Quarterly Outlook
Fixed Income Outlook: Bonds Hit Reset. A New Equilibrium Emerges
Althea Spinozzi
Head of Fixed Income Strategy
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EPS projections and the mistrust of the volatility market
Peter Garnry
Chief Investment Strategist
Summary: Our new scenarios for GDP impact in 2020 are now worse than those presented in early March and future EPS paths point towards a 45% decline in earnings in a worst case scenario with severe downside dynamics. The recent rally has been fueled by improving sentiment due to significant policy actions from the Fed, the US and European governments. The current VIX and term structure also suggest that equities have more downside risk. Equities find themselves in a mistrusted rally by the volatility market.
Economic data are beginning to be released with the IFO survey in Germany plunging yesterday to the lowest levels since the Great Financial Crisis in 2008. Today the US initial jobless claims rose to 3.29mn against 1.70mn expected and up from 281 in the prior reading suggesting significant impact on the US labour market from the COVID-19 outbreak. We are currently in a guessing game about the hit to GDP and corporate earnings. The GDP forecasts have wide dispersion for 2020 and companies are withdrawing their financial forecasts due to the enormous uncertainty. Earlier this month released our initial scenarios for GDP and the impact on EPS in the S&P 500 Index. Today we are updating our model based on our new assessment of the economic impact from COVID-19.
Our two new scenarios for GDP growth are now including a worst case scenario that’s even worse than the 2008-2009 decline in GDP and a base case scenario that’s a bit milder and recovers to around trend growth by 2021.
Based on a fitted quantile regression model of quarterly GDP growth and quarterly changes in GDP growth since 1954 we predict EPS path at different percentiles. The median of the two EPS paths implies 12-month trailing EPS being down 21% in the worst-case scenario by Q4 2021 and down 10% in the base case scenario. The 25% percentile paths provide a picture for how much EPS could decline under more severe downside dynamics. These paths takes EPS down by 35% in the base case scenario and down by 45% in the worst case scenario.
With the S&P 500 drawdown at 34% and assuming unchanged valuation multiples it gives a market-based input to how much earnings could be down. If the worst case scenario plays out and we get a severe credit crisis then we could see new lows in S&P 500 and EPS decline of close to 50%. Time will soon tells us where the world is headed.
As we pointed out in our Market Call podcast this morning the VIX Index remains elevated above 60 suggesting more downside risks to equities in the short-term. But the VIX futures term structure also remains in steep backwardation with the second month contract on the curve trading at 37% discount to the VIX Index. But even more importantly the second month contract has risen in recent days despite the rally in equities suggesting the volatility market is not yet believing that equities have turned a corner.
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