Our quarterly S&P 500 forecast for 2024 Q2 (average price returns) indicates a 7.2 percent increase over the first quarter of 2024. Our monthly forecast for April is slightly higher than March’s average. Geopolitical problems such as the Russia-Ukraine, the Red Sea crisis, and the Gaza conflict cannot be captured in a forecast model. Thus, any uncertainty concerning these issues makes the 95 % confidence interval around the point forecast rather wide.
Our monthly S&P 500 forecast for April is a 1.55 percent increase over the average of March.
The model-based forecast takes into account the changes in oil prices and yield spreads. However, a forecast model cannot possibly capture the full impact of the uncertainty caused by the war in Ukraine, escalating tensions in Gaza or the Red Sea crisis.
Our prediction for June, based on our econometric model for the US non-farm payrolls is 940, 000. This is well above the market analysts’ prediction of 700,000. Our monthly forecast for the SP 500 index reflects this improvement in job creation.
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Last Thursday the S&P 500 index posted its worst one-day drop since March 16. The markets turned bearish as the reopening of the economy caused concerns about a second wave of the pandemic. Investors were worried that some US states may have to re-impose lockdowns because of the spikes in coronavirus cases. What we have is a pandemic-indexed S&P 500 nowadays, rising or falling with Covid news.
This week the market sentiment has been lifted with several positive economic news: The advance retail sales in May (both seasonally and inflation adjusted) posted 17.7 percent increase over April. The market’s expectation was less than 10 percent monthly growth. The retail sales were only 6.3 percent below the level of May 2019.
Another positive development was on the job front. According to the US Department of Labor press release, the downward trend of unemployment insurance claims continues. In the week ending June 6, the advance figure for seasonally adjusted initial claims was 1,542,000, a decrease of 355,000 from the previous week’s revised level.
In addition to these early signs of economic recovery, there has been a report about a drug (dexamethasone) as an effective treatment for the Covid-19 patients. The news let the S&P 500 index to rally in the last two days. It is inevitable that the markets will be swayed by news related to treatment options or potential vaccines till the pandemic is fully contained.
From the policy-makers side, two developments have contributed to the bullish sentiment of this week. Firstly, the Trump administration proposed a $1 trillion infrastructure plan. We think this plan signals markets the government’s commitment to doing whatever it takes to make a quick recovery possible. Forcing a ‘U’ shaped recovery to a ‘V-shaped’ one is a challenging task. Therefore, as a second measure, the Fed announced that it would buy individual corporate bonds on the secondary market. These bonds should have remaining maturities of five years or less. This move comes on top of the Secondary Market Corporate Credit Facility. The Fed was already purchasing exchange-traded funds which include investment-grade and some high-yield corporate debt.
We believe that the Fed’s purchases of the corporate bonds in the secondary market will support the tightening in credit spreads. Our monthly forecast for high yield spreads was already indicating tightening in June . We think the extra liquidity owing to the expansion of the bond-buying program might lead to further spread-tightening in coming weeks.
Is the S&P 500 index out of whack with the economic reality? You can bet on it. Yes, the index has a big chunk of tech firms that continue to do well (26%). Yes, there is optimism with regard to relaxation of the lockdowns. Despite these positives, the vast majority of US firms hit the doldrums. As the audible warning on the London underground says, we should indeed “Mind the gap” between the irrational rallies of the S&P 500 and the plunge in the economic output.
In the US, total non-farm payroll employment fell by 20.5 million in April, and the unemployment rate rose to 14.7 percent according to the U.S. Bureau of Labor Statistics‘s report. This is the highest rate in the history of the series since 1948. Likewise, the labor force participation rate decreased to 60.2 percent, the lowest observed rate since 1973. The US employment fell sharply in all major industry sectors, with particularly heavy job losses in leisure and hospitality.
