Americas CIO View

COVID-19 prevention: an unprecedented global economic shock

Prioritizing prevention over production: expect a sharp but brief recession

Many cities and institutions around the world are putting prevention over production. They are curtailing large group activities through March or longer to contain the virus. Local actions and the Federal 30-day U.S. travel ban to or from Europe and parts of Asia are tremendous global economic shocks that will bring giant short-term supply and demand-side destruction. Disruptions comparable or worse than after September 11, 2001 and the onset of the financial crisis in late 2008. However, this shock and economic downturn should be brief; with no subsequent wars or extended balance-sheet repair. Gross-domestic-product (GDP) growth should rebound strongly in the back half of 2020.
Moreover, we think this economic shock will be less damaging to S&P 500 profits than past recessions; because the disruptions from this health-security shock are tilted toward in person services. Whereas, the S&P 500 is tilted toward virtual economy or electronic and automated services, such as technology, communications, and internet retailing; which are about a third of S&P 500 profits. Virtual services and essential goods and services from health care, consumer staples and utilities are now about half of S&P 500 profits. Although heavy manufacturing and financial services are still important earnings contributors, they are much smaller than historically, energy is minor, and a 2008 like surge in mortgage defaults and financial-system distress is unlikely.

We cut our 2020E S&P 500 EPS to 150 dollars, down 10% vs. 2019, down 20% in the first half

We expect S&P 500 earnings per share (EPS) to fall about 10% to 150 dollars in 2020 from 164 dollars in 2019. We expect the first half of 2020 S&P 500 level to be down 15-20% year-over-year, followed by flattish earnings in the second half. Our quarterly S&P 500 EPS estimates are: 33+34+41+42 = 150 dollars. We introduce 2021E (expected) S&P 500 EPS of 171 dollars. Adjusting for a lower interest rate, oil price and related capex outlook, we now estimate normalized 2020 S&P 500 EPS at 160-170 dollars. When recessions occur, long-term investors focus on normalized or recovery EPS to gauge valuations. Metrics such as S&P 500 EPS excluding negatives are also used. Although negative earnings might threaten bankruptcy at some companies, they are not perpetual and mask the earnings power of the index. We expect big first half of 2020 losses at S&P 500 airlines, energy, hotels (inc. cruise, casino operators). We expect huge profit declines at S&P 500 retailers, restaurants, auto, transports and aircraft. Many industries will receive government liquidity and liability support and regulatory and creditor forbearance.
During the recessions of 1982, 1991, 2001, S&P 500 EPS fell near 20% from its four-quarter peak to trough. Declines were led by 25-50% plunges at energy, materials, and industrials. Each large sectors back then. Technology and consumer-discretionary earnings fell less than those sectors, yet more than the S&P 500 average, but mostly from tech hardware and auto, which are much smaller parts of these two sectors today. Except in 2008-2009, when S&P 500 EPS fell 45% led by financials, financial-sector earnings, especially banks, usually do not fall more than the index average.

We cut S&P 500 2020 end target to 3100, 18.75 times 2020 normalized S&P 500 EPS

The S&P 500 fell 27% from its 3386 February 19 peak to its recent 2480 trough, among its steepest declines in history. At Friday's 2711 closing price, the S&P 500 is right on the -20% bear-market line. We expect the S&P 500 to revisit its lows near-term, quite possibly lower, but then trade in a large range between 2500-3000 until the U.S. election. We consider 18-20 times trailing normalized earnings to be fair given low interest rates, low investment fees and a higher quality sector mix of the S&P 500 vs. history. Our intrinsic fair value estimate for the S&P 500 at 2020 end is 3150, our yearend target is 3100 and our 12-month target out to March 2021 end is 3200.

Fourth quarter S&P 500 EPS likely 40 dollars plus, but uncertain and valuations are repricing for risks

Feasibility and visibility of normalized earnings estimates will be crucial to navigating this market. Our sector preferences tilt toward attractive valuations on normalized earnings where we have better confidence in our normalized earnings estimates. Our confidence is badly shaken at industrials, materials and financials. Our confidence is shattered at energy. Our 150 dollars 2020E S&P 500 EPS includes just one dollar from energy. Energy's normal S&P 500 EPS is roughly 6 dollars or just 3.5%. Consumer discretionary, excluding internet retail, and airlines within industrials are hit the hardest by this in-person delivered services shock to the economy. Here uncertainty is less about the level of normalized earnings, but rather when a return to normal occurs. Consumer-discretionary stocks will likely be most sensitive to domestic virus developments.

A different type of recovery will occur: return to work will be priority soon

We expect unemployment and jobless claims to temporarily jump, in part on expanded eligibility for those at shut workplaces. But provided new daily infections plateau in coming weeks on preventions, we think many businesses and employees will begin to shift their priorities back to production and seek safe ways to return to work with precautions. Frequent hand washing, facility sanitizing, distancing, masks, and temperature checks will most likely be the new norm. But not going to work is unsustainable in the long term in our opinion.

Appendix: Performance over the past 5 years (12-month periods)

 

02/15 - 02/16

02/16 - 02/17

02/17 - 02/18

02/18 - 02/19

02/19 - 02/20

S&P 500

-6.2%

25.0%

17.1%

4.7%

8.2%

Past performance is not indicative of future returns.
Sources: Bloomberg Finance L.P., DWS Investment GmbH as of 3/16/20

 

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