As we sit down to write this piece in early April 2020, we think it is important to acknowledge a few things. First, we are hoping you and your families are safe and well. Second, we understand that there is a lot of anxiety about the crisis itself as well as the downstream repercussions, both from a human and economic perspective. Third, the virus is moving across the globe, and events are changing rapidly. There may be some new information that makes this quarterly review obsolete by the time you read it, but we are going to move on with what we know now. Hopefully, you have been able to use this time to do some activities you don’t normally have the time to enjoy.
To show how unusual this quarter has been, it was January 11th when the Dow closed above 29,000 for the first time, expressing investors’ optimism over the US/China trade deal. It was also only February 19th when the S&P 500 hit an all-time-high, capping the longest bull market in history. Less than 1.5 months later, its quarter-end return was -19.6%, highlighting the speed and sharpness of the market turnaround.
In our last quarterly review, we wrote about the challenges of making investment predictions. This recent experience reinforces our view that whatever amount of time economists spend putting together their detailed forecasts, at the end of the day, they are still just forecasts. We should not fully rely on forecasts because unforeseen events like COVID-19 can throw everything out the window.
Understanding the Economic Fallout
Unlike the financial crisis of 2008-09 which started on Wall Street and moved onto Main Street, this current crisis moved from Main Street to Wall Street. The short story is we have a global pandemic that is impacting supply and demand at different times and in different places. We have seen countries handle the health crisis differently; we have seen this among states in our own country. What makes this crisis so challenging is that our economy is set up for high connectivity while the health response calls for social distancing.
From an economic perspective, we have seen a multi-pronged approach from both a monetary and fiscal policy perspective. On the monetary side, we have seen aggressive action from the Federal Reserve. Acknowledging they were slow to act in the 2008-09 financial crisis they have been much more decisive this time by throwing everything but the kitchen sink at the issue and have done so quickly.
For example, they lowered Fed Funds rates twice (first to 1%-1.25 % and then essentially to zero) and have announced or already implemented several programs. Some of these programs, like quantitative easing (where the Fed is purchasing $500M in Treasuries and $200M in Mortgage-Backed Securities) were used during the Financial Crisis. However, they have also announced new and unprecedented programs like the Primary Market Corporate Credit Facility, where they are purchasing high-grade corporate credit. The sum of these programs is to keep financial markets functioning. While the Fed has used a lot of bullets from their arsenal, there is still more they can do.
Enter the US government and fiscal policy measures. Specifically, the government passed the Coronavirus Aid, Relief and Economic Security (C.A.R.E.S.) Act. Another unprecedented step, this $2 Trillion package goes down as the largest in US History, significantly larger than the $831 Billion American Recovery and Reinvestment Act of 2009. The CARES Act covers direct cash payments to individuals that qualify, expanded unemployment insurance, support for small businesses, and provides aid for state/local governments. Like what the Fed is doing, the CARES Act is meant to limit economic fallout.
So, what’s next? While the monetary and fiscal stimulus is helping to stem the tide, they are not a cure to what ails us in the first place, the virus itself. Having a vaccine, some other medication a method to limit the effects of the virus, or simply seeing a reduction in its spread will help us know we are on the road to recovery, both from a health and economic perspective.
So, is the US economy about to enter or already in a recession? The National Bureau of Economic Research (NBER) is the nonpartisan group that officially determines the start and ending period of recessions. As a rule of thumb (not the official definition), a recession is often defined as two consecutive quarters or six straight months of negative economic growth (GDP). Therefore, a recession is only announced after it has already started, meaning we may be currently in one though it may not be formally announced for months. In the end, the duration and depth of the health crisis will likely be the major determinant of the economic outcome.
To keep things in perspective, the year-to-date return for the S&P 500 through March 31, 2020, was -19.6%. As a reference point, the annual return for the S&P 500 in 2008 was -37%. In other words, while seeing equities fall 20% is never fun, we have seen declines like this before. As an advisor, our goal is to develop a long-term financial plan that considers both your goals as well as your tolerance for risk. Unless one of those items has changed, we recommend sticking with your plan and maintaining discipline through these turbulent times.
To show the swiftness of the decline in a picture, the chart below shows just how quickly the S&P fell by 10% from its peak on February 19, the fastest correction on record.
The S&P also broke the record for the fastest decline to a bear market, defined as a drop by 20% from peak levels, taking only 15 trading days (source: Payden and Rygel, looking at post-war history).
