Sharp Decline, But An Equally Sharp Rebound

Sharp Decline Incoming

The base case scenario is a sharp decline in economic activity and a rebound either in the 2nd half of this year or early next year. We know Q2 will be a ‘kitchen sink’ quarter where growth will be terrible. The main question is how quickly the economy recovers from this weakness. 

Q2 estimates are the worst we’ve ever seen for a quarter. Goldman is calling for -5% growth which has only happened 6 other times since 1950. Oxford Economics is calling for a 12% decline in GDP which would be the largest drop since the 1940s. They expect 1 million jobs to be lost, but they see a similar-sized GDP rebound in Q4.

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The charts above review bear market and recovery scenarios based on if they were structural, cyclical, or event-driven. Sometimes it might be hard to tell what a recession is being caused by, but this one is simple. This is an event-driven recession. As you can see, event-driven bear markets have losses of near 30% on average since the 1800s. The trough on Monday gave us a decline of 29.2% which means we are in line with the average. 

Obviously, that doesn’t mean this is over, but it suggests the calls for a 50% or more decline might be too pessimistic. The average length of bear markets is slightly below 10 months. We might be through most of the decline, but not close to the end of this crash. It’s also possible that this crash ends sooner than average. As you can see, it takes less than 20 months to recover from such negative shocks which makes sense because the decline is smaller and shorter than average. 

China Is Recovering

Recently, the situation in China has been improving. Be sure to ignore the official monthly data because this is a fast-moving story. We knew for weeks the February data would be bad. With China, we'll focus on March and April to see how quickly it recovers. For Italy, we'll look at April and May to see a recovery. And for America, we’ll be looking at May and June. 

As you can see from the chart below, the average congestion index in 100 Chinese cities was way below the past 2 years after the Lunar New Year. In the past 2 weeks, it has been rising which means the gap with prior years is falling. At this trajectory, congestion could return to normal in April. That’s amazing to see because the number of new COVID-19 cases has been low. There were only 21 new cases on March 16th and 13 new deaths. The number of active cases fell from 9,893 to 8,967.

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Labor Market Recession Is Here

This has been a record-long streak of positive monthly job creation. That streak will end in either March or April. There will be a big spike in jobless claims and the unemployment rate in the spring and the summer. As you can see from the chart below, there has been a major surge in the number of Google searches for the term “unemployment benefits.” That spike corresponds with an increase in claims to above 850,000. 

The last report showed claims of 211,000. Expectations for the week of March 14th are 220,000 claims. In either this coming report or the next one, claims will start to spike because of COVID-19. This along with the decline in stocks and the decline in the ISM manufacturing new orders index will push the leading economic indicators index into negative yearly growth which will signal a recession is near.

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According to Connecticut, there have been 30,000 initial unemployment claims since Friday. The typical range is between 3,000 and 3,500 per week. If you extrapolate these numbers to the whole country, 1% of the entire labor force lost their jobs in the past few days. A scary aspect is that the overall country’s data will be worse than that of Connecticut because it wasn’t one of the hardest-hit areas. Hardest-hit states are New York and Washington which employ way more workers than Connecticut. 

San Francisco bay area and Hoboken, New Jersey have ordered citizens to shelter in place. New York City is considering doing the same. Hope is whatever fiscal package is being worked on is passed within the net few weeks and puts money directly in the hands of the people. 

The good news is the bond market is selling off sharply. That’s because a fiscal stimulus creates growth and inflation. The selloff is good news because it means the government’s plan is credible. 10-year yield has risen 78 basis points from the record low of 0.38% to 1.08%. 

Extreme Bearish Sentiment

In the midst of this extremely volatile market, the equity allocation of fund managers has fallen by the most since at least 2001 as you can see from the chart below. When all you see is bad news, it is comforting that sentiment can’t get much worse. 

Change in sentiment has never been sharper. This survey is from the first week of March. Imagine how bad it would have been if it was done in mid-March? Well, you won’t need to imagine soon because the AAII investor sentiment survey will be released on Thursday. I’m expecting a further increase in the percentage of bears.

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Conclusion

There will be a very sharp spike in jobless claims in the 2nd half of March and into April. Economic weakness will match the selling in stocks and the negative investor sentiment. The best news I can find is that the Chinese economy is on pace to be back to normal in the next few weeks. 

If America follows that trajectory, we could see improvement in the summer. That combined with low stock prices, the coming $1 trillion fiscal stimulus, low oil prices, and an easy Fed could help stocks recover in the 2nd half of the year.