The U.S. economy was firing on all cylinders as we entered 2020, as measured by gains on Wall Street and, more importantly, through Main Street successes including small business profits and employee wage gains. As we all know, the momentum was derailed by a black-swan event in the form of a global health pandemic, coronavirus (COVID-19), which, by itself, was significant enough to force governments to shut down economies to prevent the virus from overwhelming global health systems. To make matters worse, a historic crash in the oil price exacerbated fallout from the health crisis.
The oil price collapse is perhaps unlike any other asset decline in history.
Prices turned negative for a short period last week as the combination of a demand breakdown and a positive supply shock inundated the world in oil, to the point at which owners paid investors to take crude stock off their hands rather than paying short-term storage costs.
From mid-February through late March, the U.S. stock market fell 35%, peak to trough. This represents the quickest decline of such magnitude in market history, including the monumental drops of 1929 and 1987. Throughout the crisis, our advice has been as follows:
- Follow our model discipline and maintain existing positioning. This approach allowed us to avoid permanently impairing capital by reacting emotionally during a market panic, and it has allowed us to participate on the upside given the subsequent market rebound. The extraordinary levels of high volatility have subsided, permitting us to assess expected returns and risks thoughtfully and unemotionally.
- Enhance liquidity. Shore up cash on hand and credit lines to meet spending needs for the next two years to bridge the gap from today’s uncertain outlook to the brighter days ahead.
- Tax-loss harvest taxable accounts. We have been aggressive in this area, harvesting losses in our strategies and swapping into comparable assets without compromising a portfolio’s ability to participate in any rebound.
Perhaps the most unusual thing about equity price action over the past two months may be the staggering extent to which the market has rallied since March 23. The S&P 500’s ascension (+31% off the low at its peak) suggests the stock market believes the worst of the coronavirus impact may be behind us as economies slowly begin to reopen. With that said, certain areas remain vulnerable to negative ripple effects. Credit spreads have not approached anywhere near the levels we saw in the recessions of 2002 and 2008, but they remain elevated. The real question is how much of this stress will remain in the sectors and industry groups most affected (e.g., financial, energy, retail, travel and hospitality, restaurants, and emerging markets), rather than seeping into more-insulated areas of the economy.
Where Things Stand
The economy and stock market appear to be disconnected. The equity market is down merely ~15% from its peak, yet the current employment situation and forthcoming GDP figures echo those of the Great Depression. Capital markets (e.g., stocks, bonds, credit, and commodities) are generally forward-looking, leading the economy by 12-18 months, so they will provide clues as to the likely shape of the recovery. Thus, the equity revival over the last month could suggest that a combination of aggressive and unprecedented monetary and fiscal policy has permanently taken the worst-case scenario off the table and that a “V”-shaped recovery may be in the cards. On the other hand, lingering economic damage, and current prices when considering upcoming earnings and dividend cuts, would suggest the equity markets may be too optimistic about a likely recovery. After all, bear markets associated with a recession usually last more than the five weeks.
Expect market volatility to remain elevated over the next six months, even after the tremendous resurgence in equity markets.
Interest rates are likely to stay low given the response of both the bond market and the Federal Reserve to short-term deflationary headwinds. Dividends are likely to be cut as companies hoard cash to weather the storm until the economy works its way back to some semblance of normalcy. In the current environment, there is an overwhelming temptation to chase yield in search of income. We advise investors to resist the temptation, since the pursuit comes at the expense of thoughtful consideration of credit and solvency risks which accompany the increased yields. Though it is unlikely the economic and financial stresses will be as bad as those experienced during the Global Financial Crisis (GFC), structural impairments in certain stressed areas of the economy will take time to play out.
There has been understandable stress in the municipal bond market on the notion that the likelihood of reduced revenue from sales and property taxes will result in financial pressure. The possibility of such credit concerns in normal times, much less during exceedingly stressful times, is exactly why we favor high-quality active managers in this asset class. We are encouraged by the actions taken by the Federal Reserve to stave off systemic issues. We do, however, acknowledge the likelihood of idiosyncratic problems around some of the municipalities with weaker balance sheets barring a quick resurgence in the economy.
