April 2020
By: Pat Guinet, CIMA®
First Quarter Market Update
The first quarter of 2020 has been an unprecedented period in U.S. financial market history across numerous dimensions:
- The U.S. stock market fell into a 20% bear market in the shortest time ever—just 22 days—and continued further, dropping 30% in a record 30 days. The typical historical bear market peak-to-trough decline has taken around 12 to 18 months.
- Short-term expectations of stock market volatility, as measured by the VIX index—often referred to as the market’s “fear index”—closed at an all-time high in its 30-year history on March 16. And the market’s actual realized volatility has only been higher in October 1987 (Black Monday) and the late 1920s.
- The 10-year and 30-year Treasury bond yields fell to all-time lows of 0.54% and 0.99%, respectively, on March 9.
- Oil prices had their biggest one-day drop since the 1991 Gulf War, plunging 25% on March 9, triggered by a price war between Saudi Arabia and Russia.
Year to date, larger-cap U.S. stocks have fallen 30%. Growth stocks have continued to hugely outperform Value: the Russell 1000 Growth Index has fallen 25%, while the Russell 1000 Value Index has fallen 35%. Smaller-cap U.S. stocks have done even worse, falling 38%.
Developed international stocks have fallen 34%, and emerging-market stocks have dropped 31%. Much of the differential between U.S. and foreign stock market returns has been due to the appreciation of the U.S. dollar, which has risen roughly 4.5% year to date.
In the fixed-income markets, core bonds have gained 1.1%, once again providing their key role as portfolio ballast against sharp, shorter-term stock market declines. As noted above, Treasury bond yields have fallen sharply. They have been extremely volatile as well—shooting up on some days when stocks were also sharply selling off. The 10-year yield is currently at 0.76%, down from 1.92% at year-end.
First Quarter Portfolio Performance & Key Performance Drivers
Financial markets in 2019 were a positive surprise for many investors; however, the start of 2020 has been the exact opposite. Just three months ago, most investors were astonished at the stock and bond returns of 2019 during the eleventh year of a historic bull market. BUT one thing is constant: Just as no market pundits expected strong stock and bond returns last year, none of them expected a 30% stock market drop in the first three months of 2020 and the real possibility of a severe economic recession.
When you diversify across asset classes and consider a variety of potential scenarios, there will always be leaders and laggards in your portfolio. Some positions work well in strong up environments like we experienced last decade, while others benefit portfolios during tougher times like the start to the 2020s. Put together, they build resiliency and protect a portfolio from betting on a single outcome, which can be a disastrous financial result if the opposite happens.
We are very happy with our decision to use both tactical and alternative investments in our portfolios to help buffer the volatile and challenging times we are currently experiencing.
Foreign Stocks
Positions in foreign stocks have been a headwind in this first quarter. European stocks have underperformed U.S. stocks during this swift and severe downdraft, while emerging-market stocks have fallen a similar amount as U.S. stocks. As markets have fallen, there has been a strong “risk-off” demand for U.S. dollars and a resulting appreciation in the U.S. dollar. This has hurt dollar-based investors in foreign stocks. In fact, European markets have performed in line with U.S. markets in their respective local currencies. And emerging-market stocks have outperformed U.S. stocks in local terms—dropping only 23% in local-currency terms. We expect the dollar to weaken as the crisis abates and a global recovery resumes.
Lower-Risk, Tactical Funds, and Alternative Strategies
Lower-risk and diversified alternative strategies and tactical strategies have outperformed during the quarter, providing ballast in portfolios during the current bear market.
Update on the Macro Outlook
Coming into the year, we saw the potential for a moderate rebound in the global economy (especially outside the United States) on the back of reduced U.S.-China trade tensions and extensive global central bank monetary accommodation. And in January and early February, there were signs the manufacturing sector had bottomed and a nascent global recovery was indeed underway. Stock markets rallied to all-time highs.
However, the arc of the coronavirus and the increasingly aggressive U.S. and global response to try to slow its spread has drastically changed everything. Our base case now—and it seems most investors, economists, politicians, and central bankers agree—is that the U.S. economy is headed into recession in the second quarter. It is likely to be a severe one, with a sharp contraction in GDP and an unprecedented rise in unemployment and jobless claims.
The consensus also appears to believe the recession will be short in duration, with a rebound beginning around the third quarter. But this is by no means a sure thing. To the extent equity markets are not fully discounting a more severe outcome, downside risk remains.
