Last quarter was unprecedented in many ways. Global economic activity basically stopped as the world sought to slow COVID-19 infections and protect the health care system by ‘flattening the curve’. The efforts seem to be working, with strong evidence that the worst of the contagion has passed. Virus-induced deaths will likely turn out to be orders of magnitude less than initially predicted. We’re all thankful for that.
I won’t spend much time discussing the virus since the updates come so rapidly. Nor will I expound on the fiscal responses, other than to say that they have been large and necessary, and there will likely be more. The leadership team at SIMA has done a wonderful job updating clients on these measures, and I encourage you to reach out with any questions you might have.
But I will discuss the monetary responses.
Let’s first acknowledge that we’ve just gone through one of the roughest, most volatile periods in stock market history, with much of the carnage occurring over a five-week period. Just how bad was it?
- US stocks declined 20% in just 16 trading days—the fastest bear market ever.
- Large cap US stocks fell 33.9%[1] peak-to-trough; small caps fell 41.9%[2].
- The volatility index (also known as the VIX) soared to 82.7, the highest level ever.
- The average daily move in March was 5%—higher than any month in the Financial Crisis and the Great Depression.
- The yield on 10-year Treasuries fell to an all-time low of 0.38%.
We’re living through one of the greatest pandemics since the Spanish Flu more than 100 years ago, the greatest economic contraction since the Great Depression, the greatest oil price contraction maybe ever, and the largest central bank / government intervention of all time.
The future of all of this is uncertain and unknowable. The toughest question remains how society’s leaders will make the trade-off between protecting their citizens and restarting their economies. Without any historical precedent, they’re not in an enviable position. Until we have a vaccine or we reach herd immunity, I expect we’ll have a rough but determined recovery.
Turning to the markets, there’s no doubt that panic was overdone in late March. Markets typically overreact to extreme uncertainty, especially when the left tail[3] contains really bad outcomes. That’s because the market is a discounting mechanism. Markets must price in all the things that can happen. At the early stage of the virus, the span of potential health-related outcomes was very wide. The economic outcomes were equally wide. This is a large reason why volatility was so high; it reflected the uncertainty and potential impact of a very wide range of outcomes.
Now that the rate of growth of new infections is slowing, the worst-case scenarios are less bad. With potential outcomes narrowing, we also get an improvement in the market’s ability to accurately price (or discount) new information. As such, volatility has come down and stocks have recovered nearly half of their losses. It’s always the case that more things can happen than will happen. That’s the very definition of risk.
But we’re not out of the woods yet. Virus-related outcomes might be narrowing, but economic outcomes are still unclear. Many cities and states are effectively shut down, so it’s too early to predict what shape the economic recovery will take. It all depends on how quickly we can reopen the economy.
Corporate earnings will fall as a result of the economic shutdown, but nobody knows how far or for how long they will remain depressed. An analysis by Bridgewater, the world’s largest hedge fund, determined that the market was essentially pricing in a 50% decline in earnings over the next two years, followed by a slow recovery in which earnings don’t reach their pre-COVID peak until 2030.
History doesn’t support that level of sluggishness. Corporate earnings have fallen before, sometimes by a lot. But in the modern era, they have regained their prior peak in less than four years, sometimes less than three. Economies recover too, even from extreme events. German and Japanese GDP reached pre-WWII levels less than a decade after the war ended. The resilience of modern economies to severe shocks in consumption and output is truly amazing. All of history supports that, yet we view each shock as terminally unique.
I’m reminded of this quote by British philosopher and political economist John Stuart Mill:
“What has so often excited wonder, is the great rapidity with which countries recover from a state of devastation, the disappearance in a short time, of all traces of mischief done by earthquakes, floods, hurricanes, and the ravages of war. An enemy lays waste a country by fire and sword, and destroys or carries away nearly all the moveable wealth existing in it: all the inhabitants are ruined, and yet in a few years after, everything is much as it was before.”
An additional reason to think that the world won’t be ending has been the Fed’s enormous monetary response. In addition to opening the lending facilities we last saw in the Financial Crisis, they recently announced that they would be buying corporate bonds, and even some high-yield debt funds. The lender of last resort is now the buyer of last resort. This is unprecedented in the US. But that’s where we are now.
One last note about liquidity programs; they’re hard to end. It took nine years for our Fed to end QE after the last round, and now here we are with more. But if investors have learned anything over the last decade, it’s not to fight the Fed. Buy what they’re buying. If the Fed is buying corporate bonds, don’t short them. If they’re buying equities, the price floor is in. It’s not crazy to think equity purchasing could happen here. Japan’s central bank has been doing it for years. Nothing is off the table.
There is still plenty of fear and unresolved questions. Yields on 10-year Treasuries are still very low (0.60% as of this writing) and the VIX is still elevated. As such, we continue to position portfolios defensively, which we think makes sense for most investors. Within public equities for example, we favor large caps because of better earnings sustainability and better balance sheet strength. In fixed income, we still prefer higher credit qualities and lower durations.
But there are a few asset classes that we have underweighted in the past which are now are starting to look more attractive, particularly those areas that have been hardest hit over the last two months. This includes certain tranches of corporate fixed income and small cap cyclical stocks. For those clients with longer time horizons, we may reposition portfolios to take advantage of the value created in these areas. We will keep you updated on strategy changes as they occur.
– Your team at SIMA Wealth Partners
[1] S&P 500
[2] Russell 2000
[3] In a probability distribution, rare events (more than three standard deviations from average) are said to be tail risk events. Losses occur on the left side of the distribution.
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