Written by Julius Probst
The COVID-19 shock has already led to a huge repricing of assets despite the fact that Central Banks and fiscal authority are currently scrambling for policies that can help put the economy on life support. Central Banks have promised to pump billions of dollars (or euros or pounds, respectively) into the economy. Furthermore, fiscal authorities in advanced economies are currently designing large stimulus packages.
While the suggested measures are certainly sizeable, there is reason to believe that they still might not go far enough, as I have argued recently. However, just last night, the Fed announced that from now on its asset purchase program will be open-ended until the economic outlook improves, Powell having his own whatever-it-takes moment. This means that the Fed’s actual QE will most certainly end up being several times larger than the initial 750 billion assumed above – finally some good news!
In this blog post, instead of focusing on policy measures, I have a look at asset prices and fundamentals and argue that we should expect lower asset valuations for a prolonged period even after we have recovered from the initial COVID-19 shock. Let me explain why.
As a macroeconomist and economic historian by trade, let me indulge in some economic history charts first, before getting back to the contemporary crisis. Almost every generation has one event that scares them for life. For the Americans of the early 20th century, it was the Great Depression.
Economic historians have estimated that the unemployment rate in the US exceeded 25% during the Great Depression, and that real GDP contracted by more than 25% . The enormous amount of optimism and the financial excesses of the 1920s were replaced by several years of economic depression and stagnation, greatly exacerbated by a fanatical commitment to the gold standard (Eichengreen, 1996). Risk aversion stayed high for many years and an entire generation avoided the stock market after getting completely burnt. Of course, the start of World War II didn’t exactly help. Consequently, it took more than an entire decade for the Dow Jones to recover and reach its previous peak.
In Germany, the Weimar hyperinflation of the early 1920s was an equally dramatic event. Money became practically worthless over the course of several months and a loaf of bread would end up costing one hundred billion Deutsche Mark. In fact, listening to German politicians today complaining about the ECB’s asset purchase programs in recent years, one might think that this fear has been transmitted across several generations. However, basic economics would tell you that QE was never going to be very stimulative or inflationary in a zero-interest-rate environment, aka the liquidity trap (Krugman, 1998).
In terms of more recent shocks, the Global Financial Crisis and the subsequent recession were bad enough. In the US, the unemployment rate soared from 5 to 10% within a little over a year. Again, it took almost an entire decade for the economy to reach full employment again. Similar to the Great Depression, several years of excessive risk-taking in financial markets led to a Minsky moment. A financial collapse was only prevented because the Fed introduced a range of policy tools over the course of several months that were intended to calm the markets and effectively bailed out Wall Street, but not Main Street. While policy makers prevented a Great Depression 2.0, it only led to a timid recovery with meagre nominal wage growth for many years to come.
Of course, the European situation with the Euro debt crisis and mass unemployment in Southern Europe was much more dire. While it certainly hurt an entire generation that has been suffering from unemployment and underemployment for many years, there is good reason to believe that the current shock from COVID-19 will be much nastier than anything financial markets or the economy have experienced in our lifetime. In the short run, it can be Great-Depression-bad, despite massive policy stimuli. While a V-shaped recovery could imply a big rebound in the second half of 2020, this is far from assured, and a lot will depend on what policy makers decide. As I see it, there’s literally no fiscal or monetary stimulus that could be too large right now. However, there is still a big chance that when the dust has settled, financial markets will have changed for years to come. Prices across the board are currently adjusting. This is true for equities, which have depreciated at a speed never seen before, but it is also true for debt, both corporate and governmental, currencies, commodities, real estate, and crypto. Almost all asset classes, except for the true safe havens, are getting slaughtered right now. Let’s have a look at why.
Let me start with another historic chart: US industrial production during the time of the Spanish flu. One can see that the index plummeted by almost 25% from the fall 1918 into early 1919. While this also overlaps with the World War I demobilization, a significant share can probably be attributed to the pandemic, which killed more than half a million people in the US alone. Therefore, this chart could be an indication of what to expect over the next few months.
Let’s turn our attention now to more contemporary data. With the US having a more flexible labor market than many European economies, the COVID-19 shock will translate into significant job losses. Estimations from professional forecasters are suggesting that initial job claims in the US will skyrocket next week by as much as 2 million, and probably more. This would dwarf anything we have seen during the Great Recession, both in terms of size and speed. Andy Harless couldn’t be more on point when he Tweeted that we should call this shock the Fast Depression.
The effect on US employment will be considerable. Expect the number to plunge by a couple million to below 150 by the end of April – and things could deteriorate from there. In a bad case scenario, the US might lose some 10 million jobs in the short-run and the unemployment rate could edge up to a number significantly higher than 10%, the peak value of the Great Recession. The one big difference is that all of this is likely to happen over the course of several months instead of 1.5 years. What is really going to hurt workers is not only the rate but more importantly the duration of unemployment. Policy makers should therefore work not only to lessen the negative employment shock, but also to shorten it.