It is also instructive to remember that the indexes shown above represent what happens in various slices of the markets, which is different from the economy. Said differently, equity markets are comprised of various stocks while the economy is the sum of the goods and services produced. For example, getting a haircut at a salon is a service included in economic activity measurements, but is not measured by a particular stock. Also, consider that one way to measure a stock’s value is to look at its expected future cash flows. Therefore, it makes sense that the markets anticipate where the economy is expected to be, not necessarily where it is today.
Overall, several themes continued as large-cap stocks outperformed small-cap stocks over the quarter (the Russell 2000 benchmark suffered its worst quarter on record ), likely due to beliefs that larger-cap companies have more liquidity and access to capital during a crisis. From a sector perspective, energy stocks have been hit the hardest from the one-two combination of almost complete demand destruction (e.g. no one is driving or flying) and a price war between Russia and Saudi Arabia.
International stocks underperformed their US counterparts during the quarter. Like in the US, large-cap stocks outperformed small-cap and growth stocks outperformed value.
Not surprisingly, non-US markets have also been impacted by COVID-19. In the case of China, where the virus started, the impact was felt earlier than places like Italy, which started seeing cases a little later. Like the Fed, global central banks are taking action to support their economies.
Within developed nations, the returns coming from different countries were quite diverse ranging from Denmark (-9.6%) to Austria (-38.2%). Some of the larger countries in the known-US indexes also experienced disparate returns for the quarter. For example, Japan and Switzerland outperformed the US declining -17.4% and -12.2%, respectively, while the UK (-30.0%), Canada (-28.9%), and France (-28.0%) all underperformed the US (Source: MSCI World ex-US IMI).
Emerging markets also underperformed the US over the quarter. Keep in mind that China is a significant part of most emerging market indexes (roughly one-third weighting). Knowing that emerging markets underperformed the US and that China is a large portion of the index, it may come as a surprise that China outperformed the US, declining -10.3%. However, other countries with larger weightings in emerging markets did not fare as well including Taiwan (-19.6%), India (-31.8%), Brazil (-50.8%), and South Africa (-41.6%) (source: MSCI EM IMI).
Overall, international equities remain undervalued relative to both historical averages and current US valuations. Investors should also keep in mind the return of international equities can be driven by the dollar’s relative strength or weakness versus foreign currencies (the Wall Street Journal Dollar Index ended the quarter higher/stronger). Overall, almost all developed and emerging market currencies depreciated versus the dollar over the quarter.
Global Fixed Income
Fixed income markets experienced greater variability in outcomes than is normally seen. Specifically, most fixed income outside of cash or Treasuries earned a negative return this past quarter. No spread sector was spared, with high yield (i.e. non-investment grade) spreads widening the most. Even investment-grade fixed income and municipal bonds, which are higher -quality, saw negative returns during the quarter. This appeared to be a flight to liquidity over a flight to quality as some investors took a “sell everything” approach in a rush to cash.
The following chart shows the yields for the 3-month T-bill and the 10 -year Treasury bond at the end of the last five quarters. You can see the dramatic decrease in Treasury yields from 12/31/19 to 3/31/20. Remember, prices move inversely with yields.
With the Fed Funds rate now at essentially zero, the only way they could move further is by going negative. While other central banks have resorted to this (e.g. Japan), the results haven ’t been promising, and the Fed has stated outright this isn’t something they want to do. The chart below details the Fed Funds rate since around 2005. As the chart shows, with a 100-basis point rate cut, the Fed Funds rate is now at zero, the same place we ended up during the financial crisis in 2008-09.
Municipal bond returns fell during the quarter, leaving some to wonder if municipalities represented a significant credit risk. Overall, the financial strength of municipalities generally improved after the 2008-09 financial crisis, and the muni bond managers express they are not seeing any changes in most muni bond fundamentals; however, certain sectors like nursing homes, healthcare facilities, and airports could be impacted. Interestingly, at the time this was written, municipal bond yields in the aggregate are now higher than similar Treasuries (on both a pre-tax and tax-equivalent yield basis).
In these volatile times, it is important to remember the purpose of fixed income in a portfolio. Overall, we view fixed income as a means to reduce overall portfolio volatility, given that equities are expected to have much higher volatility. Even with some fixed income sectors having negative returns for the quarter, they still provided a dampening to overall portfolio volatility. Our client portfolio’s focus will continue to be on high-quality bonds with an emphasis on short to intermediate duration government and corporate bonds, where default risk is relatively low.
As always, please reach out to your advisor if you have any questions about your personalized Investment Plan.
Hyland Financial Planning