First Quarter Market Recap
Domestic Equities: The S&P 500 lost -19.6% during the first quarter. Optimistic expectations regarding moderating trade tensions and healthy earnings growth were swiftly reversed as the COVID-19 outbreak spread, ending the longest bull market in history and causing a likely recessionary period that is being referred to as the “Great Lockdown.”
Deterioration in the economy caused by business shutdowns offset by unprecedented stimulus from Congress and the Federal Reserve have contributed to historically high levels of volatility and divergent views regarding the future path of markets.
Despite every sector in the S&P 500 finishing lower, given the unique viral cause of the market correction, sectors have experienced significant dispersion. Sectors such as technology and healthcare fared relatively well while other cyclical sectors such as travel, leisure and consumer discretionary suffered materially.
International Equities: COVID-19 had a more significant impact on international markets during the first quarter. Developed international equities as measured by the MSCI EAFE Index finished the quarter down -22.7% and emerging market equities ended the quarter down -23.6% as measured by the MSCI EM Index.
The impact of COVID-19 has varied widely across countries, depending on factors such as demographics, geography and level of preparedness to combat the spread of COVID-19. In addition, the crash in oil prices may continue to cause heightened market volatility.
Commodities: Broad-based commodities, as measured by the Bloomberg Commodity Total Return Index, finished the quarter down -23.3%. The demand destruction caused by government-imposed shutdowns across the world has caused many commodities to decline significantly in price.
Oil prices plummeted over the quarter, with prices for specific futures contracts going negative as demand from auto, air travel and manufacturing underwent significant reductions. Gold has been the commodity standout from a positive performance perspective, rising nearly 4% over the quarter.
Fixed Income: Fixed income markets returned 3.1% as measured by the Bloomberg Barclays Aggregate Index, due to a significant fall in Treasury yields as investors sought safety amid the worsening coronavirus outbreak. In addition to strong demand for Treasuries, investors also rushed to raise cash, leading to market imbalances and significant liquidity issues. As a result, many credit-related securities traded aggressively down in price based on the lack of liquidity, rather than on the merits of their fundamentals. In response, the Federal Reserve took unprecedented measures to inject liquidity into the financial and credit markets by lowering the Federal funds rate to near-zero, and by reinstating many old stimulus measures that were used in the Global Financial Crisis of 2008, as well as initiating a stable of new programs.
TABLE 1: MARKET PERFORMANCE AS OF 3/31/2020
The COVID-19 humanitarian crisis has upended the lives of most of the world’s population with a velocity that we have never before witnessed. Over 90% of people across the globe live in countries that have implemented some form of shutdown as a result of COVID-19. There are over three million cases and over 230,000 deaths worldwide as a result of the virus, with the U.S. accounting for one-third of these cases and reporting nearly 60,000 deaths over the last few months. The virus has now become the leading cause of death for Americans, overtaking other diseases such as heart disease and cancer and killing more Americans than the Vietnam War.
The virus is having a similarly catastrophic impact on the economy, resulting in unprecedented volatility. Within a month, the S&P 500 contracted 34% to reach a recent trough on March 23rd, setting a record for the fastest bear market in history. In whirlwind fashion, the month of April proved to be the best month for U.S. equities since 1987, with the S&P 500 climbing back 13%. This has caused investors to form divergent views on whether we’re past “the” bottom of the market or have simply experienced “a” bottom of the “Great Lockdown,” which is what the COVID-19 crisis is being referred to by many.
Although technically we have now entered a bull market in equities, recent economic data is providing a preview of things to come, calling into question whether we have turned the corner as COVID-19 appears to be stabilizing globally, or whether the recent rebound is nothing more than a bear market rally. These types of rallies are often experienced during recessionary periods (e.g., we experienced a rally of approximately 24% during the Global Financial Crisis). Initial readings suggest that GDP for the first quarter declined 4.8%, the largest drop since the Global Financial Crisis. Given the fact that the first quarter only captured the initial impact of the COVID-19 crisis, consensus estimates for the second quarter indicate GDP during the second quarter may drop 25% to 40%. Moreover, the International Monetary Fund estimates that global GDP will contract approximately 3% this year, causing the deepest global recession since the Great Depression nearly a century ago, when global GDP fell by an estimated 15%. For comparison, global GDP shrank just 0.1% during the Global Financial Crisis.
