Macro matters

COVID-19 touches down in the U.S., the Fed cuts rates and markets shudder

Chief U.S. Economist Lara Rhame’s updated breakdown of the virus and market volatility

Lara Rhame
March 4, 2020 | 7 minute read

COVID-19 surfaced in the U.S. last week, adding immediate relevancy to the waves of negative news about the rapidly spreading coronavirus. In the face of skyrocketing volatility, the Fed cut rates 50 bps in an effort to smooth market jitters and bolster the economy. We check in on the market reaction, U.S. economic risks and resiliency, and potential further policy response. Despite policymakers’ efforts at being proactive, investors will likely need to navigate volatility for months to come.

Fed surprises markets with 50 bps rate cut

Last week equity markets were pummeled on news that the COVID-19 coronavirus had landed in the U.S. and could be more widespread than initially thought. The S&P 500 fell -11.4% in the week ending February 28, the worst weekly loss since 2008. Within just six trading sessions, investors saw four months of gains vanish.

Into the storm of market volatility stepped the Fed, even faster and more aggressively than markets had anticipated. The Fed cut the Fed funds target band by 50 bps on the morning of March 3 to 1.00%–1.25%, citing “evolving risks to economic activity” from the coronavirus. Markets had a short-lived positive reaction to the rate cut, but quickly came under further downward pressure.

I liken the equity market reaction to how I would feel if my husband surprised me with two dozen beautiful red roses. My immediate reaction would be positive, but my mind would quickly turn toward whatever real news warranted such a surprise – it probably wouldn’t be good. Fed Chair Powell seemed to trigger some of the same reconsideration in his press conference. He was open about the fact that a rate cut could “support broad economic activity,” but also said that the virus “could weigh on activity for some time,” and that the “magnitude and persistence” of the virus’s impact was highly uncertain.

Exactly how effective can Fed rate cuts be against the coronavirus? The Fed is sending a clear signal that whatever else the economy may face, a banking-induced shortage of liquidity is not going to be a problem. However, the real issue for our economy may quickly become aggregate demand, which we analyze below. The reality is that Fed rate cuts – and the Fed may well continue cutting rates in the near future – will be only one of multiple policy responses needed in the weeks and months ahead.

Get comfortable with volatility

It now seems like a distant memory, but U.S. equity markets had been melting up over the past several quarters, shrugging off signs of a moderating global economy in 2020, slowing earnings growth and mounting pressure to profit margins. Initially, concerns about COVID-19 were virtually ignored as the S&P 500 responded by hitting an all-time high on February 19.

The correction of the prior two weeks has seen the 12-month forward price-to-earnings valuations fall from 19.5 – a top quintile of historic valuations1 – to now 17.1.2 To some observers, this is an overdue correction of valuations that had deviated significantly from underlying fundamentals. While we would agree, the speed of the move is certainly cause for concern. Moreover, a 17.1 P/E valuation is still above the long-run average,3 indicating that there could be further downside in the months ahead.

For investors who gave up four months of gains in only six trading sessions,4 it is a powerful reminder of the devastating toll that volatility can take on portfolios. The second half of last year saw the virtual disappearance of volatility, particularly the fourth quarter, when volatility fell to 6.2%, well below the historical average of 15.6%.5 That world is now likely gone for the foreseeable future. Looking ahead, volatility could be with us for months – probably even quarters – and needs to be actively managed.

10-year Treasury yield: How low can you go?

If the surprise Fed rate cut wasn’t enough of a headline, the 10-year U.S. Treasury yield plunged another 16 bps, falling below 1.00% for the first time. This benchmark yield has fallen 92 bps since January 1 and 56 bps in the past 10 days. The U.S. Treasury market remains the world’s largest sovereign bond market and the most liquid, making it an obvious destination of flight-to-quality flows. While rates are lower around the globe, the move in the U.S. Treasury market has far outpaced other developed bond markets.

Where will the 10-year Treasury come to rest? That’s anybody’s guess right now. Clearly, continued rising uncertainty could push government bond yields down from here. This latest bond rally has provided some gains; for example, the Barclays Agg has returned 1.9% since February 19. Yet over this period, the S&P 500 has given up -11.3% from its high on the same day. Unlike prior years where equities and bonds have seemed to rally together, further strong gains in core fixed income will probably reflect an intensified global flight to quality, not an environment where equities are also expected to post broad-based gains.

The economy holds its breath

A looming uncertainty is what impact COVID-19 will ultimately have on the economy. While the Fed cutting rates is an important and obvious policy support, the Fed is well aware that this is hardly a silver bullet in the face of an unprecedented impediment to U.S. growth.

Let’s focus on some good news: The U.S. economy is still the biggest and most resilient in the world. An economy of $20 trillion can handle large regional disruptions, which can recover while the rest of the country keeps going. Examples of this include Hurricane Katrina and Hurricane Matthew, which devastated large cities and communities. We have also seen an industry experience contraction which the rest of the economy can offset. For example, the oil recession of 2015–2016 hit the energy industry hard, but the overall economy still avoided recession.

Make no mistake, there will almost certainly be an impact on our economy in 2020. What form that will take is still highly uncertain, which is one reason we are seeing such remarkable volatility. At this stage, it is too early to place numerical probabilities on whether or not we will have a recession. Of course, a recession stemming from this outbreak is possible, but the range of possibilities is extremely large, and the smartest people in the room are admitting that we just don’t know exactly what’s going to happen. Ironically, retail sales in February may be quite high as everyone I know seems to be stocking up on water, hand sanitizer and frozen pizzas. The economic data will arrive with a lag while the coronavirus dominates the news cycle.

For now, the key takeaways for investors are to prepare for and manage volatility, and to intensify the search for income. Uncertainty will likely linger for much of the year, causing heightened volatility which could, at times, become extreme. Interest rates are likely to continue to plumb new lows, leaving core fixed income investments with rapidly disappearing income.

  • From 1980 to 2019.

  • As of February 28, 2020.

  • 12-month forward P/E valuation averaged 16.9 from 1980 to 2019.

  • The week ending February 28, 2020.

  • Annualized weekly volatility of the S&P 500, with historical comparison range of 1928 to 2019.

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Any projections, forecasts and estimates contained herein are based upon certain assumptions that the author considers reasonable. Projections are necessarily speculative in nature, and it can be expected that some or all of the assumptions underlying the projections will not materialize or will vary significantly from actual results. The inclusion of projections herein should not be regarded as a representation or guarantee regarding the reliability, accuracy or completeness of the information contained herein, and neither FS Investments nor the author are under any obligation to update or keep current such information.

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Lara Rhame

Chief U.S. Economist + Managing Director

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