How a Coronavirus-Driven Recession Would Present Unique Challenges for Investors
The last few recessions in U.S. history happened for various reasons, but in the end, they were all due to sudden reductions in demand. However, despite reduction in demand, there was no upfront squeeze from supply reduction - that didn't happen until after demand fell and companies went bankrupt.
As fears of the novel coronavirus, also known as Covid-19, have ravaged markets, the real problem of the situation has yet to hit investors. At the moment, companies' realized losses from the virus are still speculative; thus, it's easy to think of it as a problem of reduced earnings. In many cases, though, the decline in sales will come from the simple fact that there is nothing to sell.
In February, China's manufacturing purchasing managers index fell to 35.7, down from 50 in January. This marks its lowest level since 2004. In other words, during the space of a single month, factory shutdowns from efforts to contain the outbreak have shrunk the entire country's manufacturing rate back to what it was 16 years ago.
These supply cuts introduce a variable to U.S. markets that hasn't been seen since the Great Depression, and the U.S. may not be ready for it - especially if more countries that experience outbreaks of the virus enforce similar manufacturing shutdowns.
Recessions in recent history
In the early 1980s, the Federal Reserve tightened monetary policy drastically in order to curb inflation, which led to sluggish business growth.
When the dotcom bubble burst, unrealistic demand for overvalued tech stocks disappeared, taking a good chunk of imagined market value with it. According to analyst estimates, more market value was lost from dotcom stocks than from fear caused by the Sept. 11 terrorist attacks.
In the Great Recession, the subprime mortgage crisis led to record mortgage foreclosures, with demand for goods collapsing as people lost their life savings and were forced to penny-pinch in order to get by.
The investors that came out on top after these recessions were generally the ones who were invested in a portfolio of companies with strong long-term demand prospects, strong balance sheets and no major interruptions to their production capacity. They did not engage in panic-selling; after all, it doesn't make sense to sell a good company at a lower price than what it will trade at in just a few years' time. They also were not, for the most part, invested in extremely overvalued stocks, which often lose their overvaluations permanently in the wake of a sharp enough market downturn.
Warren Buffett (Trades, Portfolio) offered the following advice in his 2019 letter to shareholders:
"Charlie and I do not view the $248 billion detailed above as a collection of stock market wagers - dalliances to be terminated because of downgrades by 'the Street,' an earnings 'miss,' expected Federal Reserve actions, possible political developments, forecasts by economists or whatever else might be the subject du jour. What we see in our holdings, rather, is an assembly of companies that we partly own and that, on a weighted basis, are earning more than 20% on the net tangible equity capital required to run their businesses."
In other words, as long as an investor remains confident about the companies they have chosen to entrust their money to, there is no reason to sell when the market takes a turn for the worse due to temporary demand problems that will be resolved quickly.
Supply for the demand
The U.S. last saw a recession caused by both supply and demand problems during the Great Depression, when a variety of factors affecting trade and monetary policy led to both a stock market crash and steep declines in industrial production. A record number of factory shutdowns led to unemployment, which led to even lower demand as poverty rates went up. Industrial production fell nearly 47% between 1929 and 1933, leading to a 30% decline in gross domestic product.
After the Great Depression, the second-largest recession in U.S. history was the Great Recession, which saw GDP decline by only 4.3%. From 2007 to 2009, the economy was mostly being squeezed from the demand end, so GDP was able to make a quick rebound.
The chart below shows the "Buffett Indicator," or the ratio of total market cap to GDP, for the U.S. Whenever the total market cap surpasses GDP, it indicates that the market is overvalued. As you can see, GDP growth in the U.S. has been steady since 1970, with its biggest stumble being in 2008.
Along with the 4.3% GDP loss came a much more significant loss in the stock market as stock prices tumbled. Total market cap tumbled back down to about the same level as the 2002 low, despite overall GDP growth from 2002 to 2008. This shows how declining GDP, caused by production slowdowns, results in the most severe stock market corrections.
When only a shortage in demand kicks off a recession, consumers in the U.S. can still go out and spend their money on whatever they choose. However, supply shortages resulting from supply chain interruptions can mean that even if you want to buy something, you may not be able to, which further reduces the flow of money to businesses.
Market vaccinations
What makes the coronavirus-related supply chain problems unique in U.S. history is that they are the result of fear, much like panic-selling in the stock market. The more people fear the virus, the more quarantine efforts will cut into both supply and demand.
One vaccination for markets has already been administered - the popularity of value investing principles. "The market has been conditioned to buy on any weakness," said Keith Buchanan, portfolio manager at GLOBALT, regarding the Dow Jones Industrial Average's 5.1% upsurge on Monday following a week of declines.
Another factor dulling the effects of negative market sentiment is that Fed Chair Jerome Powell said on Friday that policy makers "will use our tools and act as appropriate to support the economy." Some consider this a guarantee of another base rate cut, though this is by no means set in stone.
If the new coronavirus has an outbreak in the U.S., however, the only real way to prevent the economy from slowing down (or even possibly shrinking) would be for people to not shut down significant portions of the supply chain.
A successful vaccine or treatment could make all the difference here. Interest rate cuts won't do anything to stop factories from being shut down, but a cure is "one element that could sustainably and effectively prop up sentiment," wrote Seema Shah, chief strategist at Principal Global Investors, in a Thursday blog post.
Regulators have rushed to speed up approval for human trials of potential vaccines or treatments for the Covid-19. Among the frontrunners is Gilead Sciences (NASDAQ:GILD). According to a statement from the World Health Organization, the biotech giant's experimental antiviral drug remdesivir is the most likely to show success. The drug has been tested on approximately 1,000 patients so far, mostly in China, and will also be tested on U.S. patients who contracted the virus overseas. As a result of this news, Gilead has seen its stock price defy the general market downtrend over the past week, rising 12.5% to trade at $75.40 on March 2.
Conclusion
One thing is certain - if a company is forced to cut production, it won't be able to sell as many products. In the short term, this may only result in an insignificant quarterly loss, but if it continues for multiple quarters, companies may find it harder to recover. This is especially true if they have weak balance sheets and are unable to pay off creditors due to consecutive losses.
However, as Peter Lynch once said, "You can flip a coin over where the market is headed over the next year." Though factory shutdowns in China foreshadow a possible larger-scale decrease in global manufacturing output, we do not yet know how widespread the new coronavirus will become, or how long the current outbreaks will continue. It's possible that a company like Gilead will develop a successful treatment sometime over the next few months. Still, investors on the defensive may want to pay close attention to any new developments and carefully review the fundamentals of any financially weak holdings whose factories are being shut down.
Disclosure: Author owns no shares in any of the stocks mentioned. The mention of stocks in this article does not at any point constitute an investment recommendation. Investors should always conduct their own careful research or consult registered investment advisors before taking action in the stock market.
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This article first appeared on GuruFocus.
