How should investors make sense of the recent dramatic gyrations in stock and bond markets in the context of the phenomenal spread of covid-19? Our macro-based models suggest that the equity market correction and decline in real bond yields were for the most part consistent with markets pricing in, over the past year, a trending rise in uncertainty about a low and stagnant long-term real economic growth. One way to think about the effects of Covid-19 is that it is an additional source of uncertainty.
As shown in Exhibit 1, US equity markets lost about 28% of their value from February 19th to March 24th, erasing all gains from the past year – a drawdown all too reminiscent of the first market losses in October 2008. At the same time the VIX, a measure of short-term risk or stock return variability over therecent past, shot up and more than quadrupled from its near historical lows of 14 to about 60, peaking at 82 on March 16th- around the highest values reached during the 2008 global financial crisis! Of course, these figures will change daily, and possibly in an extreme way.
As for bond markets, according to Exhibit 2, the yield on US 10-year real bonds (TIPS) experienced a roller coaster ride. Following a year of continued decline, the yield went below zero on January 28th and fell further about 57bps through March 6th. It then bounced back to 62bps on March 19th before dropping again the following day and through March 24th near but below zero at -13bps.
How should investors approach these wild gyrations in markets and understand the nature of uncertainties they are signaling? To grapple with these issues, investors should keep their focus on the long-term drivers of economic growth. In particular, the question boils down to whether or not such short-term changes in markets price in higher uncertainties about long-term, real economic growth. To us, the implication is that the transmission of Covid-19 to the economy and markets depends on whether the economic shocks last for long periods of time.
Exhibit 3 shows how our macro-based models that link macroeconomic fundamentals to asset values in a consistent fashion can help better understand these complex connections. According to our models, macroeconomic uncertainty about relatively low and stagnant real economic growth has been increased by about 50% since March 2017. Although this increase is significant, it still pales relative to the experience of the 2008 Global Financial Crisis. Our models also suggest that recent market moves are consistent with markets pricing in this rising uncertainty. In some sense, the surprise could be not that equity markets sold off, but rather that they took so long to do so.
As for bond markets, the trending decline in real yields is consistent with investors’ demand for insurance in the face of higher uncertainty about long-term growth. The past week’s surge in yields reflects monetary policy responses to help mitigate a possibly acute liquidity crunch leading to solvency crises similar to the 2008 experience, with sudden flows into shorter maturity bonds and money markets to address short-term funding needs.
Of course, the appearance of covid-19 and the policy responses to it add uncertainty about long-term growth. Our models provide insights into the key drivers of long-term trend economic growth: growth in the labor force (workers) and growth in total factor productivity (TFP). The latter reflects the impact of innovation and efficient allocation of resources on economic growth, after taking into account the effect of capital and labor. Both the growth in active population and in TFP have remained relatively low since the 2008 global financial crisis compared to their historical average trend. And TFP growth has been stubbornly stagnant.
Going forward, the key question for investors is whether or not covid-19 will have a lasting negative impact on labor force growth and TFP growth. Unfortunately, the timing of the resolution of this risk is itself uncertain, with potential consequences at this stage that are hard to measure! In such situations, investors are well advised to continue monitor signals to changes in the drivers of long-term growth. Some analysts are already revising their growth expectations to reflect a severe downturn spread over both the current and the next quarter. Our models indicate that increases in uncertainty could lead to further corrections in the equity market, with real bond yields skimming at near-zero levels or below for a prolonged period of time. Subsequent notes will explore alternative scenarios of growth and uncertainty in the US and other major economies including China, along with their impact on returns.
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