For One Bank, A Global Recession And A Bear Market Just Became The Baseline Forecast

One persistent source of consternation for critics of what, until three weeks ago anyway, was an inexorable ascent for US equities, was the seemingly unrealistic assumption of a “hockey stick” inflection in earnings growth during the back-half of 2020.

One argument is that the market, being the forward-looking beast that it is, was looking ahead to 2019 when, during 2018, equities sold off hard despite record profit growth (courtesy of the tax cuts). By that logic, 2019’s blockbuster equity gains amid decelerating (and eventually falling) earnings growth meant that the market was pricing in an inflection in 2020.

That argument was made by the likes of Ned Davis, for example. “Although over the long-term it is true that stock prices are positively correlated to earnings growth, over the the short-term, stock prices tend to be inversely correlated”, a note from December reads.

Read more: Prophesying Profits.

By that rationale, the following chart isn’t all that surprising, let alone alarming.

But, as the chart title (and subtitle) emphasize, the idea that corporate America is going to come out of the current (shallow) earnings recession and deliver on expectations for solid bottom line growth later this year is now a dubious proposition.

The US is sure to see at least some economic activity curtailed in both the manufacturing and services sectors as health officials attempt to slow the spread of the coronavirus. And multinationals have already delivered warnings on the likely hit from supply chain disruptions and reduced demand in foreign end markets for their products.

Those considerations presage lower growth, lower revenue and, ultimately, lower earnings.

There’s nothing at all hyperbolic or otherwise bombastically bearish about that assessment. That is a rational, common sense take. Indeed, Goldman slashed its outlook for 2020 S&P 500 EPS growth to 0% late last month. The bank also trimmed its outlook for 2021. For those who missed it, the post is here, but the gist of it is captured in this visual:

That was on February 27. Things have gotten considerably worse on the virus front since then, and I don’t think anyone would accuse me of trafficking in fear if I were to suggest that, eventually, we’re all going to have to come to terms with the possibility that US corporate earnings will be, at best, flat this year.

“Typically, earnings estimates drop by 10% as the year progresses, and that is absent a tail risk event like the coronavirus”, JonesTrading’s Mike O’Rourke said this week, noting that although this crisis, like other crises, will pass “there will be a slowdown [and while] the equity market will try to look through to the other side, that should be hard to do in an expensive tape that lacks meaningful earnings growth”.

Indeed. And therein lies the problem with calling a bottom in US equities which, prior to the virus-inspired rout, were trading very rich on a forward multiple, especially in big-cap tech.

“From a fundamental perspective, the market has simply moved from pricing in earnings growth of more than 20%, which would have easily been the fastest of this cycle, down to now pricing in flat earnings”, Deutsche Bank said, in a recent special report on the outlook for the global economy and markets given the evolution of the epidemic. “It has yet to price in any drops in earnings from the expected slowdown in activity”, the bank went on to say, before delivering the sobering news. To wit, from the same note (which is really just a compilation of views from the bank’s various strategists across assets and regions):

We see the selloff as having further to go and in our central scenario we expect equity markets to be down by 20% from their last peak (S&P 500 at 2700). With the speed of the selloff seeing several technical indicators jump to extremes, many have been asking when and at what levels to buy back in… In episodes when vol got elevated historically (>1.5 sigma moves) as has happened, it has taken on average 6-7 weeks for vol to subside. The S&P 500 typically took another 4-5 months after that to recoup losses as investors raise exposure only slowly with trailing vol typically an input into risk management models.

In addition to the 2,700 SPX downside central scenario, the bit about certain investor cohorts raising their exposure “only slowly” as trailing realized falls when vol. finally subsides is crucial.

Remember, the vol.-targeting crowd is “escalator up, elevator down”. You can read more on that here, but suffice to say leverage in that universe had reached levels last seen in January of 2018 prior to the selloff. Over the last month, that exposure was purged:

It will not be rebuilt as quickly as it was shed – that’s not how it works. Again, think of it as “escalator up, elevator down”.

Deutsche also has a “more severe” scenario.

“With our central scenario seeing a rebound in macro growth to above trend rates in Q3, we expect equity markets to bottom earlier, during Q2,” the bank went on to say, before cautioning that “in the more severe scenario, we see equity markets selling off by more, by around 30% from the peak (S&P 500 2370) corresponding to an average recession selloff”.

(Deutsche Bank)

As you can see from those two visuals, the bank’s baseline forecast is now for a global recession in H1, characterized by “the EA and Japan recording two quarters of moderately negative growth, the US economy hovering near zero with a contraction in Q2, and China experiencing one quarter of decline in Q1”. Notably, DB sees Australia succumbing to a recession for the first time in nearly 30 years thanks in part to lost exports to China.

Again, those projections are from March 2, but this week, the bank’s Binky Chadha (who, generally speaking, is a bullish fellow) reiterated that “just two weeks in, it is much too early to declare this episode as being done”.

As a reminder, Chadha’s 2019 target was 3,250, a target he left unchanged for 2020. Valuations, he reckoned, were too rich headed into the new year.

Remember, all of this comes at a decidedly inopportune time. Global growth is coming off its worst year since the crisis. And, thanks in no small part to the anti-globalist/protectionist bent adopted by some political opportunists seeking to capitalize on the rising tide of nationalism, global trade volumes contracted for the first time since the crisis.