The Market’s Optimism is Naive

There Is No Rule Saying The Second Outbreak Has To Be Smaller Than The First. Just Ask The Spanish Flu

Common knowledge says if you want to know what going to happen in the future, just look at the markets. With regards to the COVID-19 epidemic, the markets have a good track record. They reacted earlier and more swiftly than the world’s politicians. Recently is has bounced back. Can it be trusted?

Remarkably, the market now sits only 3% lower than it was in June and a full 10% higher than it was only 18 months ago. The traders with the crystal ball are suggesting things will soon get back to normal. History suggests otherwise.

Traders have reason to be optimistic, cases in New York are starting to level off¹, and positive signs are showing in Europe with the number of new cases and deaths dropping over the weekend². The problem, however, is with the asymmetry to why they dropped in the first place.

Death and sickness were not the reasons that the market dropped. As much as I’m sure Wall Street heart weeps for their brothers and sisters in Italy, the real reason for the panic was the risk of government-imposed lockdown and a recession or worse. It is believed that China’s GDP contracted 10% in the first quarter, its first contraction since the cultural revolution over 40 years ago³. Italy and Europe, whose economies were struggling before the virus⁴, could fair much worse.

To improve the economy you need to lessen the lockdown. With the relaxation of laws comes great risk. There is no rule that states that the once you’ve flattened curve once, it can’t shoot straight back up.

The Second Wave of The Spanish Flu in The UK Was Far More Deadly — Source: NAP
The pattern repeats itself during the Swine Flu epidemic in the UK in 2009 — Source: Wikipedia

Now as cases drop behind sealed off borders, one has to wonder what’s next. The optimist has a lot on their side. This crisis blew out of control in secret. As millions went about their everyday lives, the virus multiplied and spread in the shadows. People went to football games, shook hands, hugged, went clubbing and coughed with an open mouth. This will never happen again. Countries and cities now full of people with immunity and governments are providing better and better testing capabilities every day. Summer is not the way, likely bringing with it some welcome relief. But does this mean that things will get back to normal?

Despite Italy’s huge outbreak, only 0.2% of the population have tested positive to the virus. Due to poor testing in the country, likely, the true number is 10x that amount⁵. However, 2% is still a long way below the threshold of 60% required for herd immunity⁶. While regions such as Lombardi that were smashed by the outbreak are likely to be able to partially re-open without significant risk of another uncontrolled outbreak. Can the same be said for Rome, Berlin, London, Brussels or Amsterdam?

Cities act like concentrated urban hubs from which the virus spreads. Unless significant herd immunity has been developed in all of these financial centres, restrictive, economically destructive laws must continue to be enforced until a vaccine is developed in 18 months time⁷. Only 0.07% of Lazio, the Italian region whose capital is Rome have tested positive to the virus and only 9% of tests returning positive results⁸. The dream of reduced transmission due to herd immunity in such cities will likely remain just that.

Without herd immunity, the only chance is that common-sense restrictions and social distancing will allow the economy to rebound slowly until a vaccine arrives around October 2021. Could dramatically increased testing rates and social changes halt the virus in its tracks? South Korea looks like a best-case scenario.

Source: OurWorldInData

Following an explosion of cases, Korea has reduced and then maintained a steady and low rate of infection while keeping the majority of factories, retail and restaurants open⁹.

Health officials would retrace patients’ movements using security camera footage, credit card records, even GPS data from their cars and cellphones. “We did our epidemiological investigations like police detectives,” — New York Times

Unfortunately, such infrastructure is unique to South Korea and other Asian countries such as Singapore, Taiwan & Hong Kong who all invested heavily in epidemic defence following deadly outbreaks of SARS and MERS. In Korea laws mandate that are registered with “real names and national registry numbers¹⁰” and can be tracked with precise accuracy by health officials. This combined with over 8 million CCTV’s, South Korea is a disease tracking, surveillance state like no other. Despite this, significantly disruptive measures such as closing all schools were still required.

Such an outlook could be viewed as a fanciful best-case scenario given that no western city on earth has the infrastructure that's comparable. Still, this dream holds a recession, as is likely the case for South Korea. Growth in the first quarter of 2020 was projected to be between -1.3% and -3.7% with little improvement on the horizon¹¹.

Back in America, Goldman Sachs & Morgan Stanely originally predicted that Q3 growth will be 19%¹² and 29%¹³ respectively. What they don't say is how they presume America will do infinitely better than South Korea without the technology or the political will. They say businesses can’t grow and invest in times of uncertainty, how is this for uncertainty?

— What percentage of the population are currently immune to the coronavirus?

— When will the vaccine be available?

— Will the virus mutate?

— Does immunity to the virus last?

— How will consumers respond to being locked in their rooms for 2 months

— Is it safe to start going to restaurants?

How will GDP grow at 30% when there is a huge chance the entire population live in fear. 70% of GDP in western economies is consumer-driven, without confidence, there is no economy.

Indeed, analysts at J.P. Morgan seem less optimistic.

The bank’s house view is that the unemployment rate will remain elevated at 8.5% during the second of the year, while the peak-to-trough decline in real U.S. GDP will be 10%, versus the 4% decline during the financial crisis. “And this is all assuming that the virus is history by June, which might prove significantly optimistic,” Matejka wrote (head of global equity strategy at J.P. Morgan) — Source:

If we are facing a prolonged recession, one must ask if the markets have priced this in after dropping 22% from their recent highs or 3% since last June. In 2018, 10% was wiped off the Dow Jones due to interest rate hikes and fears of a trade war. This was a period where the US economy had record unemployment and good GDP growth. These fears pale in comparison to the risks the real economy currently faces.

Source: CNN

There is a very real risk or continued economic atrophy and a prolonged recession. Even when it becomes safe and a vaccine is developed, people who have lost their jobs will not immediately get them back, savings will dwindle and consumption will drop in an already stretched American middle class.

Just over 16 months ago the down 10% was wiped off the S&P500 in a strong and growing economy due to trade war fears and increasing interest rates. They were wrong and in the next 5 months, it gained 20%.

In the last few weeks, the stock market has rallied 14% while the true economy was decimated. Economic indicators are backward-looking and the stock market forward-looking, but I’m yet to meet a trader who can tell me what they are looking forward to.

An Empty Times Square — Source: LA Times















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