The depth and duration of the recession—and the strength and timing of the ensuing recovery—depend on two key variables:
The effectiveness of the medical response and economic policies (and their impact on human behavior at the societal level), will help answer the fundamental economic question of how severe and how long the economic downturn and recession will be. And the answer to the economic question will help answer the investment question of how severe and how long the equity bear market will be.
The financial markets and the real economy are interconnected—each drives the other and can reinforce or magnify a trend in one direction. A rebounding stock market supports the real economy and vice versa through positive wealth effects, increased incomes, profits and spending, risk-taking, and optimism. But they can also feed off one another on the downside, in a self-reinforcing negative spiral that can ultimately lead to an economic depression if the spiral is not broken.
On the Coronavirus
We are not medical experts, virologists, or epidemiologists. As a result, we have little to say on the medical side of things that others haven’t already said, or that all of us aren’t hearing and reading every day in the news. What we will say is that, as we write this, the data show the virus is continuing to spread at an increasing rate in many countries, including the United States and across Europe. There is still little clarity or certainty as to when this trend will flatten and decline.
We expect financial markets to react positively at the first signs of a flattening in the number or rate of new daily cases reported, as we saw happen in China in February, and also happened during the SARS epidemic in 2003.
Italy may be a leading indicator of the progression of the virus in other developed countries. Many experts have said the U.S. virus situation is roughly two weeks behind Italy’s. But there are also important differences between the two countries (e.g., medical infrastructure, demographics, policy response) that make for an imperfect comparison.
On the Economy
The near-term economic damage from the United States’ and other countries’ response to the virus now looks almost certain to be severe (barring some unexpected major medical breakthrough in the near future).
On Sunday, March 15, the Federal Reserve held an emergency meeting where they cut the federal funds rate by one percentage point to near zero. The Fed also announced it was restarting quantitative easing (QE) with at least $700 billion in planned purchases of Treasury bonds and mortgage-backed securities.
Over the following week, economist after economist slashed their second-quarter GDP forecasts deeper and deeper into contractionary territory. They may have changed again by the time this is published, but to give a sense of the magnitude, going into the last week of March, Goldman Sachs was forecasting a 24% annualized decline, Morgan Stanley a 30% decline, JPMorgan a 14% decline, and both Bank of America and Citigroup a 12% decline, to name a few. For comparison, the worst quarter during the 2008 financial crisis was an 8.4% annualized GDP contraction, in the fourth quarter of 2008.
As mentioned earlier, an economic slowdown—particularly an extremely sharp one due to extreme virus containment efforts—can quickly morph into a self-reinforcing negative spiral. Consumers cut back spending, businesses layoff workers, unemployment rises, incomes drop further, spending drops further, corporate profits drop, companies and households default on loans, companies go out of business, investment and employment drop further, etc., causing an even deeper and longer recession (if not depression) and bear market.
In this case of a severe external shock, the government’s economic policy responses are critical. There are two main levers: monetary policy (central banks) and fiscal policy (government spending, tax cuts, unemployment insurance, loans, debt forgiveness, etc.).
One lesson learned from the 2008 financial crisis is: When it comes to the policy response, go big and go fast. Time is of the essence (just as it is with the virus response). Governments need to make a credible commitment to “do whatever it takes” to support the economy and prevent the negative spiral from taking hold.
Monetary Policy
The Fed and other major central banks seem to be all-in to support the fluid functioning of credit, lending, and financial markets, and their critical role as the “plumbing” of the real economy.
As noted above, at an emergency meeting on Sunday, March 15, the Fed cut the federal funds rate to near zero and restarted QE. A week later, it increased the QE program from “at least $700 billion” to essentially an unlimited amount in order to keep interest rates and borrowing costs low. The Fed also initiated a number of programs—going beyond the tools it enacted during the 2008 financial crisis—to try to ensure enough credit, loans, and liquidity are flowing to banks, businesses, households, and the overall global financial system. It is likely the Fed will do still more (e.g., increasing their asset purchases to support the huge fiscal stimulus that is coming or even effectively monetizing the debt or “helicopter money”). Other major central banks are also starting to pull out all the stops, and more will likely come until the crisis period ends (and maybe beyond).
