Sound familiar? It should. It’s the consensus view. While we agree there is little doubt the economy is facing significant near-term challenges, we believe it’s possible the consensus view is misjudging some of the risk dynamics related to a second wave threat.
Second Wave Considerations
Many market-watchers are citing a second wave of contagion as a key risk later in the year, as states begin to undertake a patchwork approach to reopening their economies. A subsequent wave of COVID-19 cases is being widely referenced as a potential catalyst for a second leg lower in equities. Without a doubt, this is not an illogical base case – there are certainly reasons to be worried. However, as the three points below suggest, we believe it is possible that markets have already priced in many of the risk dynamics related to a second wave.
- The lockdown was never about the total eradication of COVID-19.
The US, like many countries in Europe, reacted too late to contain the pandemic. The federal government, state governments, and public health systems moved too slow and were unprepared for the virus once significant contagion became apparent. There seems to be consensus understanding that any viable treatment or vaccine is – at the very least – 6 to 12 months away. Vaccine and pharmaceutical specialists in the US, India, China, and elsewhere are working to compress standard procedures that can normally take a decade or more into a matter of weeks. They are working urgently – but ending the lockdown was never contingent on the discovery of a medicine.
- The COVID-19 lockdown was about buying time and establishing some certainties.
Increasing case numbers and growing death rates led to lockdown unanimity. The lockdown was required to gain a better understanding of the severity of the virus, work to stem the contagion, improve testing, and achieve some clarity around COVID-19’s fatality rate. It is important to note: There has been progress on these fronts.
- The US is positioned to begin reopening because a better handle on COVID-19 “uncertainties” has been established.
As of early May, over 80,000 deaths have occurred in the US as a result of COVID-19. This is without question a national tragedy. Remaining mindful of pandemic victims and their families is as important as recognizing that American healthcare professionals have proven they can handle the outbreak. Nurses, doctors, administrators, paramedics and frontline workers of all kinds have saved thousands of lives and helped to prove that COVID-19’s fatality rate is lower than was initially feared. They deserve our appreciation and thanks.
The effort made by healthcare workers to stem the tide of cases has been vital, and its importance cannot be overstated. The suggestion that the US requires vast improvements in testing and contract tracing has been widely discussed. While important, it seems likely that the US is too large to successfully implement a testing and tracing system comparable to South Korea’s. Moreover, the country’s deeply held traditions of civil liberty make the prospect of implementing more intrusive contact tracing initiatives, as well as continued or expanded state-mandated containment measures, politically daunting. The health risks related to COVID-19 are real – continued adherence to social distancing measures, handwashing protocols, and the use of masks are crucial components of containing further spread of the virus. However, we believe markets have priced in a second wave of cases and begun to account for the ability of the healthcare system to contend with it. Of note here is that in some states hospitals are starting to implement road maps for bringing elective procedures back online.
Slow and Steady
Reopening from the lockdown will be slow and measured. This isn’t going to be like Black Friday. Restrictions will remain in place and they will be lifted with caution in the attempt to slow the spread of a second wave. While no one is expecting 100% across-the-board participation in containment measures like handwashing and face masks, awareness about the dangers of the disease and how it spreads has increased exponentially. It is likely that the hardest hit areas of the country will be better at self-policing for COVID-19 than areas that were spared the worst of the outbreak. There is evidence that the virus may have been in the US earlier than initially thought. As a result, it’s possible that the number of people who have been infected by the virus is higher than we know, including asymptomatic cases or cases presenting only minor symptoms. This is not to discount the serious health risks associated with COVID-19 – this is not just “the flu” – it only means that important work on how the disease spreads and manifests continues.
Maintaining Risk Mindfulness
While the situation remains fluid, we believe as of late spring that unless we see things turn more dire – including an increase in COVID-19’s lethality or evidence of a renewed strain on healthcare systems – a measured nationwide reopening will continue through the end of the year. The experience of the last few months has the potential to help address and contain a significant second wave of cases, allowing for a gradual reopening and the establishment of a “new normal” carry on. The stock market is not the economy. Large index players appear to be virtually unaffected by COVID-19, and they are likely large enough to play a role in holding up the broader market. While we believe we will see business failures, we do not believe they will occur on a scale that significantly threatens the long-term survival of the US economy. In addition, the number of the COVID-19 business closures could be contained in part by merger and acquisition activity in a world where distressed managers are looking to sell. In the meantime, risks that we are watching include:
- Increasing political partisanship around federal aid dollars as the November 2020 US elections draw nearer.
Should legislators decide that politics are more important than the economy and start to split hairs on further support – particularly support for state and local governments – a multitude of problems could follow. If partisan tension ratchets up, the market might force Congress to react.
- An unexpected and significant increase in fatality rates.
As discussed above, there is evidence that healthcare systems can handle large numbers of COVID-19 cases in terms of treatment. Nonetheless, evidence of increasing virus lethality has the potential to reverse hard-fought gains.
- Consumers and business retrench.
The COVID-19 experience is unparalleled in a modern economy – nobody can say for sure how consumer spending might look coming out the other end of the crisis, or know in advance exactly how the allocation of capital on the part of businesses might change.
- The liquidity backdrop tightens.
While it’s impossible to say exactly how or why this might happen, that it occurred at the beginning of the crisis served as a surprise for many. The Fed remains on high alert and is in “whatever it takes” mode to prevent a credit crunch from happening. So far, the Fed’s actions have proven successful and that’s commendable.
- Market sentiment and positioning becomes “offside bullish.”
By “offside bullish” we mean an overestimated recovery. Admittedly, we are a very long way from this as of early May – but we believe it’s worth keeping in mind. To take one example, the March selloff saw over $100 billion redeemed out1 of ETF2 and Long-Only3 equities. During the mid-April bounce, they saw $20 billion come back in. In the weeks since, $20 billion has gone back out. In case you’re not keeping score, that’s $0 back in during the recovery – not exactly bullish.
Plenty of unknowns remain, as do a multitude of risks. Life as we know it has changed drastically over the last few months, and for many – including frontline responders – this has been a period of chaos and heartbreak. Still, much work has been done to answer the call, and this work continues. Regardless of whether or not you take a bull or bear perspective on the remainder of 2020, our guess is you’re doing so with a bit more humility and gratitude.
2 An exchange-traded fund, or ETF, is a marketable security that tracks an index, commodity, bonds, or a basket of assets like an index fund. ETFs trade like common stock on a stock exchange and experience price fluctuations throughout the day as they are bought and sold.
3 Equity Long-Only or Long-Only equities is a type of investment strategy that utilizes only long positions in the assets it owns, with “long” referring to the expectation that the asset (stock, commodity, or currency) will rise in value over time. This approach is used by many hedge funds.