On February 19, the S&P 500 index closed at an all-time high, the novel coronavirus (COVID-19) was still seen as primarily a Chinese issue (though a few other countries were reporting their first deaths), and the democratic primary was dominating the U.S. news cycle. What a difference six weeks makes! With shocking speed, COVID-19 has spread to nearly every country on the globe, leading to drastic containment and mitigation measures worldwide. While the focus of world leaders remains on alleviating the potentially dire human cost of COVID-19, these measures have also delivered unprecedented economic and market shocks. These in turn have resulted in swift and equally unprecedented monetary and fiscal policy responses on a global basis. In this commentary, we will discuss these shocks, the responses thus far, and the outlook moving forward.
The efforts to slow the spread of COVID-19 are causing severe disruption in the global economy, and a recession now appears inevitable. Global stock markets have responded to this threat, with the S&P 500 crashing from its February 19 high into bear market territory with record speed (a bear market occurs when a stock index falls 20% or more from its previous high). We are still waiting for the full impact of containment measures to show up in economic data; however, the data we have seen so far has been discouraging. In our January commentary, we pointed to a resilient service sector and strong consumer sentiment as signs of economic stability, along with record low unemployment. All three of these measures have now declined precipitously in the wake of COVID-19. The March Flash Purchasing Managers’ Indices for the U.S. and Europe declined dramatically and were led lower by the service sector, which comprises most of the economic activity in the developed world. February consumer sentiment showed its largest monthly decline since 2008 (Ned Davis Research), and initial unemployment insurance claims for the fourth week of March were at a record 6.6 million (Department of Labor). These data points are likely harbingers of the shock to economic activity that lies ahead. Adding to the pain, oil prices collapsed in March as demand diminished from the effects of COVID-19 while fears of oversupply were rekindled as Saudi Arabia and Russia failed to agree on production cuts in response to the demand shock. The collapse in oil prices will adversely affect U.S.based shale oil producers, potentially dealing a further blow to the economy.
Global leaders have responded to the economic shock through massive monetary and fiscal policy measures. The Federal Reserve acted quickly to alleviate the blow from COVID-19 on the economy and markets, announcing two emergency interest rate cuts in March that brought the target federal funds rate back down to 0%. Further, the U.S. Congress passed the CARES Act, a $2.2 trillion fiscal stimulus package, which President Trump signed into law on March 27. The CARES Act includes provisions for direct payments to individuals, enhanced unemployment benefits, loans and other relief to businesses, and support to state and local governments, amongst other measures. There is already discussion of further relief packages at the federal level if conditions warrant.
While equity markets have crashed into one of the fastest bear markets in history, fixed income markets have also been inordinately challenged in recent weeks. For much of March, liquidity in bond markets slowed to a trickle; traders were not able to buy and sell bonds easily or, in some cases, at all. The liquidity shock has been pervasive on a global basis and has impacted all segments of fixed income, including government and agency debt, corporate debt, asset-backed securities, commercial paper, and money market funds. Of note, the pain even extended to the world’s most liquid asset class, U.S. Treasury bonds. Bid-ask spreads have widened dramatically and many fixed income exchange-traded funds (ETFs) have experienced a broad-based dislocation between price and net asset value (NAV), both troubling symptoms of the lack of liquidity across fixed income markets. We have also seen continued stress in the market for overnight repurchase (repo) agreements; difficulty in this critical segment of the market is an indicator of short-term funding strains in the financial system.
In order to combat liquidity issues and to help get fixed income markets functioning again, the Federal Reserve (Fed) announced an unprecedented set of asset purchase and support programs, which include purchases of U.S. Treasuries, agency mortgage-backed securities, and debt issued by private corporations and support for the commercial paper market and money market funds. The Fed will also be active in repo operations and other measures to support liquidity in short-term funding markets that are critical to the banking system. While these programs are reminiscent of the quantitative easing (QE) measures adopted in response to the Global Financial Crisis, they are meaningfully larger and broader in scope and, unlike in 2008, are open-ended with no limitations. Further, the Fed has responded to a global shortage of U.S. dollars, which caused strains in overseas markets and a sharp appreciation of the dollar, by establishing dollar liquidity swap lines with foreign central banks. To date, these proactive and significant measures have helped to alleviate liquidity strains across global fixed income markets, but signs of stress remain.
Lack of liquidity hasn’t been the only sign of stress in fixed income markets. Credit spreads, which serve as a measure of default risk, have widened dramatically since the onset of the crisis. Spreads for both investment grade and high yield corporate bonds have widened to levels usually only seen during severe market crises. Even spreads in typically low-risk parts of the fixed income market, such as short-term lending between banks and agency mortgage-backed securities, have widened substantially. When credit spreads widen, it indicates an increased likelihood that companies will default on their debt; a significant rise in companies filing for bankruptcy protection could have more serious longer-term consequences for the economy as businesses are forced to restructure.
Compared to liquidity issues, the Federal Reserve is more limited in its ability to ease a credit shock. The Fed’s asset purchase and support programs mentioned earlier are intended to help to a degree but are primarily focused on addressing liquidity issues. Additionally, the CARES Act offers support to corporations and small businesses in distress, though only time will tell if this will be enough help to stem a tide of defaults. Companies that are struggling to repay their debt may continue to request forbearance from lenders and additional government support, but political pressures may limit the level of government support to private businesses. This is an area to watch as a large credit default cycle could create more prolonged difficulties for the economy and capital markets.
