First Quarter 2020 Market Commentary
THE FIRST QUARTER of 2020 will be one for the history books. The rise of and response to Coronavirus (COVID-19) left the global economy reeling and fueled the worst first quarter in the U.S. equity markets in more than a hundred years. Not only that, but the S&P 500 also experienced the most rapid decline ever from a peak. On Feb. 19, the S&P 500 topped at 3386, the highest close ever for the index, marking the end to the 11-year bull market. In just 15 trading days, the S&P 500 tumbled into a bear market with a 26.7 percent decline during that time period, 9.5 percent of which came on March 12, which marked the start of the bear market (defined by a decline of 20 percent or more).
What’s more, the index continued to deteriorate for another seven trading days, finally marking the low of the quarter on March 23, down a whopping 34 percent from the February peak. Despite a sharp rally into quarter’s end, the S&P still declined 19.6 percent for the quarter. U.S. small cap stocks fared significantly worse, down 30 percent for the quarter, while the worst U.S. sector was energy, down 50 percent, a result of the economic shutdown and the price war that escalated between Saudi Arabia and Russia.
While we were of the opinion that the economic cycle was a bit long in the tooth and the risk of a recession was rising as we entered 2020, the reversal in fortunes has been nothing short of stunning with the external shock of the COVID-19 pandemic causing economic activity to cease in a way that the world has never experienced. The abrupt downturn—coupled with fear, uncertainty, high valuations and overleveraged corporate balance sheets—led to a wave of market panic.
The longest period of economic expansion in history is over. While most recessions are caused by exogenous shocks, which then expose the imbalances of the past cycle (typically those with stretched balance sheets), the end of the recent cycle was much more severe. Not only were business balance sheets very poor heading into this crisis, but the U.S. economy was dealt multiple shocks: mandated domestic business closures; disruptions in lending from severe financial market stress; and an oil price war.
We are in the midst of a period that is extremely difficult to forecast. There has never been an economic contraction like what we are experiencing now. There is no doubt to us that we are experiencing a severe global recession. The only questions are how deep will the contraction be and how quickly will it rebound? In our view, U.S. GDP for the first quarter will not be horrible. The economy was relatively strong through February. Furthermore, despite a precipitous drop in spending on travel, entertainment, restaurants and broader discretionary retailing, March saw a surge in consumer staples and online spending.
It’s the second quarter that will see the most severe downturn in economic activity. We expect the depth of the downturn will be worse at its trough than the Great Financial Crisis, which saw GDP drop roughly 12 percent from the second quarter to the fourth quarter of 2008. We believe that the current contraction could be double that—with the hopes, but certainly no guarantee, that the recovery will be much swifter, given the self-imposed nature of the downturn.
Within this decline, the velocity of money will plummet. There will be huge reductions in discretionary consumer spending. Corporate investment spending on capital equipment, already weak, will dry up. Homebuilding could see a significant decline off a weather-enhanced first quarter. The broader services economy, often lauded as the bright spot of the U.S. economy and the goal of emerging economies, will suffer greatly. Even typically-safe industries like health care and utilities will be hard hit. Consumer staples is the only true recession-proof sector. Given the forced shutdown of the U.S. economy, it is obvious that the economic consequences will be widespread and severe. However, the policies discussed below can help the economy avoid a depression.
The trigger to this crisis was different than any other downturn. What is also different is the unprecedented speed and size of the monetary and fiscal response to the crisis. Policymakers have responded in huge fashion in an attempt to keep the recession from turning into a lasting depression.
The U.S. Federal Reserve (the Fed) lowered interest rates twice in emergency meetings and unleashed a host of programs to help ensure the smooth functioning of the banking system and fixed income markets.
