The financial markets have taken investors on a tumultuous journey in the first quarter of 2020, with equities seeing record highs before plunging into bear territory in the shortest time frame on record. We have all become more familiar with the term ‘social distancing’ and now fully realize the threat a pandemic presents to the global economy. In the short term, most of us have focused on health concerns and the day to day volatility of the financial markets, which in March was at record setting levels. Now that some of the initial panic fueled “adrenaline” has subsided, the focus has shifted to the next quarter or two.
For the first time in the history of our country we know that a recession is inevitable. We don’t yet know how deep it will be or how long it will last, but the markets have attempted and are attempting to price in the appropriate amount of risk to this intermediate-term outlook. The consensus is that there will be a large contraction in growth (estimates range from -9% to -40% decline in GDP) in the second quarter and a gradual rebound after that. Market participants are parsing the incoming economic data for any indications of how deep the economic damage will be. At the same time, they are looking for indications of improvement on the health news and how and when the economy will potentially reopen. The consensus view is still coming into focus, but it is generally thought that over the next several months, the health news will improve enough to shift the focus to reopening the economy, at least on a limited basis. We expect volatility to remain heightened and the markets headline dependent through this period.
There are also significant long-term ramifications of the pandemic. From a market and economic perspective, the deficits and expansion of the Fed’s balance sheet are certainly two of the largest considerations. Conventional wisdom suggests that the dollar must weaken, inflation must increase, and bond yields must rise, all persistently, as the price for the massive stimulus and resulting deficits.
While the causes and conditions are different, we would point out that those same views were widely espoused during the Global Financial Crisis (GFC) as policymakers responded aggressively. Below is a chart (25 years’ worth of data) that shows the expansion of the monetary base during and after the GFC. Investors had many of the same worries regarding the inflation, the dollar and bond yields, none of which came to fruition over the subsequent decade; inflation (as measured by Consumer Price Index) averaged 1.8% and Fed officials often commented that it was below comfort levels. Bond yields have generally trended lower in the wake of the GFC and the dollar higher.
Could it be different this time? Absolutely. One must think that there are ramifications to the amount of U.S. deficit spending funding stimulus packages; however, many of those same conditions have been in place since the GFC. The United States is just one of many countries that has lowered the base lending rate and undertaken quantitative easing (QE), an unconventional monetary policy. When short-term interest rates are at or approaching zero, QE increases the money supply by allowing central banks to purchase assets with newly created bank reserves, providing banks with more liquidity. Similarly, the European Central Bank has created a targeted lending facility, making liquidity available to banks at -0.75% and is buying public and private sector bonds in large volume. The Bank of Japan has extended its purchases of stocks, bonds, and other assets and kept its short-term interest rate target at -0.1% and a pledge to guide 10-year government bond yields around 0%.
If the U.S were to maintain current policies, while other central banks reversed course, one could reasonably expect the U.S. currency to weaken and domestic yields to increase. It should be noted, however, that global central banks have been making a coordinated and aggressive response to the pandemic.
With the United States’ powerful demographic trends of an aging population and technological advances, we expect central bank rates and bond yields to remain “lower for longer,” at least directionally, as long as the following factors also remain consistent:
- The U.S. is not an outlier on fiscal and monetary policy.
- The dollar remains the world’s reserve currency.
- The trend of globalization continues.
In a recently published paper, researchers at the Federal Reserve Bank of San Francisco looked at the long-run consequences of pandemics that have resulted in more than 100,000 fatalities. Their work suggests that the natural rate of interest (short-term interest rate that would prevail when the economy is at full employment and stable inflation) have declined for decades after a pandemic, reaching its lowest point about 20 years later. We also believe, based on behavior exhibited after recent recessions, that the private sector savings rate will increase as businesses and households deleverage and increase safe reserves held in liquid, high quality assets (bonds, cash and money markets).
Despite the recent performance of gold, inflation expectations remain muted by most measures. The 10-year benchmark Treasury traded at historic low-yield levels recently. It remains below 1% on a yield basis. Approximately $10 trillion in global sovereign debt trades at negative yields. For all of the aforementioned reasons, we believe the probability exists that bond yields will remain in the “lower for longer” environment in place since the GFC for an additional extended period. There remains a role for bonds in a multi-asset portfolio, but investors need to be mindful of their return potential in portfolio construction.
