March 12, 2020

What Happened

There is broad-based selling in capital markets as coronavirus-related headlines linger. President Trump announced a 30-day ban on most travel from Europe to the US, the NBA and NHL suspended their seasons indefinitely, an increasing number of colleges are suspending classes and other events across the US are being cancelled.

Our Take

While there continues to be human tragedy, the latest developments also add to investor uncertainty. There is little doubt that there will be a dramatic short-term impact on the economy. The probability of at least one quarter of negative economic growth is high. Therefore, a key question for longer-term investors is: Are the economic effects of the coronavirus likely to be similar to a storm or will it cause permanent damage to the economy?

In an interview this morning, former FDA Commissioner Dr. Scott Gottlieb opined that he believes this pandemic is a one or two-month episode. He believes March will be a very challenging month and issues will probably persist through April, but we will get through this. That said, he noted the coronavirus is likely to return in the fall but hopes that by then we will have a point-of-care diagnostic test and perhaps even a therapeutic treatment to control smaller outbreaks. This is one person’s view, and of course, the range of outcomes remains wide. However, assuming this is a reasonable outlook, if the US does see a recession, it will likely be relatively short in nature and not more than two quarters.

Equity View

We discussed in previous notes that the median stock market pullback during a recession has been 21% and the average has been 28%. As of Thursday midday, the S&P 500 is already down 26% from its high, effectively already pricing in an average recession. Of course, a potential recession could be greater than average. However, it is also important to understand that once stocks find their low during a recession, a year later, markets have climbed an average of 32% and a median of 37%, historically. Also, during the entire recession period, the S&P 500 has averaged a 0% return. That is, with markets acting as a discounting mechanism, much of the damage for stocks tends to occur prior to the recession and before it is half way over.

From a longer-term perspective, we would not underestimate the resiliency and adaptability of the US economy. Since World War II, the economy has been in expansion 85% of the time, reflecting that good times tend to far exceed the bad times. The average expansion has lasted more than five years versus less than one year for downturns.

While never comfortable, pullbacks and corrections are the price of admission for investing in the stock market and participating in the potential for higher long-term returns. Since WWII, we have seen over 10 market declines of more than 20%. Although painful in the short term, the markets have always eventually rebounded. The S&P 500 Index has compounded at an annualized return, including dividends, of 11% over roughly the past 75 years.

Fixed Income View

Over the past two trading sessions, US fixed income has failed to provide the counterbalance in portfolios one would expect during a strong equity drawdown. Generally, when equity markets falter, investors rotate out of more volatile asset classes into those perceived as safer in general. Throughout history, high quality US fixed income—US Treasuries, in particular—has provided that safe harbor. This week, US fixed income did not play its typical role of portfolio stabilizer as equity sentiment soured. Instead, many fixed income sectors endured price weakness and higher yields. As major US equity indices fell double-digits in a three-day span, many bond prices fell simultaneously.

High yield corporate bonds experienced larger losses relative to high quality bonds, but even those carrying investment grade ratings were not immune. Highly rated corporate and municipal bonds sold off significantly as liquidity dried up. On Wednesday and Thursday, as US equities tumbled, 30-year US Treasury yields actually rose 40 basis points, pushing those bonds close to a 9% loss, despite serving as one of the safest assets in the world. Most high quality fixed income sectors experienced similar weakness.

Our Take

When noting the unexpected weakness in high quality fixed income securities, one must consider it in context. Ahead of the three-day selloff, 30-year US Treasury bonds rallied roughly 29% between February 12 and March 9. Over the same span, the S&P 500 declined 19%. Other high grade fixed income securities reacted in similar fashion, providing the diversifying characteristics investors seek. More recently, that relationship has faltered for one primary reason: liquidity. With risk sectors in freefall, traders and investors looked to their highest quality, liquid assets to raise the cash they demanded. The supply of fixed income securities for sale overwhelmed the number of willing buyers who were reticent to deploy cash given the current climate of uncertainty. The “sell at any cost” attitude that pervaded global equities bled into US fixed income. This resulted in bond prices falling (i.e., yields rising) and credit spreads widening sharply (i.e., the additional yield available on a given debt security relative to a US Treasury bond of the same maturity). High yield credit spreads jumped to their highest point in four years, but the reasons differ. The spike in risk aversion created large, abrupt outflows in high yield corporate debt, particularly from the energy sector. Crude oil’s 41% price decline since February 20 will apply a great deal of pressure on the oil & gas industry and threatens the creditworthiness of some issuers.

Importantly, there is a distinct difference between liquidity risk and credit risk – though both are disruptive forces. A market facing liquidity challenges like, fixed income does today, makes it difficult to exit positions in an orderly fashion and at reasonable prices/yields. Liquidity events tend to take place when anxiety is high and rationality is low. A credit crisis occurs when the threat of widespread defaults intensifies and lenders’ willingness to lend dries up. In our view, what we are currently experiencing in US fixed income is primarily a liquidity event.

On Thursday afternoon, the Federal Reserve (Fed) entered the fold, unveiling a plan to provide a massive liquidity injection for the US Treasury market over the next four weeks. The Fed will conduct a series of large overnight repurchase agreement operations to ensure the level of liquidity in short-term lending markets remains “ample.” It also intends to insert itself as a buyer of $80 billion of various US Treasury securities, providing enhanced liquidity directly for the US Treasury market. Even with the Fed’s support, there are certain sectors that will face strong near-term credit pressure, particularly energy and industries closely tied to tourism and hospitality. We do not anticipate widespread defaults, especially in high grade corporate and municipal issuers. We maintain our high quality fixed income bias. While we expect volatility to remain high and spreads to stay elevated, for those who have been waiting for an opportunity to deploy cash in high grade bonds, valuations are now at attractive levels. For those investors who do not demand immediate liquidity, we encourage a patient approach to their fixed income allocations.

Bottom Line

Much uncertainty remains. This uncertainty will continue to weigh on investor sentiment until there is greater clarity on the extent and potential longevity of the coronavirus outbreak. The US economy is already experiencing its impact, and it is hard not to expect at least one quarter of negative growth. However, equities already reflect recession-like conditions and so do parts of the bond market. We believe longer-term opportunities are starting to present themselves, while the day-to-day price swings are likely to remain heightened for the foreseeable future. Investors should also remember that there is a high price to be paid for comfort. From our vantage point, the long-term return outlook is improving for investors who are not forced sellers at current levels.


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