Market Volatility Explained

by | March 18, 2020

This morning, March 18th, global equity markets are again in steep decline, despite the stepped up fiscal and monetary commitments announced in the past few days. Although the policy steps to address the pandemic and its economic consequences are becoming more realistic, they are likely not enough to stabilize markets for two reasons.

First, few can doubt there will be a global recession. The annualized decline in world output in the first half of this year is likely to be larger than at any time since the 1930s, exceeding that of the Great Recession. The evidence is already arriving based on early first quarter Chinese data (where the pandemic first appeared), and in light of the public health measures adopted around the world in the past week.

As a consequence, the decline in global corporate profits over the next few quarters will at least rival that of the dotcom bust or the Global Financial Crisis, but will be much more widespread. Very few companies will avoid significant declines in earnings. The unknown totality of lower corporate profits will continue to drive market volatility.

Second, despite central bank and other policy efforts to support credit markets, numerous companies will suffer ratings downgrades as their earnings and cash flows come under pressure. Others will teeter on the edge of bankruptcy. Government guarantees may save some firms from insolvency, but credit markets can’t be sure which firms, apart from major airlines, will be bailed out. Credit markets are therefore prone to sell-offs, which could be exacerbated by poor liquidity.

How far can equity markets still fall?

The current price-to-earnings ratio (P/E) on the US S&P 500 index is just over 16, roughly on par with its century-long average. It is difficult to believe that valuations should trade near long-term norms in today’s uncertain conditions. It is clear that stocks remain vulnerable to valuation downside. 

Also, as noted above, corporate earnings will fall sharply. The parallels from the financial crisis or the dotcom period suggest that earnings per share could drop 30-50% this year. If so, and if the P/E falls to (for example) 15, then ‘fair value’ for the S&P 500 resides near 1750, well below its current index level of 2325.

Global stock markets could easily fall another 20-30% from here.

As for bonds, yields are climbing. This may be linked to expected government deficits stemming from planned tax cuts, spending increases and personal transfer. But some of the pressure on interest rates may also be related to strong borrowing demand as companies rush to bolster their cash balances by borrowing while they can.

Either way, the challenge of rising yields can be solved by central banks going ‘all in’ by increasing significantly their purchases of bonds. Expectations that central banks will intervene should cap the rise in bond yields before long.

Filed Under: Economics

About the Authors

Larry Hatheway

Larry Hatheway has over 25 years experience as an economist and multi-asset investment professional. He is co-founder, with Alexander Friedman, of Jackson Hole Economics, LLC, which offers commentary and analysis on the global economy, policy & politics, and their broad implications for capital markets. Prior to co-founding Jackson Hole Economics, LLC Larry worked at GAM Investments from 2015-2019 as Group Chief Economist and Global Head of Investment Solutions, where he was responsible for a team of 50 investment professionals managing over $10bn in assets. While at GAM, Larry authored numerous articles on the world economy, policy-making and multi-asset investment strategy. Larry was also the lead investment manager for various mandates, funds and an actively managed multi-asset index. Larry also served on the GAM Group Management Board, was Chairman of the GAM London Limited Board and served as member of the GAM Investment Management Limited Board. Larry was also Chairman of the GAM Diversity & Inclusion Committee. During his tenure at GAM, Larry was based in London, UK and Zurich, Switzerland. From 1992 until 2015 Larry worked at UBS Investment Bank as UBS Chief Economist (2005-2015), Head of Global Asset Allocation (2001-2012), Global Head of Fixed Income and Currency Strategy (1998-2001), Chief Economist, Asia (1995-1998) and Senior International Economist (1992-1995). During his tenure at UBS, Larry was also a standing member of the UBS Wealth Management Investment Committee. While at UBS, Larry worked in Zurich, Switzerland, London, UK (various occasions), Singapore and Stamford, CT. At both GAM Investments and UBS Investment Bank Larry was widely recognized for his appearances on Bloomberg TV, CNBC, the BBC, CNN and other media outlets. He frequently published articles and opinion pieces for Bloomberg, CNBC, Project Syndicate, and The Financial Times, among others. Before joining UBS in 1992, Larry held roles at the Federal Reserve (Board of Governors), Citibank and Manufacturers Hanover Trust. Larry Hatheway holds a PhD in Economics from the University of Texas, an MA in International Studies from the Johns Hopkins University, and a BA in History and German from Whitman College. Larry is married with four grown children and a loving Cairn Terrier, and resides in Wilson, WY.

Alex Friedman

Alex Friedman is the co-founder of Jackson Hole Economics, LLC, a private research organization which provides analysis on economics, politics, the environment and finance, and develops actionable ideas for how sustainable growth can be achieved. Friedman is a senior leader with two decades of experience growing and transforming organizations in the financial and non-profit industry. He was the CEO of GAM Investments in London and chairman of the firm’s executive board. Previously, he was the Global Chief Investment Officer of UBS Wealth Management in Zurich, chairman of the UBS global investment committee, and a member of the executive board of the private bank. Before moving to UBS, Alex Friedman served as the Chief Financial Officer of the Bill & Melinda Gates Foundation. He was a member of the foundation’s management committee, oversaw strategic planning, and managed a range of the day-to-day operating functions of the world’s largest philanthropic organization. Friedman also created the foundation’s program-related investments group, the largest impact investing philanthropic fund in the world. He started his career in corporate finance at Lazard. Friedman served as a White House Fellow in the Clinton administration and as an assistant to the U.S. Secretary of Defense. He is a member of the board of directors of Franklin Resources, Inc. (Franklin Templeton), a member of the Council on Foreign Relations, Chairman of the Advisory Board of Project Syndicate and a board member of the American Alpine Club. Friedman is a regular contributor to a range of newspapers and thought leadership groups and is also the author of Babu’s Bindi, and The Big Thing, both children’s books. He is an avid mountaineer and rock climber and led the first major climb to raise money for charity through an ascent of Mt. McKinley. Friedman holds a JD from Columbia Law School, where he was a Harlan Fiske Stone Scholar, an MBA from Columbia Business School, and a BA from Princeton University.

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