Controlling the spread of COVID-19 and ultimately developing a vaccine will be critical to getting the global economy back on track. In the meantime, global recession now seems inevitable, and the primary question confronting investors is the potential depth and duration of the economic pain. A “V”-shaped recovery represents the best-case scenario and would likely occur if containment measures prove effective in stemming the spread of the virus. In this scenario, businesses and schools would reopen more swiftly, and the prompt action by monetary and fiscal policymakers would facilitate a relatively quick economic recovery, a return of liquidity to fixed income markets, and a reduction in credit risk. Indeed, a recent report from the Federal Reserve Bank of New York titled Fight the Pandemic, Save the Economy: Lessons from the 1918 Flu offers hope to economies that have been swift to adopt containment measures. The authors note that areas that were quickest to implement social distancing measures during the 1918 influenza epidemic had both lower mortality rates and faster and more robust economic recoveries. Yet there are of course many threats to the hoped for “V”-shaped recovery, which could result in a slower, more drawn out “U”-shaped recovery, or an even more concerning “L-shaped” outcome, where economic activity does not recover for a long time due to more permanent damage wrought on the global economy by the pandemic.
Below we outline key threats to the potential economic recovery that we are closely monitoring:
The biggest threat to a quick and robust economic recovery is that current COVID-19 mitigation measures cannot be lifted in short order. This would necessitate longer-term shutdowns of economies and cause persistent disruptions to global supply chains and a more pronounced shock to demand. China, the first country to be affected and the first country to get back to work, will likely be a bellwether here. A new outbreak in China or in any other country that was initially able to control the outbreak could cause the rest of the world to extend containment measures. In that case, additional monetary and fiscal stimulus would likely be needed, and the ability of policymakers to keep economies afloat would be severely tested.
Another threat to recovery is that, even if we see relatively rapid containment of COVID-19 cases and a return to normalcy, the cracks that have emerged in fixed income markets continue to widen. Bond markets came into this crisis in a vulnerable position; corporate balance sheets had elevated levels of debt and there was a preponderance of less creditworthy borrowers susceptible to an unexpected economic shock. In addition, repo markets showed signs of stress months before COVID-19 became news and required Fed intervention as early as September 2019. Finally, many of the current liquidity issues in fixed income markets have been exacerbated by stricter bank regulations over the past decade. These regulations have significantly reduced the inventory of bonds banks hold on their balance sheets, which has limited their ability to be liquidity providers to markets in times of stress. Given these issues, even a shallow recession could trigger more sustained challenges in fixed income markets.
Finally, once an economic recovery takes hold, we may need to deal with the effects of unprecedented amounts of monetary and fiscal stimulus across the globe. Record low interest rates and a rapid rise in government deficits both have the potential to be economic accelerants that could have longer term inflationary effects. Add in low oil prices and pent up consumer demand, and inflation could take off with unexpected force. This would likely require policymakers to respond to maintain price stability via higher interest rates and tighter fiscal policy. Failure by policymakers to calibrate an effective response to a possible reflationary impulse could trip up the economy anew.
Considerations for Investors
As of now, only one thing seems clear: uncertainty around COVID-19 and its impact on the global economy and capital markets will continue to dominate headlines and result in heightened volatility for the foreseeable future. What, then, can investors do to help weather the situation? Most importantly, now is the time to focus on your long-term financial plan and to avoid making short-term decisions driven by fear.
Don’t Try to Time the Market
History shows that investors are poor market timers. Trying to sell assets at the peak or buy at the bottom is usually a losing game. The annual Quantitative Analysis of Behavior Study by DALBAR (see below) repeatedly shows that the average mutual fund investor significantly underperforms the market, likely due to the proverbial “buy high, sell low” behavior that has plagued investors for generations.
It can be tempting to “chase returns” by seeking to invest in only those investments that have recently been the strongest performers (e.g. technology stocks in the late 1990s). However, history has shown that a diversified portfolio has resulted in a more consistent journey for investors over time and has helped to reduce risk.
Investing can be a challenging endeavor that requires enduring shortterm pain to reap long-term reward. One-year returns for the S&P 500 index since 1937 have been negative 25% of the time, with the largest drawdown currently standing at -37% (see below). Said differently, an investor in the S&P 500 experienced declines in one out of four 12-month periods over the past 80+ years. More importantly, 20-year rolling returns for the index have been positive in every period since 1937 (see below). In short, the gains in the positive years have outweighed the drag caused by the negative years and have allowed long-term, disciplined investors to grow their investments over time. In closing, we believe it remains prudent for long-term investors to stay disciplined and to avoid fear-induced, emotionally-driven changes to their investment strategy. We will continue to monitor developments closely as we endeavor to thoughtfully manage your investments amid a challenging capital market environment. We would welcome the opportunity to speak with you to review your financial plan and to discuss potential risks and opportunities from the recent market turmoil. Thank you for your continued trust and confidence in our leadership as we guide you in the pursuit of your goals and dreams.