This reiterates the idea of not blindly chasing yield and focusing on a return of capital rather than a return on capital when investing in fixed income.
Investors should not lose sight that real medical progress has been made against COVID-19, even if we are not yet crossing the finish line. Ultimately, remedies such as antivirals and vaccines are going to solve this global health pandemic. While America’s industrious biotechnology and pharmaceutical companies are working hard to solve this part of the equation, investors should recognize that, in the meantime, the curves for infections, hospitalizations, and fatalities have flattened substantially. “Social distancing” has worked, avoiding the burden which was projected to overwhelm the healthcare system. Even though progress on medical remedies may take a while, the numbers have not met the apocalyptic initial projections.
As a result, governments across the world are plotting their courses for reopening their economies, though it is not going to be easy to get things started immediately. Success will depend on 1) appropriate discernment of the proper business rollout, 2) strict regulations for those permitted businesses, and 3) self-limiting behavior from individuals. Herd immunity may also bring some benefits as increasing evidence points toward a larger number of people (many of whom were asymptomatic) having already contracted the virus, thus lowering its fatality rate.
While the likelihood of a “V” recovery has diminished (though not been eliminated), additional scenarios such as a “U,” “W,” and even the possibly of a “square root” shape have entered the discussion. Ultimately, the path of the recovery will be determined by how economies can reopen safely and effectively. A vaccine for the virus which, even under the best-case scenarios, is several months away from mass distribution, will accelerate the economy’s ability to recover its February peak. Until then, the competing need to reopen certain areas of the economy safely and effectively with the ongoing responsibility not to undermine progress on slowing the spread of the disease will determine how the outlook evolves.
For this reason, we think there is a high likelihood of further fiscal stimulus, which should lead to compelling investment opportunities, such as infrastructure investments. After the immediate crisis subsides, we expect greater attention to be turned to the sustainability of government debt and its consequences for interest rates, inflation, and the U.S. dollar. This global health crisis has accelerated decisions we must confront on an unsustainable debt trajectory we have followed over several years, especially emanating from the entitlement programs of Social Security, Medicare, and Medicaid, as a greater proportion of the population reaches retirement age.
A key takeaway is stressful situations in capital markets generally bring about superior expected returns for a globally diversified portfolio over the long run, even as we acknowledge certain areas and certain players may be impaired indefinitely.
From a strategic standpoint, the starting point for asset class returns has changed from what we published in our 2020 Capital Markets Forecast at the start of the year. We will elaborate more on this over the coming weeks.
What This Means for Investors
During this unprecedented bout of volatility, the right course of action has been to refrain from panicking, to enhance liquidity, and to harvest tax losses aggressively. We remain alert to the potential of gaining exposure to certain areas of the markets through the options markets.
We continue to encourage clients who have more than two years’ worth of spending needs set aside in cash and short-duration fixed income to deploy their “dry powder” into strategies.
This will require staying invested for at least 18 months to ride through elevated market volatility over the near-term. Investors should take six months to average in, and we recommend starting now.
Although the end of this crisis will occur only upon identification of the proper medical solutions, this does not preclude interim positive results from occurring in certain areas of the markets. While equities in aggregate are poised to increase over the long run, much uncertainty remains in the near- and medium-term. As we often say, capital markets lead the economy, not the other way around. We continue to follow our model discipline and to analyze capital markets for clues about whether the sharp increase off the stock market bottom is the beginning of a new bull market or, instead, a rally within a greater bear market.
If you are not yet a client and would like more insight into our investment strategy, and how to lean into the information within the context of your allocation and investing decisions, please contact us at firstname.lastname@example.org.
For our clients, we thank you for your continued trust and loyalty. Further communication is coming to provide you with an in-depth analysis of our outlook and portfolio recommendations.