Mark P. Bernier, CFA | Posted on Apr 02, 2020
Our nation has been faced with some incredible challenges in its relatively short history – revolutions, civil wars, world wars, cold wars, financial panics, and pandemics. Each of these challenges arose from unique and sometimes surprising circumstances and those who experienced these events first-hand, I’m certain, felt that life as they knew it was forever changed. And so we find ourselves here, at a moment in time when fear and uncertainty are palpable and the 24-hour news cycle does little to bring optimism. Our daily lives have been disrupted to say the least – forced closures of businesses and schools, stressed supply chains, stressed healthcare systems, travel limitations, and the millions of Americans who (will) find themselves unemployed in response to efforts to slow the spread of COVID-19. Undoubtedly, the economic impact will be significant; economists are “attempting” to forecast those impacts now. It will take some time for the economy and markets to recover, but we feel confident that like many other times in our country’s past, the challenges we collectively face today will present opportunities for tomorrow.
Over the next few months, we are likely to see some of the worst economic data reports in a generation. The estimates for economic contraction in the second quarter are wide-ranging, but decisively negative. The median estimate of second quarter US GDP contraction (gross domestic product, or total economic output) from a recent survey conducted by MarketWatch, Inc. of 16 prominent economists stood at -12%. To put that into historical context, some of the estimates used to produce the median score would put the expected contraction in second quarter GDP on par with declines last witnessed in the late 1940s. US unemployment, which hit a 50-year low of 3.5% in February, is likely to double or perhaps triple in the months ahead.
The global economic impact from COVID-19 is almost impossible to measure in real-time and will be influenced by policy makers’ decisions to implement further restrictive measures to contain the spread of the virus and the monetary policy and fiscal policy support necessary to reduce the economic impact. These policy decisions are particularly important in the U.S., where the service sector represents more than 70% of our economy. With retail shops, restaurants, and tourism at an effective standstill, businesses and employees of these businesses stand to be most severely impacted. At the time of this writing, the U.S. Federal Reserve cut the Federal Funds target rate to zero and instituted a number of “whatever it takes” policy initiatives designed to provide liquidity and support to the financial system. These extraordinary policy initiatives, and those of other central banks around the world, will not produce an economic recovery on their own, but they have tempered the volatility we were witnessing in certain parts of the bond market that were a reflection of the extreme risk-off environment in mid-March.
Fiscal stimulus packages are being announced around the globe, all with the aim of providing financial support to industries, businesses, and people most affected by the temporary closure of commerce. In the US, Congress is working on what is expected to be the largest economic support legislation in our history – a $2 trillion package that could include $500 billion in loans to companies, $350 billion in aid to small businesses and $150 billion to hospitals and healthcare providers. Unemployment benefits may also be bolstered, including an extension to the duration of benefits. Direct payments to taxpayers also appear to be included in the draft measure. In all, this is a monumental effort to lessen the economic impact of an effective temporary shuttering of the US economy.
Though the economic impact is likely to be severe, it is also expected to be relatively short-term. Many of the same economists who contributed to the survey referenced above expect a significant rebound in economic activity in the back-half of 2020. The key contributors to the magnitude of that rebound will be the effectiveness of the stimulus packages referenced above and indications that virus transmission containment efforts are successful. Both conditions will permit businesses to reopen, commerce to flow, and the interruptions to daily life to subside.
Bonds of nearly every type also experienced unprecedented levels of volatility in recent weeks. Even typically safe-haven US Treasuries were not immune to the “sell first, ask questions later” conditions in mid-March. Spreads, or the difference in yields between US Treasuries and other types of bonds, widened to levels not seen in over a decade. See the tables below of various widely-followed bond indexes from FactSet. These tables show the differences in spreads from year-end 2020 to March 20, 2020.
Spreads widen when investors (1) buy more US Treasury bonds than other bonds (2) investors sell more other bonds than US Treasury bonds, or (3) a combination of the two actions. Most recently, investors selling other types of bond investments were the primary reason for spreads widening, resulting in bond prices falling and interest rates (or yields) rising. The indiscriminant selling of certain types of bonds led to the Federal Reserve instituting some of the programs and policy initiatives referenced earlier. The liquidity provided by these programs should help to stabilize spreads in important parts of the bond market.
In the coming weeks, we anticipate that the bond market may continue to experience elevated levels of volatility. Though the “rush to cash” conditions we witnessed in mid-March seem to have abated, investors will need to assess bonds and bond issuers on a case-by-case basis. Bond issuers in the oil industry will bear particularly close watching, as the collapse in oil prices from $60/barrel in January to under $30/barrel as of this writing will stress the ability of some issuers to make timely payments of interest and principal. This is part of the reason why spreads in the High Yield portion of the bond market expanded so dramatically. Even investment-grade bonds (those rated BBB- by S&P or Baa3 by Moody’s or higher) will warrant closer scrutiny. However, the breadth and depth of this sell-off has undoubtedly created opportunities to purchase higher-grade bonds at higher yields (lower prices) than those available just a few short weeks ago.
From its peak on February 19, 2020 at 3,393.52 to its low (as of this writing) on March 23, 2020 at 2,191.86, the S&P 500 experienced the fastest decline of 30% ever. Fear and panic were prevalent and palpable, as investors liquidated positions in favor of cash. The VIX Index (sometimes referred to as “the fear index”), which measures expected volatility of the S&P 500 spiked to levels not seen since 2008. Stock prices are often considered a forecasting mechanism – a stock’s price is theoretically a reflection of the present value of future earnings or cash flows of the company; a 30+% decline in stock prices reflect a tremendous amount of “bad news.” What we have seen time and time again in the stock market is that events like this present some of the best long-term opportunities, though it is impossible to know when the market has bottomed in real-time. When we are inundated with negative headlines, volatile markets, and significant market declines, it can be challenging to maintain perspective and focus on longer-term goals. The following tables illustrate the importance of maintaining perspective and sticking with your investment plan.
Courtesy of Invesco Ltd. Courtesy of Invesco Ltd. Courtesy of Invesco Ltd.
The Importance of Asset Allocation and Diversification on Display
Markets like these provide strong empirical evidence of the value of diversification across asset classes and segments of the economy. Consider the table below.
Courtesy of Invesco Ltd.
Though this table does not include the current period, we can draw some important comparisons from our recent past that are still applicable today.
For millions of Americans, and people around the world, life as we knew it has changed. For most, it will be temporary. Others will not be so fortunate; it is impossible to ignore the human toll these events have had and will have. Yet we remain optimistic about the future. Important lessons will be learned and many of the smartest people on Earth are all working toward the common goal of finding a cure or treatment to this pandemic that has directly or indirectly impacted us all. The economy will regain its footing, people will get back to work, schools will reopen, and we’ll visit restaurants and theme parks. It may take longer than we want, but we will get there. In the meantime, we remain open for business and dedicated to helping you achieve your goals. We hope you and your families remain safe and healthy and we appreciate the opportunity to work with you.