The 11 year-long bull market in U.S. equities—and the accompanying economic expansion—ended abruptly in the first quarter of 2020, as the novel coronavirus (COVID-19) pandemic propelled the world into a state of fear and panic. The disrupting force of the virus on global supply chains, investor confidence levels, and, most importantly, the health and wellbeing of countless people around the world drove market volatility to levels not witnessed since the 2007-2009 Global Financial Crisis (GFC), with some measures exceeding peak levels experienced during the GFC.
Investors—particularly levered market participants—recalibrated their risk postures in anticipation of the sharp decline in global economic activity, shedding risky exposures, increasing demand for ultra-high-quality bonds, and raising cash. In an effort to reverse the deflationary forces that accompany a shock to the system of this magnitude, policymakers hastily put forth monetary and fiscal relief measures in a two-pronged approach, the scope and size of which has not been witnessed in the modern era.
Unsurprisingly, global equity performance during the quarter was overwhelmingly negative, as U.S. Large Cap stocks suffered their worst quarterly loss since fourth quarter 2008 but marginally outperformed International Developed and Emerging Markets. Domestic large cap equities outperformed small cap despite significantly more expensive valuations, as smaller cap companies are expected to face significant near-term economic challenges. Stylistically, growth’s multi-year trend of outperformance versus value persisted, with record low interest rates, near-flat term structures, and multi-decade lows across energy prices weighing on the financials and energy-heavy value indices.
Bond performance was divided, with positive performance generated among the highest quality sectors of the fixed income market, such as Treasuries and agency mortgages, while credit sectors—particularly below investment-grade—posted negative returns. High yield bonds, as proxied by the Bloomberg Barclays U.S. High Yield Bond Index, declined nearly 13% amid a sharp widening in credit spreads. This widening reached a localized peak of 1,100 bps at the depths of the sell-off across credit markets in late-March. Coinciding with the safe-haven rally in the latter half of the quarter included newly established record low interest rate levels at nearly every maturity along the U.S. Treasury yield curve.
Similar to the downside volatility experienced across stocks and the credit-oriented sectors of the bond market, real assets posted overwhelmingly negative returns, particularly among those sectors most sensitive to changes in global economic growth expectations. Energy infrastructure performance across both MLPs and the broader midstream pipeline universe witnessed the worst quarterly decline on record, pressured by plummeting energy spot prices and excess global crude oil supply. Nationwide store closures, mandated work-from-home orders, and missed lease/rent payments sparked fears of a significant downturn among real estate-related sectors, driving a sell-off across REITs, which essentially matched the performance of a broad basket of commodities.
KEY MARKET THEMES & DEVELOPMENTS
COVID-19 Grips the World in a State of Fear and Panic
Entering 2020, risk-seeking investors were flying high, coming off one of the strongest and broadest calendar-year market rallies in recent memory, in which a greater than 30% return was generated among U.S. large cap stocks and equally impressive performance was witnessed across high yield bonds, REITs, and other risky corners of the global universe.
As news of COVID-19’s spread across China began to permeate global headlines and the U.S. reported its first COVID-19 related fatality in late-February, market sell-off pressures mounted, intensifying throughout March. By the time the quarter concluded, the confirmed global COVID-19 case count stood just shy of 1,000,000 and the death count at greater than 40,000. These somber figures pushed higher in the beginning days of the second quarter, closing in on 2,000,000 cases and 100,000 deaths.
The data points to a global mortality rate of 6.0% as of the publication of this commentary, a rate which has steadily increased in the past two months despite a surge in testing (and thus confirmed cases).
While the trend of the mortality data appears grim, it also paints a broad stroke, as country-specific mortality rates vary greatly. For instance, as of April 9, the confirmed number of COVID-19 cases in the U.S. was 466,033, with 16,690 deaths, indicating a mortality rate of 3.6%, just shy of China’s 4.0% rate—which appears to have leveled off—and Italy’s devastating nearly 13% mortality rate.
