Economic data, by nature, is backward looking – doing a better job of telling us what has already happened than what we can expect in the future. In the weeks ahead, data releases will confirm what we already know: the U.S. economy was all but shuttered during April. Economic activity didn’t just stumble; it was purposely shutoff out of necessity. Physical distancing measures quickly became our only defense against COVID-19 and the resulting historic collapse in economic activity is sadly a sign of responsibility.
We believe that the scientific community will ultimately be successful in its tireless efforts. However, without an immediate vaccine or some way to prove herd immunity, we expect a slow reboot to the U.S. economy. Yes, there will likely be a rebound from the extreme lows, but void of a medical breakthrough, it is becoming increasingly apparent that economic activity will not be the “V” shaped recovery that markets had originally anticipated in late March and early April.
Undoubtedly, the response from fiscal and monetary authorities has been swift and aggressive by any historic comparison. While these policies have been supportive, they haven’t come without challenges and unforeseen consequences. The Federal Reserve will be the first to tell you that zero interest rates, unlimited bond purchases, numerous new lending facilities and the promise to do more will do nothing to stop the spread of the virus nor put millions of people back to work. However, actions taken by the Fed have worked to calm financial markets during a period of unthinkable stress and should assist in the recovery once we’ve moved beyond COVID-19.
On the fiscal side, stimulus has come sooner and far outpaced the response to the 2008 financial crisis. With that said, the delay and sheer number of businesses unable to access emergency lending will cause more permanent closings (and unemployment) in some sectors than many had initially anticipated. Additionally, we see issues with the national virus and antibody testing apparatus leaving much work to be done. With some 30+ million individuals filing for unemployment benefits in the past six weeks alone, the fallout is going to be dramatic and the suffering real. As such, lawmakers are already discussing a third round of stimulus for state and local assistance (we’ll save the discussion of massive deficits and ballooning debt loads for another Market Perspective).
As states begin the unnerving process of reopening in the coming weeks and we sift through peak pandemic economic data, it would be naïve to discount the uncertainties that remain. If this virus has reminded us of anything, it’s just how quickly things can change, for better and for worse. A breakthrough from the biomedical community would be a tremendous shot in the arm, while a spike in confirmed cases or a second wave of infections would be tragic. And this is exactly the type of uncertainty that COVID-19 has forced everyone to deal with.
These periods of extreme uncertainty and market volatility are an important reminder as to why we go through the effort of constructing well-diversified portfolios. Each asset class plays a role in solving the increasingly complex equation of liquidity management, income generation, return potential and prudent risk management.
The discussion below is kept at a high level, but it is important to note that the work does not stop at the asset class level. The above considerations should also factor into the underlying positioning within individual strategies.
During periods of market stress, liquidity management is crucial. Being able to satisfy unforeseen capital requirements without being a forced seller at distressed prices is not a luxury; it is a function of good planning and is precisely the role of cash and investment grade fixed income.
Going forward, income generation is going to be increasingly difficult. With the Fed holding interest rates at zero for the foreseeable future, high yield offers a significant income advantage over investment grade bonds with historically less risk than equities. Additionally, high yield plays an important role in dampening overall portfolio volatility while not giving up too much from a return perspective (versus equities) and remains an important risk management tool.
Finally, while harboring significantly more risk than fixed income, equity exposure plays a key role in boosting return potential for clients who can withstand the increased volatility. If the past two months is any indication, it’s going to be a bumpy ride for equity markets in the short run. Investors will be forced to reconcile crumbling revenue streams, foggy outlooks and continued central-bank-driven asset price inflation. If allowed, equity exposure should be carefully calibrated to each client’s unique risk tolerance and should be viewed from a long-term perspective.
Staying diversified and staying invested will be paramount as we progress through this historic event. As Mr. Jim Morrison said, “the future is uncertain, and the end is always near.” Let’s hope this is the end of coronavirus so we can all get back to our normal lives. Stay safe, stay patient and we look forward to seeing everybody live and in-person. As always, please contact us with any questions.
When nothing else could derail risk markets, along comes the coronavirus (COVID-19). At this point, it is unclear what the ultimate human and economic impact of the virus will be, but downside risks abound. The market response has been to sell risk assets and buy the safety of U.S. Treasuries in a classic flight-to-quality trade. The S&P 500 is down -12.7% from the February 19th record close and is now down -8.27% for the year. Meanwhile, the yield on the 10-year U.S. Treasury fell 40 basis points to a new all-time low of 1.11% and is down 77 basis points for the year.
From a return perspective, investment grade bonds benefited nicely from the dramatic move lower with Treasuries 1 producing positive monthly and year-to-date returns of 2.65% and 5.16%, respectively. The broader Bloomberg Barclays Intermediate US Government/Credit Index returned 1.41% for the month and 2.85% year-to-date. There was no such silver lining for the equity markets as the selling was aggressive and broad-based. Meanwhile, the high yield bond market 2 was down slightly for the month (-1.54%) and year (-1.53%); it faired significantly better than equities thanks to the positive price appreciation from the move lower in interest rates in the broader risk off environment.
To us, the most amazing part of the recent equity market correction is not the magnitude or velocity of the price swings, but instead the instantaneous clamoring from market participants for additional Fed stimulus, emergency rate cuts, coordinated global easing and yes even another round of tax cuts from the Trump administration. What would they ask for if equity markets sold-off 20-30%? These types of reactions to a 12% market correction speaks to a much bigger issue in today’s financial markets that we’ve been talking about for years. Namely, the markets’ dependency on easy money. It’s an issue. The Fed knows it, but they don’t know what to do about it.
To be sure, additional easing from the Federal Reserve is not going to solve the coronavirus outbreak. Additionally, they have been clear that monetary policy is on hold until there is a material reassessment to the economic outlook or inflation is significantly and persistently above their 2% target. To date, neither has happened. Of course, markets are forward- looking and pricing in the future negative impact of the coronavirus, thus asking for easing today. We do not envy the Fed’s position. Trying to set monetary policy during a period of market turbulence, sparked by a novel virus that nobody knows a thing about, is challenging to say the least.
If the virus gets materially worse from here, the negative economic implications will be undeniable and unavoidable. The Fed would be forced to ease policy further, attempting to spur a stalling U.S. economy. However, if the Fed chooses to preemptively respond and the economic outcome turns out to be less dire, then their willingness to placate the markets will be on center stage. The Fed cannot afford to be reactionary at this moment. They can afford to be patient, evaluate the impact of the virus, digest incoming economic data and move when they must (rather than when the market tells them to). Of course, this path for policy would likely result in disappointment and another leg lower in equity markets and thus you can see the Fed’s predicament. What the Fed should do and will do can be different things and sometimes for good reason. This might be exactly one of those situations.
We came into the year with a defensive stance, expecting the U.S. economy to muddle through 2020 and maintained the view that risks to growth remain skewed toward the downside. The coronavirus is clearly one such downside risk and we expect it to have a negative impact on corporate earnings. We’re only 1/6th of the way through the year and we still have the democratic primaries, the next iteration of Brexit and the election to chew on.