Q1 2020 Market Events
Asset Class Performance
+ Flight to safe haven assets combined with accommodative central bank policy
– Spike in credit spreads amid coronavirus concerns
– Lack of liquidity
– Halt in economic activity
– Small cap’s higher sensitivity to market downturns
+ Fiscal and monetary policy response to the global pandemic
– Russia/Saudi Arabia oil price war
+ Flexibility and diversified sources of alpha benefited hedge funds in largely one-directional market environment
Volatility – Stocks Volatility Index and Bonds (MOVE)
Volatility spiked across markets with the VIX averaging 58 in March. This implies average daily moves in the S&P 500 Index of +/- 3.7%.
U.S. Nonfarm Payrolls (Monthly Change)
Over 700,000 net jobs were lost through mid-March, and April’s report, which includes the last 2 weeks of March, will likely be much worse.
U.S. Monetary and Fiscal Policy Response
The Federal Reserve and U.S. government swiftly enacted stimulus measures to support markets and the broader economy.
Equity — Growth vs. Value
Growth stocks like Amazon and Netflix outperformed value sectors, notable Financials and Energy, given low rates and falling oil prices.
WTI Crude Oil Prices
West Texas Intermediate (WTI) is a popular benchmark for oil prices. Oil prices tanked in March after Russia and Saudi Arabia refused to cut production and then slashed prices in order to grab market share.
Trade Weighted U.S. Dollar
A surge in demand for safe haven assets with positive yields strengthened the U.S. Dollar.
Government Bond Curves
Interest rates fell across the globe with shorter-term maturities in Germany and Japan offered at negative yields.
Fixed Income Market Update
U.S. Treasury Curve
Rates dropped precipitously, most notably on the short-end as Fed policy caused a modest steepening of the curve.
Index Performance Attribution (1Q20)
Falling Treasury yields benefited bonds, but widening spreads were a headwind, particularly for riskier assets like high yield.
Credit Market Spreads – Trailing 5 Years
Spreads blew out in the first quarter amid growing concerns about the negative economic impact of COVID-19. Monetary and fiscal responses provided some relief through the end of March, but Investment Grade and High Yield spreads are now trading above 10-year averages.
Equity Market Update
Equity Valuations (Trailing 15 Years)
The virus-driven selloff pulled down valuations to levels well below those seen at the end of 2019.
U.S. Equities – Contribution to Return by Sector (1Q20)
~95% of S&P 500 companies had negative 1Q returns, led by Energy, which contributed -2%, despite a mere 4% index weight.
Country Total Returns (%) – Top 10 Largest Economies
Returns were negative across the board, most notably in Brazil. Brazilian President Bolsonaro has downplayed the virus threat and refused to enforce a shutdown. On the other hand, China’s strict quarantine measures to stem the outbreak appear to have benefitted that market.
Alternatives Market Update
Hedge Fund Cumulative Returns – Trailing 10 Years
Strategies with significant equity and credit beta lagged more market neutral approaches over the course of 1Q 2020.
Spreads over 10-Year Treasury
Midstream energy spreads spiked following the Russia/Saudi Arabia standoff coupled with coronavirus concerns. Real Estate Investment Trusts (REITs) also weakened but not nearly to the degree as sectors impacted by oil prices.
The Purchasing Managers Index (PMI) is a measure of the prevailing direction of economic trends in manufacturing. As anticipated, global business activity plummeted to levels below 50, indicating economic contraction.
Real GDP Growth (YoY)
Forecasts for 2020 fell meaningfully, particularly in Europe with expectations for negative growth this year.
Federal Reserve Bank of New York, Recession Prediction Model, Next 12 Months
While the probability remains under 50%, it’s worth observing that in 2010 the U.S. fell into a recession shortly after the model recorded a 40 percent probability. Given today’s economic environment, the probability of a recession by August reached 38%.
Financial Market Performance
Periods greater than one year are annualized. All returns are in U.S. dollar terms.
YEAR-BY-YEAR PERFORMANCE RANKINGS OF ASSET CLASSES
These materials have been prepared for informational purposes only based on materials deemed reliable, but the accuracy of which has not been verified. Past performance is not indicative of future returns. These materials do not constitute an offer or recommendation to buy or sell securities, and do not take into consideration your circumstances, financial or otherwise. You should consult with an appropriately credentialed investment professional before making any investment decision.