A U.S. ECONOMIC CONTRACTION AND BEAR MARKET HIGHLY LIKELY / SEEKING ALPHA

A U.S. Economic Contraction And Bear Market Highly Likely

by: James A. Kostohryz

Summary
 

- A significant contraction of US economic activity in 2Q 2020 is now virtually assured.

- Although a full-fledged multi-quarter recession is not certain, the pathway to escape this outcome is very narrow, indeed.

- My best-case scenario for US stocks is a peak-to-trough decline of roughly 31%.

- Full-fledged recession scenarios - according to severity and length - will most likely entail US equity market declines of greater than 50%.

 

For reasons described in this article, a significant contraction in US economic activity in the second quarter of 2019 is highly likely. Furthermore, a bear market in US equities, associated with this US contraction and a broader global recession, is highly likely.

An Economic Contraction is Virtually Certain in 2Q 2020

If you are personally inclined to think that COVID-19 poses economic threats that are not significantly greater than the flu, then I strongly urge you to read this article.

By reading this article you will come to understand that COVID-19 poses massive threats (which are not yet widely understood by the public) to the economy of any area of the world in which there's a major outbreak.

 

Various areas around the US are currently on the verge of major outbreaks, and these actual and potential outbreaks already are having serious economic impacts. These impacts will only grow in the next few months.

 

I will briefly review the factors that will drive a US economic contraction in 2Q 2020.

 

1. Global economic recession. I highly recommend that you read this article in order to understand why a global economic recession driven by severe recession in China is now a certainty.

 

This global economic recession will have major direct and indirect spill-over impacts on the US economy, via supply, demand and impacts on the financial system.

 

2. Investment freeze. As a result of disruptions in both supply and demand, producers and entrepreneurs will cancel or otherwise postpone planned investments. A collapse in non-residential investment expenditure will likely subtract 1.0% to 1.5% from GDP in 2Q 2020. The only real question is: How severe or for how long?

3. Manufacturing contraction. Major global supply chain disruptions, particularly out of China, will induce a major contraction in activity in the US manufacturing sector – and all of the economic activity which is associated with US manufacturing production.

 

This will have several impacts. First, this will severely lower sales of manufactured goods in the US. Second, there will be substantial layoffs in the manufacturing sector associated with idled production. It's important to understand that it only takes one missing part to grind the entire mass production line of a manufacturer to a halt.

 

This, in turn, impacts both the upstream and the downstream businesses that depend on US manufacturing.

 

The direct and indirect impact of US manufacturing on the US economy amounts to about 30% of GDP. In a relatively benign scenario, I estimate that the (non-investment) supply-based and demand-based shock emanating from the manufacturing sector will not subtract less than 2.0% of GDP in the second quarter. This would be a best-case scenario.

 

4. Service sector contraction. “Social distancing” will be the new catch-phrase for 2020. Conventions, business gatherings, concerts and sporting events will be cancelled. First, companies and individuals will drastically reduce travel and all associated consumption in the hospitality industry.

 

Second, in order to protect themselves and their families against the risk of contagion, individuals will drastically reduce their consumption at restaurants, shopping malls and any commercial establishment that induces contact with other people.

 

The magnitude of the hit to US consumption activity depends on the extent and breadth of the spread of COVID-19 in the US. However, in a best-case scenario, I estimate that overall service sector final expenditure will contract by at least 3%, implying roughly a 2% hit to GDP.

 

5. Imports and exports. US exports will collapse in the third quarter of 2020 due to the decline in global demand and due to the disruption of global supply chains.

However, imports also will collapse due to supply chain issues. Thus, the net “accounting” impact on GDP from net exports is difficult to estimate.

However, it should be apparent that a collapse in imports (caused by supply-chain issues) which may “inflate” the net exports line item in GDP, will significantly lower the consumption and investment line items. In order to understand this, it's important to note that imports indirectly enable and generate a great deal of economic activity.

 

First, “intermediate” imports are key inputs in the production process of “domestically” produced goods. Second, imports of final goods generate much economic activity in the transportation and retail industries.

 

6. Relative price distortions. The prices of many goods will decline due to the collapse in global demand.

However, due to supply chain disruptions, the prices of many goods will increase – in some cases, very substantially. The resulting relative price disruptions will cause serious economic problems for businesses.

 

Price distortions also will have deleterious effects on both business and consumer confidence. In this latter regard, it should be noted that rising prices (especially upward price “shocks”) will negatively impact the psychology of business and consumer spending to a far greater extent than falling prices will positively impact businesses and consumers.

 

It should be noted that I fully expect aggressive fiscal and monetary policies. I expect aggressive monetary policies by the Fed (rate cuts and QE) and massive expenditure bills to be passed by Congress and signed by the executive.

 

I fully expect that these measures will somewhat offset the contractions in investment and consumption caused by COVID-19 supply and demand shocks. (Although I will note that these policies will actually make the relatively price distortions even worse.)