Despite these grim employment data, the stock market remains somewhat exuberant. Some small investors feed frenzy by investing in stocks, believing in the ‘V-shaped recovery’ narrative. FOMO (fear of missing out) has a new meaning when people are forced to stay in. Nowadays it means the fear of missing out on making quick gains in the stock market. However, we find flaws in this logic. Mark Twain once said “History does not repeat itself but it often rhymes”. The extent of the impact of the coronavirus pandemic is often compared with the Great Depression era. What followed the stock market crash of October 1929 may have some implications for today. The chart below shows that there were also intermittent stock rallies between 1929 and 1933. Despite these temporary monthly gains for investors, the underlying downward trend reflected the dramatic economic downturn of the Great Depression era.
Federal Reserve Bank of Atlanta‘s GDPNow forecasting model provides a “nowcast” of the official estimate prior to its release by estimating GDP growth. US ‘GDP now’ estimates from May 8th are indicating a -34.9 percent drop for the current quarter. Our own base GDP estimate for 2020 Q2, was -25.6%. We had predicted a -11 percent GDP drop if the whole stimulus package could reach its spending target in 2020 Q2. This is rather a heroic assumption. Therefore, the second quarter may mark a worse reading. GDPNow current estimate is closer to our worst case scenario.
Our model based on fundamental economic indicators suggests that the S&P 500 index should fall rather than rally in May. Our corporate earnings forecasts are pessimistic. Based on the forecast company profits, we find the S&P 500 index overvalued, almost in the bubble territory. The P/E ratios are close to the heights of the dotcom bubble. The stock market is not just made of Amazon and Netflix. The health sector aside, the consumer-oriented industries and services, banking and energy sectors are expected to take the brunt of the current crisis.
The US Congress has passed a new Covid-19 relief package. The new aid bill totals $484 bn. With Thursday’s bill, the total relief package amounts to about $3 trillion. Apart from topping up the ‘Paycheck Protection Program’ with additional $310 bn, the new bill will allocate $75 bn to hospitals some of which will be used for Covid-19 testing.
The previous relief program was criticized for helping some large public companies, big restaurant chains. It remains to be seen if the new Covid-19 relief package will provide sufficient support for the SME companies.
We expect the new stimulus package to mitigate the second quarter drop in GDP. Our initial ex-relief package estimate for the quarterly drop in GDP is therefore, revised upwards. We estimate 11% GDP drop in 2020 Q2 after taking into account the latest stimulus bill.
Even after the lifting of the lockdown, the stock market is expected to stay volatile with sporadic bullish rallies. However, without a successful drug or vaccination, it is unlikely the US economy to spring back to the pre-coronavirus state swiftly. After the stock market crash of 1929, the Dow Jones Industrial Average index had also experienced short-lived bullish rallies. Nevertheless, the underlying trend remained downward until 1932 when the prices bottomed out. In order to have a sustainable recovery in the stock markets, there should be a convincing amelioration of consumer demand and corporate profits. If the ‘new normal’ imposes rules such as fewer tables in restaurants, empty seats in planes or cinemas, lower earnings may persist till 2021. We expect the supply and demand shocks to linger even in the third quarter as a result of the social-distancing rules.
Meanwhile the new initial unemployment claims in the week ending April 18, was 4.43 million. This brings the total number of jobless to 26.4 million since mid-March (source: U.S. Department of Labor). The prospect of some states planning to reopen and the 15.4% fall in the initial claims from the previous week led to a S&P 500 rally. We expect the April average of S&P 500 higher than March. The advance seasonally adjusted insured unemployment rate was 11.0 percent for the week ending April 11. This marks the highest level in the history of the seasonally adjusted series.
We believe that the downward trend in initial unemployment claim may continue as the US states relax the lock-down rules. The keyword search in Google trends for the word ‘unemployment’ has not yet demonstrated a convincing downturn. The chart below shows the index of clicks on the keyword ‘unemployment’ dramatically rising since March. The Covid-19 relief plan has not so far affected unemployment.