A mid-October 2019 pandemic exercise hosted by the Johns Hopkins Center for Health Security, in partnership with the World Economic Forum and the Bill and Melinda Gates Foundation named “Event 201,” showed that a novel coronavirus might take 18 months to run its course and could result in the global loss of 65 million people, although the inputs used in the simulation were not identical to that of COVID-19 according to a later-published Johns Hopkins statement. Nevertheless, this recent simulation, along with daily public and private sector projections, highlights the seriousness and unpredictability of the virus’s path, drawing troubling parallels with the 1918 Spanish Flu, which contained multiple waves.
Amid this multitude of uncertainties, a premature end to the lockdown and social distancing measures currently in place could potentially trigger a second wave of infection, resulting in new outbreaks and a return to lockdown and social distancing, sparking a vicious negative feedback loop. This dynamic maycause further economic and psychological harm to an already strained global populace, resulting in bouts of continued volatility and unpredictable policy responses.
Incoming Economic Data Set to Shock and Awe Investors
The pre-virus set of conditions was not particularly robust, with annual growth among Leading Economic Index gauges across the U.S., euro zone, and Japan concluding 2019 at 0.1%, -3.0%, and -6.0%, respectively. Moreover, while the U.S. labor market ended 2019 strong on an absolute basis, it exhibited little to no improvement year-over-year (YoY), with growth across broad fundamental labor market gauges such as the Conference Board’s Employment Trends Index (ETI) crawling to a halt by the end of 2019, with a -1.6% YoY reading.
An early glimpse into COVID-19’s deleterious effect on the labor market has been on display each Thursday morning over the past three weeks, as the Department of Labor’s weekly initial jobless claims report—i.e., first-time filings for unemployment insurance—indicates that the U.S. economy shed nearly 17 million jobs in the 3-week period ending April 3. For context, at the depths of the GFC in late-March 2009, the peak in weekly jobless claims was 665,000. With a labor force of approximately 160 million people, the U.S. headline unemployment rate could already stand close to double digits, versus the previous peak of 10% in October 2009.
Continuing jobless claims, which measures the number of unemployed persons receiving benefits for at least 2 weeks, exploded to nearly 7.5 million people for the week ending March 27, the highest level in history.
The Conference Board’s broad measure of the fundamental health of the labor market—known as the Employment Trends Index (ETI), which aggregates 8 labor market variables such as initial jobless claims, job openings, and temporary employment—plummeted in March, with the steepest monthly drop-off in history and a shocking 45% decline YoY, also the worst decline on record.
Much like the broader economy, the labor market strengthens during expansion, with growth typically stalling late-cycle before falling off sharply in recession. The unprecedented deterioration in the labor market that began in March may have placed the economy in recession, the depths of which are unknowable at present and will not be confirmed until well into the next expansion.
Investors must now grapple with how much of the looming downturn has already been incorporated into current valuation levels. Furthermore, it is impossible to quantify the longer-term effects on consumption behavior and risk-taking once normalcy is restored.
From a technical standpoint, it may surprise some to learn that the National Bureau of Economic Research (NBER), the research institute commonly known for their business cycle start and endpoint approximations, does not necessarily require two consecutive quarters of negative real GDP growth to classify a recession. Rather, the NBER defines a recession as, “…a significant decline in economic activity spread across the economy, lasting more than a few months, normally visible in real GDP, real income, employment, industrial production, and wholesale-retail sales.”1 Without a sharp and immediate recovery in U.S. business activity—which may not be a prospect amid policymakers’ indications that a gradual resumption of activity is preferred—the unofficial likelihood is that the economy has already entered recession.
Policymakers Put Forth Historic Relief Measures
In the first quarter, the Federal Reserve (Fed) and U.S. Congress took drastic measures aimed at stemming the deflationary bias that accompanies a growth shock. The Fed announced back-to-back emergency cuts to the federal funds rate (FFR), the latter of which set interest rates back at the zero bound, while also announcing a new $700 billion quantitative easing (QE) program aimed at Treasury and agency mortgage purchases. Futures traders expect short-term rates to stay near zero until at least 2023, as the forward curve remains anchored essentially flat near the zero bound.
As the virus spread and infected risk markets, the Fed stepped up their game, expanding their QE program further to include an unlimited (open-ended) scope of asset purchases, as well as the creation of a special purpose vehicle (SPV) that retains the ability to purchase investment-grade corporate bonds. Increased QE measures resulted in a staggering $1.1 trillion increase in the Fed’s balance sheet in the month of March, bringing the year-to-date increase to an astounding $1.9 trillion, making the Fed’s balance sheet the largest on record, at more than $6 trillion.
