The fear trade in the market is on full-blast and it wouldn’t surprise anyone if the market enters correction territory very soon. But we may not see stocks fall into an abyss the way they did in March.
Stocks got pummeled hard Thursday, as data are beginning to show the resurgence in coronavirus cases, a development that could potentially mean another round of lockdowns which could easily keep the economy in recession for longer than anticipated. Johns Hopkins data show the 5-day moving average of new cases per day is around 27,000, up from 11,000 earlier in the month.
The S&P 500, down more than 5% at one point Thursday afternoon, was down more than 6% this week, which, in percentage point terms, is roughly halfway to a correction from the index’s post-March 23 high of 3,231. The 10-Year Treasury yield fell to 0.67% from 0.73% Wednesday and from 0.91% last week.
Stocks had risen more almost 45% from their March 23 bear market low as economic momentum from Federal Reserve stimulus, fiscal spending, state reopenings and a slowing rate-of-change in the economic contraction took hold.
When the U.S. entered a bear market in March, the S&P 500 fell 34% from its all-time-high of 3,393, hit February 19. There have been larger bear markets in U.S. history, like the one sparked by the Great Financial Crisis, in which the S&P 500 fell more than 50%, but over a year-and-a-half. The coronavirus bear market’s velocity was extreme.
In March, investors were waiting to see what the Federal Reserve and Congress would do. Without the trillions of dollars of stimulus -- amounting to a significant portion of U.S. GDP -- the market could not have rebounded as fast as it did. That’s because businesses and people couldn’t have had any access to capital and because interest rates would have been more attractive to investors than equities.
Then, the market got its juice: stimulus.
Two rounds of fiscal stimulus worth trillions of dollars enabled households to get access to cash grants. The Paycheck Protection Program (PPP) enabled small businesses to take advantage of low-cost forgivable debt as long as they held onto employees. The Fed bought corporate bonds, keeping credit spreads tight enough for companies to borrow roughly $1 trillion worth of debt capital (investment grade) in May, according to data from both Cannacord Genuity and Bank of America. For reference, investment grade corporate bond issuance was just $975 billion in all of 2019. Friday June 5, the Bureau of Labor Statistics said the U.S. economy added 2.5 million jobs in May, as states reopened, against estimates of an 8-million job loss. Markets seemed ever so slightly euphoric.
The equity risk premium -- the excess rate of earnings return expected on stocks for the next year over the interest rate on the 10-Year Treasury bond -- had crossed over to 2.99%. That’s because stocks had soared and so had treasury yields. The S&P 500’s risk premium sits at roughly 3.5% in most healthy environments, historically. High yield credit spreads -- which show the credit risk premium -- had gotten towards 5%, just a few basis points higher than historical averages. This left the market highly vulnerable to any bad news on the economy.
This week, those risk premiums are heading higher again as risk assets are sold off.
And while another day or two of viscous drops in risk asset prices will see the S&P 500 hit correction territory, this drop may not be as bad as what we saw earlier in the year.
“The fact that you do have these backstop credit facilities, that the Fed can step into the secondary market and buy corporate bonds, can provide support in the primary market as well, that should prevent a very very significant widening of spreads,” Steve Friedman, former senior staffer at the New York Fed and Macroeconomist at MacKay Shields told TheStreet. “Yes, if risk assets perform poorly here, we will see some widening, but ultimately the Fed as a backstop likely prevents the extent of the winding.”
Jasper Lawler, head of research at London Capital Group, told reporters in emailed notes "We now know that rates will be pinned to near zero through 2022 and that the Fed will increase its Treasury and MBS [mortgage backed securities] purchases over coming months at least at the current pace.”
Simply put, investors may be more confident this time around that the Fed’s continued action will keep capital markets functional and liquidity from drying up. And the Fed’s dot plot shows no interest rate hikes for several years from now.
But the Fed’s tools are no longer aplenty, as it has exhausted most of them. It may potentially increase the size of its programs, which Friedman acknowledged, but that isn’t likely to have a substantial impact on risk asset prices.
What Friedman really wants to see: “It really becomes a matter of fiscal policy -- make sure households have adequate cash flow.” The Fed can’t extend cash directly to households and certainly not for free.
So if more layoffs ensue, Congress will have to appropriate more funds from the treasury. But the political will for a third round of fiscal stimulus may be fading.
Seema Shah, Chief Strategist at Principal Global Investors told TheStreet, “At some point the government will want to remove some support.” In reference to the PPP, Shah added, "Once we miss that support, what happens then? Will companies still be able to rehire their workers?”
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