US GDP in Q2 could plunge by as much as 10 to 20%, and maybe more. Not only is the size of this shock unprecedented but also the nature of the shock means that there is considerable uncertainty around the forecast. And things are looking worse for the Eurozone, since, in contrast to the US economy, we entered the pandemic with already negative interest rates and slow economic momentum. While many economic forecasters are seeing a strong rebound for the second half of 2020, this will depend on virus containment now as well as there not being a second wave later this year. It will also depend on policymakers to create a positive shock and awe moment that will allow us to catch up to the previous level of nominal GDP in the aftermath of the shock. For this to happen, some 1.1 trillion of QE by the ECB and 750 billion by the FED will probably not suffice. Instead, policy makers would have to opt for open-ended asset purchases and commit to buy as many financial assets until the level target has been reached – QE infinity, so to speak. But as of right now, Central Banks simply do not have the mandate for such a policy.
Even if policy makers do manage to avoid significant hysteresis effects from such a big downturn and manage to kick the economy into high gear by the second half of 2020 (and this is a big IF), I argue that the current asset price crash will significantly alter financial investments in the years to come, and could potentially create a scarring effect on current generations similar to the 1930s and bigger than 2008.
Let me be clear, I do not expect that equity prices won’t recover in the long-run. However, I think that there is currently a big repricing of risk going on and that the current devaluation will last even after the initial shock has subsided.
The chart below shows the S&P 500 in real terms and natural logarithms since the late 19th century, including the Shiller cyclically adjusted PE ratio and the dividend yield. As one can see, equities have had historically high valuations since the 1990s, with the PE ratio persistently exceeding the long-run average of 17 for several decades now. While part of this is based on fundamentals due to low interest rates, some research suggests that the equity risk premium has also been relatively high over that time period, meaning that equities and other risky assets have achieved historically high returns compared to safe assets (Jorda et al., 2017). Note that low interest rates and lower dividend yields imply a higher fundamental value for equities, since future cashflows are discounted at a lower rate. Therefore, historically high PE ratios might be justified in our current period of low interest rates.
However, as one can see, the PE ratio has plunged with the recent market crash and is now all the way down in the shaded red area, which corresponds to the historic mean plus/minus one standard deviation. The crash of recent weeks has meant a rapid revaluation of risk and price in financial markets. The S&P 500 PE ratios has already fallen from about 35 to 25, meaning that is has breached the upper standard deviation again, and I expect further decline in the coming weeks and months. Investors will remember this mess for a long time, and there is no reason to believe that we can or will go back to the high PE ratios of the pre-Corona-shock era for many years. My best guess is that this big revaluation will be quite persistent. Obviously, this also implies that asset returns will be quite meagre in the foreseeable future.
And notably, it’s not only equity prices that have suffered. Riskier bonds are going down, too, and they are going down fast – note the massive increase below, similar to that of the Financial Crisis. And surely, this worrying trend will accelerate as businesses come under increasing strain and face a severe liquidity and income crunch – a textbook case of an economic sudden stop.
Finally, commodities are being dragged down too, and let’s not talk about oil. (Oil exporters are in deep trouble, and the next currency crises in EMs are approaching rapidly.) Silver and gold will suffer as well. While for a while it looked like gold was on the rise, recent events have proven that it is not truly a safe haven. Similar to the Bitcoin nutters, gold nutters fail to understand that it is not the US dollar or US Treasuries. First, most gold is financialized as well as it is traded on commodity exchanges. When all asset prices plunge across financial markets, there is little reason for gold to go up. Second, even if you hoard real gold in your safe, it is not like a gold bar will help you with your grocery shopping right now or make you safe during a global pandemic. As I wrote on my own blog a while ago, gold is relatively useless as a safe asset, and even as a hedge. Silver is plunging even more, since it still has many applications in industrial production and is therefore more closely related to economic growth.
So, all asset classes are suffering big time right now: equities, higher risk debt, and especially commodities. It is a truly epic cycle of repricing of risk and valuations that will leave a trace in financial markets for a long time. Investors will remember this moment for a while!
I have previously written about secular stagnation and what it means for the long-run economic outlook of advanced economies, here, for example. The basic fundamentals have not changed with COVID-19. Expect low growth, relatively low inflation, and low interest rates on safe assets for years to come. However, another side-effect of secular stagnation was extremely high asset prices on risky assets with PE ratios way above their historic norm, which was one thing going in our favor (if you were an asset owner that is).
As argued above, the COVID-19 shock might be the scarring event of our time and has probably led to a complete revaluation of risk. Investors’ perceptions could fundamentally change with the current pandemic. Expect lower equity price ratios and higher yields on riskier debt (and therefore lower bond prices), potentially for years to come. The days of PE ratios above 30 are surely over! We have passed the secular stagnation regime with high asset prices and moved into a secular stagnation regime with low asset prices. Unfortunately, it is not a great outlook.