The Fed Did Right Thing, But It's a Whole New Ballgame
(Bloomberg Opinion) -- Over the last few days, as concerns mounted about the coronavirus and its impact, markets were pricing in a 50 basis-point interest rate cut by the Federal Reserve as early as this week. Central bankers obliged Tuesday morning by delivering this reduction. They did the right thing.
U.S. stocks, initially cheered by the news, soon reversed course — and indeed, some investors are asking what good this move will do. The Fed can’t print a vaccine, and others have correctly noted that this isn’t a problem created by monetary policy. All of this is true. But central bank easing can help cushion markets from becoming even more chaotic, blunt potential liquidity issues, and maybe prevent a crash as hundreds of inverse and short financial products have the potential to turn a decline into a rout from too much short-side speculation.
But what if markets plunge after the central banks move? Does this mean they wasted their bullets? This is true only if one believes the goal is to prop up markets and send them back to their mid-February all-times highs. Instead, I would argue that markets are signaling that the coronavirus is causing a secular shift in thinking. Central banks would be wise to manage this decline and not over-reach and think they can reverse it.
Leading the list of investor concerns that sparked the recent market slump is the experience out of China, South Korea, Italy, Iran and even the rest of the Middle East and Europe in dealing with the coronavirus. It suggests the U.S. should expect the number of cases to reach into the thousands. This should lead to widespread restrictions on travel and large gatherings (school closings, canceling sporting events), quarantines and enough loss of economic activity to push the U.S. economy into recession by as soon as the second quarter.
But bigger picture, the global supply chain, especially if more shortages develop in the coming weeks, will get a rethink similar to the worst-case scenario from the trade wars. This means de-globalization and returning manufacturing processes closer to home. Providing a tailwind for this will be a heightened populist anger that government mismanagement by many major economic powers contributed to this virus spreading more than it should have. Such de-globalization means a return of inflation, which has been dormant for decades, which in turn could be what finally halts the 40-year bull market for bonds.
Any pullback in bonds, after this last flight-to-quality rally on recession fears, would compress both earnings and multiples. Gone might be the days of the stock-market peak last month, when shares traded at a forward price-to-earnings ratio near 20, one of the highest ever. This was predicated on all-time lows in interest rates and globalization. Now a p/e multiple near 12 to 15 might be the order of the day. This is fancy way of saying stock prices could decline 20% to 30% and then have to overcome a secular rise in inflation and interest rates to achieve a new all-time high.
It is possible this is overstating the case. If this is wrong, we stay home for a few weeks and move on as if little has changed. We think such short memories, especially if the virus hits the U.S. as it did other countries, might prove to be wishful thinking.
Last week, the S&P 500 Index declined more than 11% for its fifth-worst week in the last 80 years. All of the other instances — the fall of France in 1940, the October 1987 stock market crash, the technology peak in April 2000 and the financial crisis in October 2008 — marked secular and long-lasting shifts. The 2008 drop accelerated a populist anger that produced, among other things, Brexit and President Donald Trump.
We believe a secular shift occurred last week. People may have to go through the five stages of grief before accepting it.
This column does not necessarily reflect the opinion of Bloomberg LP and its owners.
Jim Bianco is the President and founder of Bianco Research, a provider of data-driven insights into the global economy and financial markets. He may have a stake in the areas he writes about.
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