In the meantime, the oil price has also been grabbing headlines. Last Monday West Texas Intermediate crude oil price became negative – $36.96 a barrel from $18.31 on Friday (Source: FRED). This was largely caused by the technical factors in the oil futures market. In order to avoid the problem of storing actual oil, the expiring contracts forced the oil traders to drop the price to negative for one day. The price sprang back next day to $9. This unprecedented incident is alarming as it exposes the scale of the lack of demand in the oil market. Generally, oil price changes positively correlate with the stock market and the price of oil is a leading indicator for the stock market. Despite the historic deal between OPEC, its allies and Russia to curb production, the expected global downturn is too severe for the oil demand to recover any time soon.
The coronavirus pandemic continues to wreak havoc in markets. Almost a quarter of the world population is under lockdown. Economists are busy trying to estimate the damage to the world economy. The predictions so far indicate that the economic impact of coronavirus will be worse than the Great Recession of 2007-2008. Here, we use the income-side approach to GDP to assess the economic effects of Covid-19.
We use the Bureau of Economic Analysis (BEA) data on the components of the US Gross Domestic Income. Our focus is mainly on the ‘Compensation of Employees’ and the ‘Corporate Profits with inventory valuation and capital consumption adjustment’. We make a simplifying assumption that the rest of the components of the Gross domestic income will change in the same proportion as the profit component.
Our estimations yield the following scenarios:
Most economists use macroeconomic models based on the spending-side approach to GDP to come up with forecasts and predictions. This approach calculates GDP using the following formula: GDP = consumption + government spending + investment + net exports. The difficulty with the GDP spending side approach is the great uncertainty with regard to calculating the components of GDP. Do we know the extent of the shock to consumption, investment, exports and imports? The simple answer is no. The government spending is a policy instrument and we may have better knowledge of that. In contrast, the shock to the other components are harder to predict. Furthermore, macroeconomic model parameters come from an era that does not have a pandemic of a comparable size. This is because there is hardly any reliable economic data, for example from the Spanish flu era. As a result, pandemic simulations do not always yield realistic estimates for GDP.
Here we pursue a more direct, ‘income-approach’ to the prediction of GDP. We make assumptions about how the income components of GDP may be impacted by the current pandemic in certain sectors and then we aggregate over the whole economy. Our method is direct and pragmatic. By not relying on any parameters based on pre-pandemic era, our approach has an advantage over more sophisticated spending-side models .
The BEA data has a fairly detailed disaggregation of the industries and services for the years prior to 2018. Therefore, we use the sector distribution of incomes in 2017 to calculate the losses in 2019.
We use the following assumptions:
90% drop in compensation of employees and net surplus (profits) in the following sectors:
All the other sectors are assumed to have a 30% drop in incomes and profits. We assume that only one third of 2020 Q1’s incomes are affected as the major shock took place in March. We assume that the epidemic already peaks and starts abating in the third month of 2020 Q2. In other words, we assume the lockdowns to be over by June and the economy to be up and running. According to our estimates, the US economy is expected to experience a 26% drop in 2020 Q2. This shows that the coronavirus impact will be worse than the Great Recession. We use these growth estimates in our stock market forecasts .
It is difficult to compare the coronavirus pandemic with any of the historical events. The scale of the damage is many folds worse than the SARS epidemic of 2003-2004. A potential benchmark is the Spanish flu pandemic of 1918, that killed 20-50 million worldwide and almost 700,000 in the US. Although the mortality rates of the Spanish flu were comparable to the coronavirus (about 2%), the supply side shock of the Spanish flu was much more severe; the mortality rate was the highest for men below the age of 40, which created labour shortages and wage increases. Furthermore, it is impossible to disentangle of the economic impact of the WW1 from the pandemic. Finally, the scant economic data of the period makes it hard to conduct a reliable comparison of the impact on economic growth.
