- Does the U.S. equity-market decline reflect a panicked overreaction or economic fundamentals?
- We reverse stress test the recent market drop, to explore which scenarios for short- and long-term growth expectations and changes in the equity risk premium explain the recent downturn.
- We find that, while much is unknown, the market has already priced in a large economic downturn with room for a price recovery if risk premia subside.
With the outbreak of the COVID-19 pandemic, market downturn and fear of worse, investors confront a key question: What have the markets already priced in? Are there scenarios in which current valuations reflect a panicked overreaction, or could investors expect further declines as the virus and economic impact spread?
Four scenarios that could explain recent market repricing
To understand these questions, we use a model relating equity prices and macroeconomic variables to reverse stress test the recent U.S. equity-market returns. The discounted-cash-flow model connects the price of equity to factors driving the expected future cash flows and how they are discounted to reflect their present value. Three factors are most relevant:
- Short-term growth: How will the pandemic change economic growth over the next year or so?
- Long-term growth expectations: How has the pandemic changed the longer-term trend growth rate? As shown in the figure below, this factor represents shocks whose impact persists for many years, while gradually returning to the previous growth path.
- Risk premium: How much do lower equity prices reflect higher required excess returns — or panicked selling — rather than changes in the fundamentals and lower expected cash flows?
Traditional scenario analysis would use a model to propagate hypothetical scenarios to the resulting future price impact. Our analysis turns this approach around and explores which forward-looking macro scenarios could explain the recent U.S. equity-market decline of more than 25%, as of March 12.
The first, “Fear” scenario looks at one end of a spectrum: The possibility that the economy will continue barely disrupted, and that markets have been panicking over nothing. The full equity shock is then attributed to scared investors demanding an almost four percentage points higher risk premium for the same expected cash flows. In this scenario, equity investors willing to ride out the storm would expect to make up recent losses in the long run by earning that higher premium, or benefit from a recovery if risk premiums subside.
A “Mild Slowdown” economic scenario is actually quite similar. In this scenario — a two-percentage point short-term reduction in growth with no change in the long-term outlook — the mildly lower expected cash flows are not nearly enough to justify the large drop in equity prices, which requires a 3.7 percentage point increase in the risk premium. From the point of view of discounted-cash-flow models, the vast majority of the value of equity comes from the cash flows and growth over the long horizon, so a short-term slowdown doesn’t much change the fundamentals.
What about more significant economic scenarios, similar to the recession and years of slower trend growth that followed the 2008 financial crisis? We consider a “Lasting Recession” with a short-term five-percentage-point drop in short-run growth and, more important, a half-percentage-point decline in the trend growth rate (see exhibit at bottom). We find that even this magnitude of decrease is already priced in to the recent stock-market decline. Investors expecting this scenario would still expect to earn a 2.8 percentage point higher risk premium at current valuations.
How much worse would the economy need to be to explain the drop in equity prices purely in terms of fundamentals, without a higher risk premium? The “Pure Fundamentals” scenario considers the opposite to the “Fear” scenario, backing out a growth scenario that explains the decline in equity prices without an increase in risk premium. This scenario would be economically bleak, a decadelong depression.
There is clearly a great deal of uncertainty ahead, as efforts continue to contain the pandemic, and many scenarios seem likely to involve significant human toll. The markets appear to have already priced in a large economic downturn. The model suggests that further price drops would be driven only by the fundamentals if a major depression is expected, and even the “Lasting Recession” scenario leaves room for a price recovery if risk premia subside.
Reverse stress testing the coronavirus shock
|Feb. 21 to March 12 MSCI USA Index
|Change in short-term growth rate
|Change in long-term growth rate
|Change in risk premium
Values in the shaded cells are outputs of the model; while values in the other cells are inputs. See the figure below for the growth paths of these scenarios.
Growth paths for the economic scenarios
The growth paths for various shock scenarios plotted relative to a 2% annual real growth reference scenario. In the model, a 5% drop in short-term growth expectations and .5% drop in trend would change 2% expected growth to a -3% contraction for 2020. In the absence of a change in trend growth, the economy would recover quickly to the baseline growth rate, but the trend shock in the “Lasting Recession” scenario leads to drag on the economy for the decade ahead.
Model cumulative impact on equity returns for the scenarios