We think the Fed moves will prove to be mixed in their application. Lower short-term interest rates at the front end of the curve will likely prove insufficient in boosting economic activity, as the Fed can’t fight the type of fear the general public is currently experiencing. At the start of this crisis, the U.S. economy was not under pressure from a high level of interest rates, so it’s our view that reducing rates will provide little boost. Not to mention, if people are afraid for their own or others’ lives, cheaper money is not going to incentivize them to go out into the world and spend. In addition, the Fed’s buying of corporate and municipal bonds, as well as fixed-income ETFs, are not overly important, in our view, at least compared to other areas with which it has become involved.
The Fed actions that we believe to have the most impact are those that ensure the proper functioning of the short-term/overnight and dollar funding markets, which were seemingly much needed as both experienced significant strain in March. These were two areas during the Great Financial Crisis that caused the most pain and panic.
While the Fed is not out of ammunition as they can do more of everything they’re doing in size, we believe they’ve pulled all the levers with the power they have, leaving the U.S. government to provide fiscal support for the economy. And, on the heels of the Fed’s response, Congress enacted multiple fiscal relief measures over the last few weeks.
Congress passed the Coronavirus Aid, Relief, and Economic Security (CARES) Act, a huge bill of federal spending and tax cuts, primarily aimed at helping the economy weather the recession triggered by the shutdown response to the COVID-19 pandemic. This legislation is three times the size of the stimulus package enacted in response to the Great Financial Crisis and may be augmented by further measures in the months ahead. Additional government support will provide aid to unemployed workers and state governments, payments to individuals, and loans to businesses.
Further fiscal support for the economy looks likely to be needed. Additional aid to state governments and small businesses will likely occur. Not to mention, there are growing talks of a large infrastructure bill, perhaps totaling a few trillion dollars. We would expect this to be a much smaller amount of funding, should it pass, as concerns rise over how much debt the U.S. will have to take on to pay for it and other programs.
Attempting to handicap possible recoveries from this economic shutdown is a difficult task. Here, we will try to do just that and lay out the likely outcomes (L-, W- and V-shaped recoveries) as we look beyond the current shutdown.
Starting with the two less-desired recoveries—a prolonged L-shaped trajectory (or lower for longer) or a W-shaped recovery (a bounce back, relapse and ultimate recovery)—there are two swing factors that could make these adverse scenarios more likely. First, is the shape of the pandemic curve. The second is the shape of the default curve in the highly-leveraged, cyclical sectors of the economy (or very small businesses) that may not have direct access to central bank and/or government balance sheets. China is the only country, as of this writing, that has supposedly shown any type of recovery in relation to COVID-19, although we believe both its economic and virus data are highly suspect. Therefore, no one has any idea what will happen with the spread of COVID-19 once the quarantines end.
A prolonged economic stagnation (L-shaped) would likely result if the current suppression strategy proves ineffective in slowing the spread of the virus. With economic activity depressed for a longer period of time, the stress on many of the highly-leveraged firms would likely default on existing debt or fail to roll over said debt when it matures, feeding back negatively into employment and demand for goods and services.
Should suppression of the virus prove successful in the near term, ending quarantine measures and fueling a recovery of economic activity, it remains possible--if not probable—that we could experience a second wave of contagion at some point that leads to additional shutdowns before another attempt to recover (W-shape). Cyclical and highly-levered companies that survived the first wave will take on additional strain, and perhaps will not be strong enough to survive further financial complications.
A V-shaped trajectory is also possible—the most desirable outcome, and likely what is currently factored into financial market prices; unfortunately, we do not think this is the most likely outcome. Such a trajectory would be the result of the combination of successful Fed and U.S. government policy interventions, in addition to not only significant medical breakthroughs such as a vaccine, but the rapid manufacture and dissemination of such a vaccine. This would require a perfect storm of positive outcomes to occur quickly and efficiently, which appears unlikely with the U.S. government involved.
Our best forecast at this point is for more of a W-shaped recovery, with perhaps the second dip being less severe than the first. This considers a potential second wave of COVID-19 once people and businesses attempt to return to “normal,” the likelihood that some businesses will fail slowly through a period of lesser economic activity, and that a vaccine will ultimately support normalized conditions and the beginning of a sustainable economic recovery at some point in 2021.