The Fed announced further stimulative measures to begin the second the quarter, including the ability to purchase below-investment-grade corporate bonds and commercial mortgage-backed securities (CMBS) and extending loans to beleaguered municipalities. These announcements helped tighten credit risk premiums in the final trading days of the quarter, which persisted into the early days of the second quarter.
The Fed is not yet directly purchasing these securities, which would fall outside the scope of allowable asset purchases under the Federal Reserve Banking Acts. The events of the past three months provide little comfort that these measures may not soon find their way into the current monetary regime, potentially with destabilizing consequences along the way, particularly if the U.S. dollar is replaced as the global reserve currency, as ballooning budget deficits, debt balances, and promises of boundless monetary support could potentially force market participants to seek more suitable alternatives, the identity of which remains unknowable at the current time.
On the fiscal front, Congress passed the $2 trillion CARES Act into law on March 27, the largest fiscal package of the modern era at nearly 10% of nominal GDP. The bill extends aid to small businesses, provides relief to the healthcare industry, extends unemployment benefits, and offers most taxpaying Americans a direct monetary payment, with delivery set to begin in mid-April. Rumors of additional fiscal relief in the way of $1 trillion in infrastructure stimulus have recently surfaced, with the combined monetary and fiscal relief measures set forth during the quarter leading some to speculate the U.S. has already entered into a period of Modern Monetary Theory, or MMT.
An already historically wide budget deficit—which stood at nearly 5% of nominal GDP through the quarter—and government debt-to-GDP nearing 110% may limit the efficacy of recently passed fiscal measures, while placing the country’s fiscal position in an even more precarious standing.
Recent media buzz has centered around the prospects for a “v-shaped recovery,” the thesis being once shutdowns and social distancing measures are lifted, the economy may resume its pre-virus growth trend. Forecasts for near-term economic growth vary widely, with sell-side estimates reflecting a decline in economic activity of historic magnitude in the second quarter, as the Bloomberg median consensus estimate points to a -22.3% (annualized) decline in real GDP in the second quarter as of April 13. For perspective, the worst quarterly real GDP reading during the GFC was -8.4% in fourth quarter 2008.
While second-half real GDP growth may exhibit a rebound from a historically weak first half, the longer-lasting damage to the economy may be felt for years to come, potentially pulling U.S. trend growth—which has averaged 2.0-2.5% in the current cycle—even lower.
Rest of Year Outlook and Concluding Thoughts
The global pandemic COVID-19 wreaked havoc on investment markets in the first quarter, resulting in a surge in market volatility and sending risky asset prices significantly lower. The market’s nature of discounting future targets, which move unpredictably during normal times—e.g., earnings and profitability levels, financial conditions, and growth trends—punished those corners of the market most exposed to a sharp drawdown in economic activity while supporting the highest quality segments of the market.
Policymakers took swift action to dampen the economic shock to the system and narrow the wide range of potential economic outcomes, including near-zero policy rates, promises of unlimited QE and a broader scope of asset purchases, and a $2 trillion fiscal package—to name just a few of the measures set forth during the quarter.
The prospect for a v-shaped recovery remains questionable, as it is inconceivable that the millions of jobs lost during the shutdown—sitting at nearly 17 million as of the publication of this document, three weeks into the shutdown—could completely and immediately return. A possible scenario could be an extended “settling” period in economic activity, resetting trend growth lower with “green shoots” becoming more widespread as we move beyond the pandemic. In the interim, however, near-term economic data is set to display significant stress, potentially placing the economy in a technical recession, the depths and duration of which remain enigmatic.
The looming set of economic conditions may appear historically grim, but for opportunistic investors entering this period of heightened uncertainty in a position of strength, the opportunity to position portfolios for success in the next economic cycle brings excitement. FEG remains confident that its approach of populating portfolios with unique active managers in conjunction with opportunistic positions that exhibit a margin of safety uncovered by a process grounded in asset valuations, fundamentals, and sentiment, may deliver results.
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Published January 2020
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