CHOPPY WATERS – A Tough Week for Markets

As I write this article, the S&P 500 equity market index stands at 2,972 after a turbulent week and exhilarating Friday session. Since February 19, 2020, the index has a -12% correction, about the same level as my last memo.

Nowadays, I am more concerned about 10-year U.S. government interest rates. The 10-year U.S. government interest rates reached a historic intraday low of 0.66% and ended the week at 0.70%; as a reference, one month ago, it was at 1.64%.

We can infer that bond market participants are asking for more fiscal and monetary actions so we may avoid a U.S. recession, based on today's low interest rate level. The fixed-income market expects that short term rates might need to drop close to zero, to manage the economic impact that Coronavirus might create.

A few days ago, on March 3, the U.S. central bank ("The Fed"), cut -0.5% U.S. government short term interest rates in an emergency action (outside their regular meeting schedule). The Fed was expected to act by March 18 meeting.

Todays' U.S. government short term interest rate cut stands between 1% to 1.25%. The unbelievable fact is that investors expect further interest rate cuts by March 18, an additional -0.75% cut, possibly reaching the range of 0.25% to 0.5%.

This week, U.S. financial equity markets have had several choppy sessions (+4% or -4% daily changes). The volatility index of the S&P 500 (VIX) jumped to 54 during the last Friday session, a level that I have not seen since 2011, usually when markets are calm, VIX stays below 20.

Oil WTI prices closed at 41.5 USD last Friday, nearly crossing the 40's price band. A significant change, because most of the U.S. shale fields struggle to be profitable at these levels.

Gold, as expected in panic periods, it shined. Gold has return +10.1% year to date. Only Gold and high-quality long term government and corporate bonds have excelled in this harsh environment.

As I see it, U.S. financial markets expect that there might be soon additional actions from the U.S. and global governments to support economies, besides the usual central bank's interest rate cuts and asset purchases. Just last Friday, the U.S. administration changed their mind about this subject; they are now considering or drafting an economic stimulus package.

Why? You may ask, we may not see any sign of an economic slowdown yet in the U.S., besides a financial market correction, but it could become more evident in the economy very soon if the virus spread accelerates.

The harsh policies we saw in other countries to limit the virus propagation give us a hint of what may come. The U.S. may implement similar strategies to curb the virus's exponential spread. The fate of the U.S. economy may depend on these additional government actions.

China's recent experience with unprecedented containment policies to stop the spread of the virus had substantial economic costs. The effects of these policies to stop Coronavirus propagation cripple the manufacturing and service sectors for a couple of weeks. Although, we have to consider China discovered and had the focus of the virus first, the rest of the world can prepare and learn from their experience.

After eight weeks of almost stopping most of the economic activity for several critical Chinese cities, their citizens are finding it hard to go back to normal. The recent Chinese report on manufacturing and service activities showed the lowest level of activity ever recorded.

One of the critical elements of managing a negative economic impact is to avoid an economic recession, which might start if the product and service supply or demand contracts abruptly.

At the beginning of the effort to contain the virus spread, the supply of products and services will be affected, as the state or federal government recommends public policies that may reduce exposure to other people for fear of virus contagion.

Now the supply shock might or not create a temporary demand impact. The key will be to avoid a long term demand shock. It is essential to ensure loans and debt markets remain open so that companies may find ample financing to cover expenses and keep jobs and new hiring active.

If debt markets remain healthy, and U.S. banks can provide plenty of loans, U.S. companies will be able to sustain employment, and the U.S. demand for products and services should remain stable. In particular, for those small and medium-size companies who have the lion share of jobs in the U.S.

The estimates for first-quarter 2020 expected earnings growth for the S&P 500 market index has changed to a -0.1% from a +0.5% a week ago. The expected earnings growth for the second and third quarters (+3.3% and 10.9%) of the S&P 500 still remain positive to this date.

The market estimated the S&P 500 market index forward price to earnings ratio is currently at 16.5 using last Friday market prices. This is still close to the average five-year ratio; this means we are close to fair value.

Of course, markets could go in any direction, much lower or higher, to the very extreme.