The data on real GDP growth in the post WWII era shows us that real GDP never contracted by more than 10% since 1958 Q1 (the Eisenhower Recession). The financial crisis (a.k.a. Great Recession) caused the second largest drop (-8.4%) in 2008 Q4. The quarterly drop in non-farm business sector employment was most severe (-6.4%) in 2009 Q3. Consequently, the US unemployment rate reached 10 %.
The expected impact of the Covid-19 on the US GDP growth is larger than that of the 2007-2008 financial crisis. One can consider the Great Depression of 1929-1932 as a possible benchmark. During the Great Depression period, which started with a stock market crash of October 29, 1929 (Black Tuesday), GDP contracted four years in a row (1930-1933) by 8.5%, 6.4%, 12.9% and 1.2%.
The stock market usually recovers well ahead of GDP as it was the case in the 1958 recession (see Fig 2). We do not have quarterly GDP numbers for the Great Depression, and the S&P 500 did not exist prior to 1957. Nevertheless, a similar pattern is observed in the annual data. Fig 3 shows the Dow Jones Industrials recovering by 1933 in a sharp V shaped movement after falling by nearly 50% in 1931. When Franklin D. Roosevelt took office in March 1933, GDP growth turned positive after years of deflation and 24.5% unemployment at its peak (source: Bureau of Labor Statistics).
The Great Depression period experienced dramatic drops in GDP that was never encountered in the downturns of the post war era. The Covid-19 crisis is likely to cause a quarterly contraction that is also severe by historical standards. However, in contrast to the Great Depression, where the banking system was very vulnerable to panic-driven bank-runs, the US banks are currently well-capitalized and well-supervised under the Dodd Frank Act. The financial regulation in the aftermath of the Great Recession made the US banking system much stronger.
Unlike the Great Depression era, the Fed has become accommodative very quickly and slashed the federal funds rate by 1.00 percentage points to a range of 0-0.25% in March. Further liquidity is on its way as the US senate agreed on a $2.2 trillion stimulus package, which includes offering $1,200 per adult and $500 per child dependent to most households as a blank check excluding high incomes. The United States has done this twice before during the Great Recession, and also in 2001, when the majority of Americans received a $300 check.
The ‘helicopter money’ type of stimulus to stimulate GDP growth is no doubt a more direct approach than the usual Keynesian policies such as cutting taxes. The influx of money for low-income people and for people with no incomes will create immediate relief in paying food and rent bills. However, the impact of the pandemic on consumer sentiment is different than that of an ordinary recession caused by a business cycle.
Currently, US consumers are anxious about their health and the future of their jobs. In the week ending March 28, the advance figure for seasonally adjusted initial claims was 6,648,000, an increase of 3,341,000 from the previous week’s revised level. This marks the highest level of seasonally adjusted initial claims in the history of the seasonally adjusted series (source: US Department of Labour). It is possible that some consumers will postpone spending until there is more certainty with regard to the pandemic. Postponing spending can trigger the Keynesian ‘Paradox of Thrift’, where increasing saving propensity might slow down economic recovery.
It is possible that our base scenario is not pessimistic enough and earnings and profits in the manufacturing sectors of the economy may drop more than 30%. As a plausibility check, one can refer to the reports from the Spanish flu. Because of the scarcity of economic data, a study by Thomas A. Garrett (2007) * used the newspaper articles from the fall of 1918 as anecdotal evidence for the economic impact of the pandemic. From these newspaper reports, it appears that commercial business had declined 40% or more. Our pessimistic scenario incidentally corresponds to a 40% drop in incomes and profits.
Clearly, the US economy in 2020 is quite different than the Spanish flu era. The service sector has outgrown manufacturing industries and the contribution of agriculture to GDP has become negligible over time. The service sector currently constitutes about 68% of the US GDP (source: BEA). The health care services aside, the Covid-19 crisis made a big negative impact on the service sector employment and the so-called ‘gig-economy’ (e.g. Uber drivers). As a result of the two to three month long lockdown on the major US cities, both the loss of output and employment are expected to exceed that of the global financial crisis.