 

Overall, regardless of how effective these expansionary fiscal and monetary policies actually are (and I do assume that they will be as effective as they can be), they will certainly not prevent a contraction in economic activity in the second quarter.

 

For example, no amount of fiscal or monetary stimulus is going to persuade consumers to go to cinemas, restaurants and shopping malls in areas impacted by COVID-19. These measures also will not alleviate supply chain disruptions.

Thus, although the depth of the contraction in 2Q economic activity depends on how severe and widespread the COVID-19 becomes, a significant contraction in 2Q is virtually assured.

 

Note that I'm explicitly not applying the “R” word. A recession generally implies a contraction in economic activity that's more widespread, severe and prolonged than that which we can confidently estimate going forward based on our limited estimations related to 2Q 2020.

 

What Will Happen to Economic Activity in 3Q 2020 and Beyond?

 

It's exceedingly difficult to forecast US economic activity beyond 2Q, at this point in time.

 

However, below are some key factors in the analysis.

 

1. Reaction of COVID-19 to weather. There's reason to believe that the rate of COVID-19 contagion will significantly decelerate in the summer. Probabilistic inferences along these lines are justified due to the known behavior of other strains of coronavirus and also due to the relatively low rates of propagation (apparently) witnessed thus far in warm nations.

 

If, as a result of lower levels of contagion/propagation during warm months, consumers are able resume their normal consumption habits by July of 2020 and global supply chain issues are alleviated by then, it's possible that the US economy will resume growth in Q3 2020.

 

However, it's far from certain that the rate of contagion of COVID-19 will slow down enough such that US consumption returns to normal and that global supply chains will be back to normal by that time.

 

2. Will COVID-19 come roaring back in fall 2020? It's unlikely that a vaccine for COVID-19 will be available to the public before February of 2021. In this context, based on the behavior of other viruses, there's substantial reason to believe that COVID-19 will cause a second and potentially more destructive wave of infections in the fall and early winter of 2020. Surely, governments and the population will have ample time to take preventative measures, which will ameliorate the impacts.

 

However, it's precisely these sorts of preventative measures by governments and the general population which are likely to impair US GDP growth substantially in the fourth quarter of 2020 and first quarter of 2021.

 

Assuming that COVID-19 does not simply disappear before a vaccine is massively distributed some time in 2020 (an unlikely scenario), then it seems highly likely that this virus will be causing havoc in the global and the US economy at least through the first quarter of 2021.

 

I have not officially published a forecast of a US recession in 2020. However, a Best-Case scenario for the US economy for the remainder of 2020 will be a significant contraction in 2Q, followed by a significant rebound in 3Q, then followed by a major slowdown in 4Q.

 

It will not take much for me to eventually rule out such a best-case scenario and officially call for a full-fledged recession which encompasses the entire four quarters spanning from Q2 2020 through Q1 2021. I have outlined the factors above which would eventually trigger a full-fledged recession forecast on my part.

 

Stock Market Impact

 

US economic recessions are virtually always accompanied by bear market declines of 20% or more in the S&P 500. Although a US recession is not yet a certainty, due to the fact that a global recession is virtually assured, it's my view that a full-fledged US recession will not be required to trigger a stock market decline of 20% or more.

 

It's important to recall that roughly 40% of S&P 500 revenues and earnings are driven by direct foreign sales. If we add sales that, indirectly, are highly dependent on global economic conditions, this figure would likely rise to over 65%.

 

I will cite only a few examples of indirect impacts from global factors. First, consider the domestic sales of energy and materials sectors of the S&P 500 which are dependent on the pricing of internationally commercialized commodities (e.g. crude oil), the pricing of which are determined in international markets.

 

Second, consider that roughly 80% of all drugs sold in the US by the pharmaceutical industry (impacting S&P Healthcare and Consumer Staples) require international inputs, primarily from China.

 

Third, consider that the production and domestic sales of the S&P industrial sector almost is entirely beholden to global supply chains.

 

Finally, please consider that domestic sales by the S&P Consumer Discretionary sector (e.g. autos and luxury goods) largely depends both on critical inputs and demand from non-US sources.

Thus, my Best-Case scenario for the US stock market, which depends upon my best-case macro-economic scenario (outlined previously) is for the S&P 500 to merely “re-test” the 2018 low of 2351.

 

This would represent a peak-to-trough decline of roughly 31%. A decline of this magnitude would be roughly in line with the “average” cyclically-induced major declines experienced in the US since World War II (average of 28.6%).

 

This scenario looks considerably “rosy” considering that the earnings prospects, and the “equity risk premium” used to discount those earnings, are considerably worse than they were in December of 2018 (when the low of 2351 was made).

 

However, if the spread of COVID-19 causes a severe contraction in consumption in 2Q and there's a major second wave of global infections in the fall of 2020, then it will become necessary to factor in a deep economic recession in the US and globally which lasts at least 12 months.

 

In this scenario, considering valuation issues and other risk factors, I would expect the S&P 500 to eventually decline by at least 50%, with potential for declines of 65% or more.