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

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.


11 thoughts on “For One Bank, A Global Recession And A Bear Market Just Became The Baseline Forecast

  1. When a test is widely available then covid-19 will be seen to be under control. Have a fever? Get tested. That bottom will happen long before vaccines or cures are invented. Recession seems an excess of extrapolation

    1. Possibly. Another equally probable scenario is that widespread testing reveals significant outbreak in USA, and we see a repeat of the consumer paralysis that occurred after 9/11. You’ll recall that 2002 was a bad year for SPX.

    2. I hope our company will be able to make up to 20 million PCR tests by the end of the year; well, at least 10 million. Along with other companies, we will be able to test perhaps up to 50 million Americans.
      I can forecast the number of true positive, but this forecast will not make you happier.

  2. What if you have no fever, pass the test, and are spreading the virus? And the thing is mutating. Similar to current versions of flu with a higher mortality rate. Could be seasonal as flu too.

    Probably are scientists who could provide good information on the pandemic, after Pence assures it is simple enough to understand for we good citizens.

    And the President has good hunches we can depend on.

    Yeah, it’s almost over.

  3. No way 1Q growth in U.S. isn’t sub 2% — i.e., lower than 4Q19. And no way 2Q growth in U.S. isn’t lower than 1Q growth (i.e., < 1.7%). Two consecutive quarters of slowing growth is the technical definition of a recession.

    1. MFN, sorry to nitpick, but a recession is technically 2 consecutive quarters of NEGATIVE growth rates.

      Going from +2 to +1.5, then from +1.5 to +1.0 is not technically a recession.

      It’s not good, but not a recession.

      Hope this helps clarify.

      1. Ah, yes, stupid of me. In which case hard to see U.S. falling into technical recession. On the other had, significant slowdown in growth seems baked into the cake. Watch those credit spreads.

  4. I certainly hope that the rosy predictions in this thread are correct. However, the data that we currently have available to us would suggest that this virus is somewhere on the order of 20-34 times deadlier than the seasonal flu, and the number of cases has been increasing exponentially where containment efforts have failed. The data also suggest that the percentage of patients that need ICU level care and mechanical ventilation is also quite high.

    Is there significant selection bias in the data due to a lack of widespread testing? Absolutely. Is it possible that the mortality rate will end up being lower than the current estimates? Sure.

    That said, if even the most conservative estimates for mortality, serious illness requiring ventilatory support, and growth rates hold, this virus has the potential to place tremendous strain on our health care system. We may find ourselves with an inadequate number of ICU beds, ventilators, personal protective equipment, and healthy ICU staff to care for all of the patients presenting with respiratory failure due to Covid-19, let alone the run of the mill conditions that hospitals are currently managing.

    It will be interesting to see what happens in Italy in the coming days/weeks. They appear to be getting close to reaching their capacity to care for critically ill patients in parts of the country, and we may see hospitals in Italy forced to make tough decisions regarding which patients to offer (or deny) ICU level care. What happens there will likely be a preview of what we’ll be dealing with in a matter of weeks.

    1. And the corresponding economic impacts of paying for that much care in the US. No centralized health care means that’s a massive amount of consumer spending sapped. A good scenario is now looking like this is a serious headwind for a year or two.

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