Financial panics occur when investors sell what they can, not what they want to. And that happens when they can’t finance their positions. Credit remains freely available for sound borrowers, and the rise in the cost of credit has been orderly – except for energy companies below investment grade.
There is no sign of sudden liquidation from popular exchange-traded funds that buy high yield debt, despite steep price declines. Equity multiples shrank and probably will shrink further as the market prices in a mild recession during 2020. But that’s a far cry from 2008, when major banks levered US$2 trillion worth of phony AAA-rated securities 60-to-one.
The stock market’s 15% fall from its February peak is painful, but not panicky. The coronavirus probably will cause a mild contraction of US economic activity during the second and third quarters, as travel and hospitality businesses shrink, consumers avoid shopping malls, and Americans, in general, save rather than spend as a precaution.
Consumer spending was the only significant source of US growth during 2019, as investment and manufacturing shrank in response to the incipient trade war. Strong economic data for the first two months of 2020, including an exceptionally large increase in February employment, indicated that the US economy was improving after the conclusion of a “Phase One” trade deal with China – before the coronavirus problem emerged.
Collapsing oil prices are a net negative for the economy, because a large part of the energy sector will suspend operations and cancel orders for capital equipment. But they also put more money into consumers’ pockets, so the overall impact will be limited.
As the chart shows, the cost of high-yield credit has risen sharply, but it remains within a longstanding historical range – except for energy, which blew up as the oil price collapsed. Companies with less-than-investment-grade ratings can still borrow at an all-in cost of 4% to 6%, extremely low by historical standards, given the extremely low overall level of interest rates.
The spread between LIBOR and investment-grade bonds jumped from around 0.4% to 1.2% during the past few days, which means that the total cost of borrowing for investment-grade companies is below 2% (with the 10-year yield at only 0.5%). That is still a record low for corporate borrowing costs. Investment-grade bonds are trading in a liquid market, and their prices track the Treasury market.
The stock market priced in a perfect world, and now it is pricing a less-than-perfect world. In late February the trailing price-earnings ratio of the S&P 500 Index was above 22. It now stands at around 19. The long-term average is 16.62. Given that the dividend yield of the S&P 500 of 1.8% now exceeds the yield on the 10-Year Treasury note by 1%, and is roughly equal to the yield on 10-year investment-grade corporate bonds, equities are not particularly rich. That suggest that once the smoke clears from the coronavirus problem, there will be good reason to buy equities.
There is even better reason to buy Chinese equities with strong businesses (especially in technology) that have little debt and strong domestic markets.
A great deal can go wrong from here, to be sure. If the prospect of a mild recession increases the chance that Sen. Bernie Sanders might win the presidency, there will be good reason to panic. But for the time being, the damage is foreseeable and limited, and markets are pricing it rationally.