Investment Commentaries: 1st Quarter 2020
| Index Returns | 1st Quarter | Trailing 12 Months |
| S&P 500 US Large Cap Index | -19.6% | -7.0% |
| MSCI All Country World Stock Index | -23.4 | -15.6% |
| Barclays Capital Aggregate Bond Index | 3.1% | 8.9% |
| US Core Consumer Price Index - (Inflation) | 0.6% | 2.4% |
*All figures as of 3/31/20 unless otherwise notes
Since the COVID crisis began in the US in mid-February, we have all been learning to deal with the danger of becoming infected with the virus and the increasingly restrictive changes to our daily lives meant to slow its spread. Markets in turn have acted like a funhouse mirror, reflecting an exaggerated version of the daily and sometimes hourly swings between anxiety and optimism. While the pandemic is far from over, increasing visibility into the economic impact of the world’s response to Coronavirus as well as an unprecedented flow of fiscal and monetary relief measures announced in the last few weeks have resulted in a balance of optimism evidenced by a partial market recovery. We discuss these issues and our views on positioning and managing portfolios through a pandemic in more detail below.
When the treasury bond yield curve inverted (short term yields dropped lower than long-term yields) last year, we wrote about how that has historically been an early indicator of recession by 6-18 months.
Near that time, we had already begun cutting back on risk in portfolios by exiting high yield bond positions and trimming allocations to emerging market stocks. But, we cautioned that little else besides the yield curve suggested a recession was imminent. By January markets were celebrating what promised to be the end of the US-China trade war and shrugging off a nearly full-blown war with Iran. At that point, Coronavirus looked to be China’s problem and markets were primarily worried about supply chain disruptions resulting from China’s forced shutdown.
Merely two months later, and recession has now become a foregone conclusion. Many indicators already suggest recession is here; few say how bad it will get or how long it will last. Unlike other recessions, this one is expected as a result of the fight against Coronavirus. The general belief is that once the health crisis has passed, the economy can be turned back on like flipping on a light switch. But, in this analogy the economy is less like a desk lamp and more like a chandelier: while we know there will be light, we do not know how many of the light bulbs will come back on.
On the bright side, the certainty of this economic slowdown has given fiscal and monetary policy makers an opportunity to be proactive instead of reactive to a recession. To dampen the economic and market impact, the Fed began by cutting interest rates to 0% and shoring up liquidity in markets with billions of dollars of bond purchases nearly a month ago. Shortly after, lawmakers passed the CARES Act - a $2.2 trillion aid package that provides financial assistance to individuals and businesses. More recently, the Fed announced additional bond purchases and even purchases of corporate bond ETF’s.
Markets had been falling sharply between mid-February and late March, with the S&P 500 index declining
by as much as 34% below its February peak. Fiscal and monetary announcements near that low in prices appear to have calmed markets, as the S&P 500 has increased by close to 25% through April 10th. The stabilizing impact of the CARES Act, which focuses primarily on keeping workers employed and consumers spending, is understandable as it acted to restore the market’s confidence that growth would resume sometime soon.
Why has the Fed’s bond-buying induced such a revival in equity markets? We think about markets and the risk spectrum like an office-tower, with government bonds occupying the ground floor and the upper floors occupied by successively riskier asset classes.
It takes something like an earthquake to cause the ground floor to move. Occupants can count on the stability of the ground beneath them, but they don’t have much of a view.
On the other hand, a strong gust of wind might cause the top floors to sway. Occupants put up with the occasional movement because they believe they are safe, trusting the building’s structural integrity.
On rare occasions like during late 2008 and more-recently in late March of this year, an external shock causes the entire structure to shake from the ground up. The reverberations stretch and widen from the lower levels, which makes the swinging more pronounced in the upper levels (see the accompanying chart that shows volatility in daily price changes over one-month periods from the “ground floor” and up).
When the Fed began its massive bond-buying operation, it essentially installed shock absorbers beneath the entire building, which in turn caused markets up and down the risk spectrum to begin calming down.
The most common measure of stock market volatility, the VIX index, increased to record levels in late March, surpassing even the heights it reached during the 2008-2009 financial crisis. Given the fact that volatility had been unusually low for most of the preceding three years, such a significant increase in such a short period of time caused investors with portfolios positioned based on the assumption of continued low volatility to act in ways that made the volatility worse. They were forced to unwind investments and in some cases shut down entirely. In order to cover losses on leveraged positions, they resorted to selling higher-quality investments, bringing prices down across the board. Maybe markets would make more sense if hedge-funds and other institutional investors were required to practice social-distancing with their portfolios.
