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COVID-19 crisis - scenarios for the next phase

Although uncertainty about the future is extremely high, it is helpful to consider scenarios that may play out from here.

From a financial market perspective, the variables that dictate the duration and depth of this bear market are clear:

  1. The success of the lockdown in achieving a peak in the number of deaths for this wave of infections.
  2. The speed with which the authorities can release the lockdown.
  3. The degree to which the economic damage is seen as cyclical rather than structural, which will largely be a function of the above two points.

Scenario 1

It is perfectly possible to argue that we have already seen market lows - or at least been close to them - if the Wuhan path is repeated globally, given both the speed and savage nature of the sell-off (a rather neat 38% fall for the Dow - a very clear Fibonacci line). If this is the case, while we will see further volatility as the death toll rises in the short term, the economic damage will be limited; not only that, the addition of monetary and fiscal fuel will have the effect of goosing risk assets higher.

Scenario 2

Alternatively, we could see a summer lull before the virus returns with a vengeance in the autumn/winter and we are forced into a repeat of the lockdown. This causes far more economic damage and we would face the prospect of round 2 of the bear market, which slides all the way into next spring, when another corner will have been turned. This could be the final low, because by then, many more of us will have been infected and health services - at least in the developed world - will have been resourced to cope.

Outlying scenarios

  1. The herd has been infected far more quickly than we realise and cannot be re-infected - scenario 1 applies.
  2. The disease returns rapidly after lockdowns end - scenario 2 applies.
  3. While the developed world manages to suppress the illness, the emerging world is ravaged by the pandemic - scenario 2 applies, at least for earnings globally.
  4. A vaccine is found which assists with the fight against the virus - risk assets will take off.

Earnings declines, P/E multiples and index levels

The economy is facing an unprecedented “stop” in activity.  The scale of the hit to corporate earnings will be severe but is, as yet, unknown.  It is instructive to consider how a significant cut to forward EPS might impact equities.

The table below considers the S&P 500 index in this context.  At the time of writing, the S&P 500 index level is 2,470.  Based upon the maths of earnings declines of 0%, 10%, 20%, 25% and 32%, we can see the implied index levels at various P/E multiples:

12m fwd EPS $120 $132 $140 $160 $176
P/E multiple -32% EPS -25% EPS -20% EPS -10% EPS +0% EPS
9x 1,080 1,188 1,260 1,440 1,584
11x 1,320 1,452 1,540 1,760 1,936
13x 1,560 1,716 1,820 2,080 2,288
15x 1,800 1,980 2,100 2,400 2,640
17x 2,040 2,244 2,380 2,720 2,992


Source: Bank of America Global Investment Strategy

Generally, strategists are converging on a 25% earnings cut for 2020.  If we assume scenario 1, as described above, a significant contraction in the P/E multiple is unlikely, as investors would look through the short-term disruption.  The P/E of the S&P 500 index began the year on a 19x forward earnings multiple, and we would expect this to fall to the long-term average, which is just under 15x.

A return of the virus in the autumn would see investors pricing in a second round of economic dislocation, resulting in concern for 2021 earnings.  In these circumstances, we would expect investors to de-rate the market, leading to a material contraction in the P/E multiple; realistically, a low double-digit P/E (11-13x) is entirely possible.  Clearly, this would represent a material fall in the S&P 500 index compared to today’s level.

Fortunately, the starting P/E multiples for other world markets are much lower; as at the time of writing, the P/E multiple of the FTSE 100 is around 13x.  That said, when the US is under pressure, it is difficult to envisage other equity markets bucking the trend.

Credit markets

With reference to fixed income, scenario 1 would not see a significant rise in spreads much beyond what we have seen already, particularly in view of the liquidity that central banks are pumping through the system.  In scenario 2, there would be another deterioration in the debt profile of corporates and individuals, which would see further losses in high yield and the risk of additional widening of investment grade spreads.

Peter Toogood, Chief Investment Officer, The Adviser Centre Limited and Embark Group

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