The Federal Reserve’s March minutes showed a central bank worried sick over the direction of the U.S. economy. But stocks raced higher, mostly because the market has been well aware of the developments and as investors begin to look past what is likely a coronavirus-induced recession.
After having risen 2% in early trading Wednesday, both the Dow Jones Industrial Average and S&P 500 rose more than 3%, after the Fed published its minutes.
Investors were net sellers of the safe 10-year treasury bond, with yields rising to 0.78%.
The Federal Reserve acknowledged that the coronavirus is putting more than mere strain on the economy, which the central bank noted entered the outbreak on strong footing. But the Fed noted that consumer spending is taking a huge hit. Social distancing is keeping people indoors and only shopping for essentials, a boon for consumer staples stocks. Plus, many who have been laid off, as stores and businesses close, will be forced to use government funds (more than $2 trillion appropriated by Congress) on staples, not dicsretionaries. That’s a negative for the latter.
Importantly, most economic experts agree that around 70% of U.S. GDP is tied to consumer spending. The country is likely in recession.
The Fed also mentioned that lowered demand across most sectors, coupled with OPEC’s inability to come to a production cut agreement, has put serious pressure on oil prices. This is pressuring inflation, the Fed thinks.
Still, Morgan Stanley investment strategists and economists wrote in a recent note that they are looking for “disinflation, not deflation.” Morgan Stanley is looking for inflation to trend at roughly 1.6%, as the goods sector sees deflation, but the services sectors sees continued inflation. Services comprise the majority of U.S. economic output.
But large services companies like Facebook (FB) - Get Report, Google (GOOGL) - Get Report, Disney (DIS) - Get Report and alike are seeing major hits to revenue and earnings on the back of lowered advertising spend, as brands tailor their ad spend to their lowered expected revenue streams. Cloud and e-commerce companies like Microsoft (MSFT) - Get Reportare Amazon (AMZN) - Get Report are seeing strength in their core businesses.
But on inflation, the Fed mentioned that “total consumer prices, as measured by the PCE price index, increased 1.7 percent over the 12 months ending in January,” which was well before the outbreak decimated the U.S. economy. A drop of 0.1% in inflation seems unlikely.
The point is that the Federal Reserve is likely to continue pumping liquidity into the rates market, keeping the cost of borrowing low for businesses and households.
The market, relieved, is taking a deep breath Wednesday. Investors have been well aware of these economic dynamics. Fed minutes can often reveal headwinds or tailwinds investors had not caught, even if the market already had general knowledge of the direction of growth and profits.
Weeks ago, stocks had priced in a recession, with the 10-year yield dropping well below where it is Wednesday and stocks down hugely. The equity risk premium, or the excess rate of expected return for the on stocks for the next year minus the 10-year treasury yield, was 7%. Historically, it sits at around 3% when the economy is humming along. Now, it’s at 4.9%.
Investors, seeing signs of a slowing virus spread globally and strong stimulus and liquidity for the short-term, are looking through the trees to see the forest.
Going forward, some say to expect another downdraft. The virus picture is still far from clear.
Earnings per share estimates for 2020 on the S&P 500 are for $156, down 12.35% from prior estimates. But Goldman Sachs’ head of equity strategy David Kostin says EPS is gong to $110. Morgan Stanley and Stifel strategists see the drop going towards roughly $130. Most on Wall Street see current analyst estimates as lagging by a few weeks the actual realistic outcome for the year.
And 2021 and earnings may drop as well, one small part of a picture that likely includes lower-than-average earnings multiples historically.
The S&P 500 is down just 16% year-to-date, as the market has bounced from severe lows.
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