What this means for markets and the economy: The financial markets’ response to current economic conditions suggests that the majority of investors are optimistic about a return to global economic activity and even growth within the next 3-12 months. The fact that markets have not fully recovered represents investors’ uncertainty regarding when the recovery will start and how strong it will be. Economists have taken to describing economic recoveries by their shape (V, L, U, W, etc…). The type of recovery gaining the most traction in the last few weeks has been the square root recovery, as depicted in the accompanying chart.
In our quarterly commentary published in January, we identified consumer spending as the segment of the economy we would be watching for signs of a recession. The same holds true when watching for and anticipating the strength of the recovery.
A recent NY Times article used credit and debit card spending records to illustrate how consumer spending has changed since the beginning of the year. With Grocery as the exception, most categories are down between 20% and 50%.
The 96% drop compared to last year in travelers going through TSA checkpoints seems appropriate by now, but changes in this figure should give us early indications of the speed and magnitude of a recovery in economic activity once the world reopens.
We will be watching these and similar high-frequency consumer-focused indicators such as movie ticket sales, hotel occupancy, and restaurant diner-counts closely for signs of recovery.
What this means for our clients: We have published two interim commentaries discussing current events, the market environment, and what actions we have taken in client portfolios since the mid-February. The last one we sent was on March 16, 2020; but we are likely not alone in feeling like months rather than weeks have passed since then. As a reminder: Your portfolios are not leveraged, and they are diversified across several asset classes to mitigate risk caused by volatility in any one asset class. Diversified portfolios are not immune from market shocks, but they have proven to be resilient in past downturns as well as the current one.
The way we protect portfolios from unnecessary risk during market downturns is in how we position portfolios when conditions are good. For that reason, we have been limiting trading activity to what we believe is necessary based on client objectives. Here are a few of the actions we have taken since our last update on March 16th:
We have used market volatility over the last month to rebalance portfolios as underlying holdings drifted away from target allocations. Most recently on March 25th, that involved using excess cash and proceeds from partial sales of bond/fixed income holdings to increase equities-exposures back to targeted levels.
As asset prices have declined, we initiated positions in the stocks of a few high-quality companies and market segments that had previously been too expensive based on our analysis. Specifically, we purchased shares in healthcare company Danaher (DHR) and consumer staples company Amazon (AMZN), as well as a minimum-volatility equity ETF (USMV) to maintain exposure to equities while dampening the impact of further market volatility.
We have also put into practice a lesson we learned in 2008 and now again in 2020: A storm is always a storm, but every storm is different. The economic reality of the situation and the potential impact on company fundamentals cannot be ignored, regardless of a particular company’s ability to weather past downturns. As the economic slow-down became more of a certainty in early March, we evaluated equity positions one-by-one to reassess their ability to weather this storm. As a result of that analysis, we cut loose a few companies and market segments that no longer fit our criteria. Consumer cyclicals stocks VF Corp (VFC) and Booking Holdings, Inc (BKNG) were both cut. We also sold out of all positions in a European Financials ETF (EUFN).
We have had several conversations with clients over the last few weeks. There are some similarities across our conversations, but some marked differences between conversations focused on investment portfolios and those focused on running businesses. As the shut-down brings economic activity closer and closer to a full-stop, small and medium sized businesses face increasingly difficult financial and operating conditions. The challenges vary widely by what type of business one operates, but a common challenge is the difficulty of learning to work in a socially distant world. On that point, you received notice a few weeks ago that we temporarily closed our physical office and our team is now working 100% remotely. We are proud of how our team has adapted to a new way of working over the last few weeks, but we are all certainly looking forward to being able to return to our physical office sooner rather than later.
As worried as our team has been for the health and safety of our clients, their families, and their businesses, we have found that we spend more time discussing our gratitude for all of your continued patience and trust as we navigate through this downturn. Our firm values frequent communication with you to discuss changing conditions and to ensure that we understand and stay updated on your objectives. Our client-service staff will be reaching out to you as usual to schedule a meeting. If you would like to set up a meeting sooner, please contact us at your convenience. We welcome hearing from you.
Matt A. Morley, CVA, CEPA
Chief Investment Officer