Many economists believe in a sharp V shaped recovery in contrast to the global financial crisis where the recovery was slow. The problem with the coronavirus crisis is that it is both a demand-side and a supply-side shock. It is clear that the generous stimulus package of $2.2 trillion can only be effective if the spread of the virus is under control. One could argue that the US consumer sentiment is indexed to the spread of the virus. Consumer and investment spending can continue to stay dormant during uncertain times.
What seems clear is that the stock market would probably recover in a V-shaped manner. However, the current crisis may have a lasting impact on aggregate supply by reducing the demand for labor permanently. The lockdowns forced the economy to operate in a different fashion. It speeded up the digital transformation for some companies. The home-office phenomenon exposed the inefficient parts of the factors of production. It led to faster transition to labor-saving technologies. In the aftermath of the coronavirus crisis, the US companies will strive to increase their earnings for their shareholders. It is quite possible that a non-negligible part of the work force redundancies will be permanent.
Fig 4 shows that during the financial crisis of 2007-2008, profits recovered much quicker than the unemployment rate. The latter indeed peaked when the company earnings recorded its highest quarterly growth. We believe that the unemployment rate will likely to stay above 10 % till the end of 2020. Therefore, additional stimulus packages might be needed to reduce unemployment.
We may feel that ‘the Year of the Rat’ has brought upon us the plague of the decade, and amidst the doom and gloom, we brace ourselves for more bad economic news. We may have to look hard, but the sky is at its darkest before dawn. Here, let us focus on the silver linings of this dark Coronavirus (Covid-19) cloud. Putting a positive spin on things boosts morale and productivity. Below are some points that come to mind:
The roller coaster ride in the markets will likely to continue for some time. Today, the Bank of England announced a 50 basis point interest rate cut. President Donald Trump’s stimulus package, which includes a permanent payroll tax cut, attempts to mitigate the effects of the pandemic and the worst oil price rout in three decades. If the oil price does not recover, nearly 50% of the US shale industry might face bankruptcy.
We believe neither the rate cuts nor the pay-roll tax measures will be effective in dealing with the current crisis. If unemployment increases drastically because of the epidemic, the payroll-tax relief will become rather irrelevant. One has to have be employed for its relevance. Even if the US interest rates become negative, it is unlikely that the US consumers’ confidence will be restored till the pandemic shows clear signs of ebbing.
We think cutting the income tax rate for the lower income bracket may be more effective. Cutting taxes increases the budget deficit at least in the short term. Nevertheless, this may be a price worth paying given the enormity of the problem in hand.
The escalation of the crisis is so severe now, a short-selling ban on stocks may be necessary. The U.S. SEC Rule 201 restricts short selling for stocks that decline 10 percent from the previous day’s closing price. Given that we are going through extraordinary times where everything is put on hold, a short-selling ban might mitigate some of the value distraction in financial markets.
Six days ago, Russia and Turkey agreed to a ceasefire in Syria’s Idlib province after the escalation of violence, which left many Turkish and Syrian soldiers dead after the clashes. The volatility in the USD to Turkish Lira has relatively calmed down since then.
The emergency interest rate cuts by the Fed has helped the weak Turkish Lira somewhat. Another silver lining was the oil price crash from last Monday. Turkey is a net importer of oil. We believe that the efforts to control Turkish inflation will benefit from the recent reductions in the cost of fuel.
Another positive development was the fact that Turkey had escaped the global pandemic unscathed up to now. Now the bad news: today, it was announced that this is no longer the case. We believe that Turkey has had longer time to prepare for the coronavirus crisis . However, the tourism sector makes a big contribution to the Turkish economic growth. If the crisis escalates, it has the potential of turning ugly, pushing the Turkish economy into the doldrums.