Fiscal Policy
While extremely accommodative monetary policy is necessary, it is not sufficient to mitigate this economic crisis. Only fiscal policy can have a large enough and direct enough impact necessary to support and sustain individuals and businesses until the storm has passed and the virus containment measures show signs of working.
Legislative haggling in Washington, D.C. over the components of what could be a $2 trillion fiscal stimulus package—nearly 10% of U.S. annual GDP—is continuing (as we finalize this on March 24). But congressional Republicans, Democrats, and the Trump administration all seem to be in agreement that something massive needs to be done and done quickly.
Public and business support is also undoubtedly strong. Therefore, the political obstacles to getting something done should be relatively low, especially considering how polarized the current political environment otherwise is. There really is no alternative. And, like the monetary policy response, the fiscal stimulus will also be global in scale, with even austerity hawks like Germany now acceding to its necessity.
The fact that most everyone across the political, ideological, and economic policy spectrums agrees that the aggressive measures necessary to slow or contain the virus could tip the U.S. and world economies into a depression is good news. It greatly improves the odds countries will act quickly and forcefully to enact fiscal, monetary, and regulatory policies to prevent that dire outcome from happening.
Current Portfolio Positioning and Potential Additional Changes
In this period of heightened uncertainty and market volatility, we want to give an update on our portfolio positioning. The good news is that stock markets now do appear to be discounting a recession, but a relatively short one, not a severe or long-lasting one. According to an analysis by Ned Davis Research, severe global recessions have been associated with an average decline of 45% in global equities (albeit there are not many data points). And a reminder: The S&P 500 ultimately dropped 59%, 49%, and 48% in the 2007–09, 2000–02, and 1973–74 bear markets noted above.
If the virus news gets worse in the United States (before it gets better), investor sentiment could take additional hits with further market declines. Such declines—driven by fear, uncertainty, and human herd behavior—can feed on themselves resulting in a major overshoot on the downside compared to the market’s “fair value” on a longer-term fundamental basis (i.e., based on companies’ long-term profitability and dividends).
We are maintaining our positions in European stocks and emerging-market stocks because their expected returns have also gotten much more attractive on a forward-looking basis after their recent price declines. And, unlike U.S. stocks, they were already at relatively attractive valuations and offered attractive expected returns prior to the virus-related selloff. As we have from the beginning, we remain cognizant of and account for their potentially larger downside risk compared to U.S. stocks in our overall portfolio construction, risk management, and expected-returns analysis.
Closing Thoughts: This Crisis Will End. This Too Shall Pass.
As investors, it is so important to maintain our focus on our long-term financial goals and objectives. As hard as it may be, from an investment perspective, we need to try to look through the current environment of fear and concern—emotions which, given the circumstances, are totally justified and felt by all of us—to the almost certain outcome of the virus crisis receding and economic recovery occurring.
As a long-term investor, trying to time market tops and bottoms is a fool’s errand. The evidence is overwhelming that most investors diminish their long-term returns trying to do so. They are more likely to chase the market up and down, and get whipsawed, buying high and selling low. But incrementally adjusting portfolio allocations in a patient and disciplined fashion in response to changing asset class expected returns and risks makes a lot of sense for long-term investors. And with the help of our research partners at Ned Davis Research we believe we have the necessary tools to navigate this challenging environment.
The time to be adding to stocks and other long-term growth assets is when prices are low and markets—and most of us personally—are gripped by fear and uncertainty rather than complacency, optimism, or greed. Investing at such times will feel very uncomfortable. It may seem like the market could just keep dropping with no bottom in sight. But that is exactly where research, analysis, patience, experience, and having a disciplined investment process come most into play.
If we invest based on our feelings and emotions, we are very likely to cash out of the market after it has already dropped a lot, locking in those losses. Then, waiting to reinvest after our discomfort and worry are gone, the market will already be much higher. That is not a recipe for long-term investment success, yet it plays out in each market cycle.
Facing the current medical and economic crisis, the situation is probably likely to get worse before it gets better. (We would love to be wrong about that.) But, with some necessary and shared sacrifices from all of us—and clearly those on the medical front lines much more than most—it will get better.
Stay the course.
Note, all returns in this commentary are as of the market close on March 23.
Certain material in this work is proprietary to and copyrighted by Litman Gregory Analytics and is used by Guardian Financial Partners, LLC with permission. Reproduction or distribution of this material is prohibited and all rights are reserved.