WHAT WILL CHANGE?
Many appear to believe that once businesses are back open that not much will be different compared to before the rise of COVID-19. We believe there will be significant changes that will affect the investment landscape and will attempt to highlight areas that are likely to see significant change and/or a lasting impact from the current crisis.
First, globalization—already on a bit of a downtrend (or at least manufacturing moving away from China)—will occur even faster as firms reduce the complexity and vulnerability of supply chains. This may lead to higher manufacturing costs and, ultimately, wage and price inflation.
Second, corporate and public sector debt levels will likely be significantly higher after this crisis. This could demand even more monetary policy with the Fed’s temporary support becoming more long term, at least in some instances. This could also lead to credit spreads remaining wider for longer.
Third, we expect many corporations to approach cash-flow expenditures differently. We see lower dividend payout ratios, fewer share buybacks and less capital investment as companies de-lever and save for a rainy day.
Fourth, many households will likely come out of this crisis with higher levels of personal debt and will have experienced severe income and/or job losses, impeding overall discretionary spending and perhaps fueling an increase in savings earmarked for low-risk investments, such as cash and bonds. Spending patterns will also likely change or be altered for a significant time period. We do expect some form of “social distancing” to persist over time, impacting entertainment and travel-related expenditures.
Overall, this economic downturn and crisis will have significant effects on economic growth, unemployment and the federal deficit in the future. We believe it will shape the financial landscape for years to come, with the potential for higher inflation, interest rates and taxes.
PUTTING IT ALL TOGETHER
Many pundits are claiming that the bear market is already over, with the S&P 500 rallying over 20 percent in just three days. We don’t agree. While this severe economic downturn has the possibility to be very short-lived, we don’t see this as being “one and done” with no lasting complications.
A shutdown of 70 percent of the economy has never happened before. This is an experiment with unknown economic, financial, social and political consequences. It remains to be seen how the dramatic hit to household net worth, from both job losses and the financial market downturn, will affect household economic decisions for all demographics, but particularly Baby Boomers, who carry the most wealth and have the shortest timeframe to retirement, if they are not already there.
The recession will be deep, but will not last forever. There will be a recovery, but we think that the economy will come back in stages with perhaps periods of setbacks, rather than a V-shaped recovery that never looks back. People will be more cautious with regard to spending and investing. Many believe that the equity markets have already bottomed. We would be surprised if that was the case. While the cause of this downturn is certainly different and could be short lived, bear markets typically end after a process of testing and retesting the lows. Not to mention, the “buy the dip” mentality is not often the predominant sentiment at said lows, which appeared to be the case in late March.
Right now, investors seem to believe that the government assistance will save the day. It certainly took the worst case off the table, but we do not think it will be enough to generate a significant recovery. Businesses have been saved; profits have not been. We have yet to see the brunt of the economic shutdown in the macro data, which will be horrible for the next few months. The market could look through this downturn as an aberration, but with market multiples at average levels and earnings forecasts barely showing any profit impairment in 2021, we believe the risk is to the downside.
During times like these, with such a murky outlook, we believe it is best to implement a defensive stance until volatility subsides and there is a clearer economic picture. We believe a caution is warranted in an effort to protect against long-term capital impairment.
QUESTIONS AND COMMENTS
Clifford T. Walsh, CFA Chief Investment Officer American Portfolios Financial Services, Inc. 631.439.4600, ext. 277 firstname.lastname@example.org
Sam J. Rozzi, CFA Manager of Due Diligence American Portfolios Financial Services, Inc. 631.439.4600, ext. 136 email@example.com
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i All index returns are total return figures accessed using Morningstar Direct on April 1, 2020. You cannot invest directly in an index. Index returns do not include trading or other investment costs.
ii FactSet Research