmaceutical interventions (NPIs) to reduce COVID-19 mortality and healthcare demand”, published 16 March 2020) is extremely helpful in highlighting the key facts to consider and explaining strategies for handling the outbreak.

In short, the facts are:

• The COVID-19 virus is the biggest pandemic since the Spanish Flu of 1918-1920.
• There is no vaccine for this new strain of coronavirus and therefore, there is no immunity within the population at large.

In response, global authorities are pursuing one of the following strategies:

1. Mitigation, which aims to slow - but not stop - the rate of infection so that healthcare services are not overwhelmed, immunity can be built over time and the vulnerable can be protected. The UK and the US have chosen this route.
2. Suppression, which aims to reverse the transmission rates in the hope that a vaccine will be found. Korea and China (latterly) have been pursuing this route. The report stresses that when the suppression is relaxed, the virus is highly likely to thrive once again. Equally, they question the social and economic consequences of suppression during the undefined period before a vaccine has been found.

In the UK, the government has opted for a policy designed to slow the transmission rate, but the working assumption is that, in terms of rates of infection, this will be marathon, not a sprint. The month of May has been cited as a likely initial peak in infections, but even if this is the case, the virus will be resurgent in the autumn and winter, in the same way as normal seasonal flu.

Economic impact

As a result, we are witnessing an unprecedented economic dislocation which undermines revenues for all types of businesses and stops the normal circulation of money between companies and therefore to employees. A rapid rise in corporate bankruptcies and unemployment is on the cards. As such, both central banks and governments have been turbo-charging their monetary and fiscal responses.

The UK government has already committed to spending a fifth of annual GDP through a combination of loans and grants to breach this gap, with more to follow. Unlike previous crises, we are dealing with the actual solvency of the business sector and this challenge will require huge ongoing government support - think state-backed guarantees for businesses, as well as individuals.

Regardless of all these efforts, there will clearly be a loss of demand from both companies and individuals and this has serious implications for earnings in 2020, and possibly 2021. Risk assets are responding to this fear and uncertainty.

Market impact

Given the scale of the economic vacuum in which the equity markets are now forced to operate, we - tentatively - offer our insights on valuations and thoughts on where we might be heading.

• As an obvious first comment, markets hate uncertainty. The health response to the virus has been deliberately harsh and the norms within which we function have been challenged.
• Companies will struggle to offer any earnings guidance for this year. This is undermining the confidence of bond and equity investors.
• Bondholders are nervous because many companies are seeing their revenues evaporate whilst still having to service their debts. Thus far, central banks have been very alive to maintaining the solvency of businesses through various interventions. Credit will remain under pressure, but with continued support, markets should avoid the very worst of the effects that were seen during the financial crisis in 2008.
• Equities are faced with an earnings vacuum and investors are desperately trying to price the short-term disruption and estimate a fair price for the longer term. The dramatic moves in stock prices reflect the scale of the uncertainty and, indeed, many developed and emerging world equities have probably declined to a point somewhere between cheap to fair value.
• The exception is the US equity market, which was unhelpfully expensive as we entered this crisis; the S&P 500 index rose by over 30% in 2019 (in US dollar terms) but with no accompanying earnings growth. Thus far, the decline in the index has only served to remove last year’s multiple re-rating. As the situation deteriorates, there is a strong chance that US equities will move to price in the recessionary implications of the virus before we can argue that the market is closer to fair value or historically cheap.

Building further upon this latter point, here are some valuation scenarios to consider, with thanks to the work of Real Investment Advice:

• Clearly, we do not know how far earnings will drop, but let us assume 30% (the current estimate from Goldman Sachs).
• The scale of declines in the S&P 500 index that are assumed by a 30% earnings reduction are set out in the table (which can be seen on our website) at various earnings multiples.

Looking ahead

Markets only experience abrupt falls when something goes very wrong, very quickly, and the coronavirus clearly qualifies. We must not dismiss the unique challenges that it presents, but, at the same time, we can look towards an end point. New viruses are highly disruptive in the initial stages, but over time, the correct level of immunity will be established within the global population and, in all likelihood, a vaccine will be formulated.

As a final thought, as and when this crisis subsides, the world will be flooded with liquidity at a time when we are slowly returning to normality.

Peter Toogood, Chief Investment Officer, The Adviser Centre Limited and Embark Group

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