Please take a moment to read ‘The Path Forward’, by Jim Allworth, Portfolio Strategist, RBC Dominion Securities.

The content provides a clear and concise view of events impacting financial markets over the last quarter and some thoughts for the future.

The Path Forward

It has been a very difficult couple of months with the well-being of our loved ones foremost in everyone’s minds. Much more than usual, there remains great investor uncertainty. We are paying close attention to markets and the underlying factors affecting the economic and earnings outlook. The economic news directly ahead will be unsettling but our forecast has the effects of the epidemic waning in the second half permitting investors to focus their attention on the prospects for a resumption of stronger growth in 2021.

How did we get here?

In January, despite the emerging COVID-19 virus epidemic in China, stock markets in North America kept climbing. In mid-February share prices turned lower as worries mounted that Chinese lockdowns would disrupt supply chains into North America.

In March the market downturn accelerated as outbreaks in Italy and Iran raised the prospect of a North American epidemic that would slow the economy to a much greater degree than any collateral damage from China. Ironically this realization was arriving just as China was restarting its economy, having brought the infection rate down to a much less threatening level.

Markets swooned because the outlook for the economy and corporate earnings has worsened swiftly over the past two months, precipitated by the spread of the COVID-19 virus and the collapse of oil prices.

Oil toil

First, the oil price situation. In March, Russia declined to participate in a proposed OPEC+ production cutback designed to shore up crude prices under pressure from excess end-product inventories and falling global demand.

Russia argued that previous production cuts had done no more than keep crude prices high enough to enable U.S. shale producers to fill the gap. Better to let prices fall far enough to force the shale drillers, many financed by debt and very few generating positive free cash flow, off the stage for good.

In an attempt to bring Russia back to the table, Saudi Arabia boosted its production by 2.5 million barrels per day, sending prices from the weak $40s down into the catastrophic $20s. That would normally put more discretionary disposable income into the hands of U.S. and Canadian consumers while stimulating more demand for gasoline. However, both effects have been largely offset by the fact that kilometres driven and discretionary spending are both weakening in response to the COVID-19 virus epidemic.

Russia, with a much lower all-in breakeven cost and a floating currency, may have more staying power than Saudi Arabia. The June OPEC meeting looks like the earliest opportunity to resolve this dispute but our commodities team believes that may stretch out into the fall. Massive crude inventories, slashed energy company development budgets, industry bankruptcies – will take an even longer time to resolve.

The oil price collapse made lenders unwilling to extend credit to the energy sector – at a time when they have been backing away from lending to travel-related businesses among others, raising the spectre of a more widespread tightening of credit conditions, damaging global growth prospects further. Massive policy shifts by central banks have been designed to alleviate this pressure. Proposed government-backed loan guarantees could help further.

COVID-19 response

Which gets us to the COVID-19 virus. “Social distancing” intended to “flatten the curve” comes at great economic cost. The fiscal responses of the Canadian and U.S. governments are designed to put a floor under the second quarter by keeping consumers and businesses financially viable through the period of maximum economic constriction.

Implicit is the idea that infection rates and the number of daily new cases should be in decline in both countries well before that quarter ends, raising a realistic prospect of social and commercial conditions improving in the third quarter with a more pronounced rebound evident in the fourth. That is our expectation.

China was able to restart its economy within a few weeks of its infection rate (i.e., how many people one person with the virus is likely to infect) falling below 1. South Korea, surprised by an explosive outbreak in late February, has pulled its “new daily cases” from close 1,000 down to less than 100 in just a few weeks.

Any sign of slowing in Italy’s runaway epidemic as well as indications that “social distancing” was having a positive effect would be welcome.

In flux

The trajectory we are looking for – the number of cases peak in April/May, then recede May/June and throughout the summer, is only one out of many potential outcomes. The “wishing and hoping” scenario – peaks sooner, recedes faster – seems unlikely to materialize. The “slower to peak and to recede” version would deepen the economic impact and likely produce a further round of government rescue/stimulus.

Two up legs to the pandemic, with the second beginning this fall and carrying into next spring, would not be unusual from an historical perspective – the Spanish Flu had three waves – raising the possibility 2021 might experience another period of economic contraction.

None of these scenarios, including our preferred one, can be said to be the obvious, odds-on favourite, leaving the outlook for the economy and earnings very much in flux in the short term.

The “value” of the market is the present value of all future earnings. Looked at that way, even big unexpected changes in the near-term earnings outlook shouldn’t have a large impact on the market value of corporations. But they usually do because, for a while, investors come to believe that the performance of the economy and market today are pointing to an altered trajectory for economic and earnings growth in the future.

Looking for positives

Looking back at a century of pandemics, wars, nuclear disasters and more, that sort of conclusion has not been useful. Within a year or two, the forces of global population growth and rising prosperity would reassert themselves and before that stock markets would go back to capitalizing future earnings appropriately.

We find ourselves in a period of near-term uncertainty. The path the pandemic takes from here, and the success of the fiscal and financial measures taken to mitigate the damage, are largely unknown. Some very unpalatable economic data will arrive over the next few months that could produce more investor concern.

However, we expect some combination of an easing in the progress of the pandemic, together with signs the policy response is having the desired effect, will allow the market to regain its composure by permitting investors to focus on improving prospects for 2021.