As a result of the swift contraction in economic activity, approximately 30 million people have filed for unemployment benefits, more than eliminating all the jobs created since the Global Financial Crisis. Current forecasts estimate that the unemployment rate is roughly 15% and may reach over 20%, depending on the extent of continuing business shutdowns, causing many to draw comparisons of the COVID-19 pandemic to the Great Depression when unemployment climbed to 25%.
On the other hand, the significant impact of COVID-19 on populations and economies has also been met with massive monetary and fiscal stimulus from the Federal Reserve and Congress, which too has no precedent and has helped fuel the recent recovery in equity markets. The Federal Reserve has dropped interest rates back to nearly zero and increased its balance sheet by over $2 trillion to $6.5 trillion to prevent a liquidity crisis and protect against additional financial distress. Furthermore, primarily by way of the CARES Act, over $2 trillion of stimulus has been approved, dwarfing the $870 million package implemented during the Global Financial Crisis during the Obama Administration, with more in the pipeline.
The Bulls Are Winning the Battle So Far…
Despite the flow of daunting economic data and dire expectations for the second quarter, the S&P 500 is technically in a bull market, having rallied approximately 30% since March 23rd. Risk assets have rebounded significantly due to a combination of increasing faith that we seem to be past the peak of global COVID-19 cases, and the confidence that the massive amounts of monetary and fiscal stimulus will be effective in offsetting the economic damage caused by the pandemic. In fact, there has been a strong relationship between the growth and decline of global cases and the level of market volatility, as measured by the VIX index, which is known by many as the “fear index.”
The current rally in equity markets may reflect the market’s role as a “discounting machine” of future expectations, having already moved beyond the near-term expectations of weak GDP and recent earnings data and already pricing in an eventual recovery, particularly as portions of the country are beginning to relax lockdown measures and reopen businesses and optimism remains high that an effective treatment or vaccine will be developed over the next 12-18 months.
FIGURE 2: CONTRIBUTION TO REAL GDP BY SECTOR (%)
…But is the War Over?
The bull case that markets seem to be reflecting, however, relies on many variables that remain difficult to quantify. First, it remains to be seen how quickly and robustly we will return to a sustainable level of business normalcy, let alone what post-COVID-19 normalcy means. The path of recovery largely depends on how quickly businesses open and people’s confidence resumes. Although the U.S. is beginning to lift lockdown measures and encourage the reopening of businesses, consumers may not be returning at the desired pace as long as they remain fearful of the virus.
As shown below, the significant contraction in GDP was driven by the abrupt 7.5% drop in consumer spending, the sharpest decline since this data began being recorded in 1959, and particularly meaningful given that consumer spending generally accounts for over two-thirds of GDP. With businesses set to reopen in the next month or two, one of the most significant factors in determining the speed and strength of the economic recovery is when consumers are going to begin spending beyond the grocery, food and healthcare categories that have remained relatively resilient through the current crisis.
FIGURE 3: DEBT PROJECTION EXCEEDS ECONOMIC OUTPUT
Moreover, consumer spending is not only about consumers’ willingness to spend as their safety concerns subside, but also their ability to spend. According to the Bureau of Economic Analysis, salary and wages dropped 3.1% in March. With unemployment continuing to increase, it is likely that income data over the next several months will continue to deteriorate as layoffs increase and business activity remains suppressed.
Even if consumer spending resumes, a significant risk remains that we trigger a second wave of infections if the plan to reopen businesses proves premature, rewinding the clock on progress we have made thus far in mitigating the spread of COVID-19. With some Asian and European countries already lifting mobility bans, they may offer some evidence of how reopening businesses and lifting mobility restrictions are working, and what consumer behavior may look like. We have already witnessed areas such as Beijing, Hong Kong and Singapore experience second waves of infections after attempting to reopen their economies. For example, during the earlier months of the COVID-19 outbreak, Singapore was lauded for its strict quarantine measures and aggressive testing procedures. Also, many argued that Singapore had a distinct advantage in controlling the spread of COVID-19, given it is an island country with a small population of approximately 5.7 million people. Despite the country effectively limiting the rate of new cases to single digits in February, Singapore has now become the new COVID-19 hotspot in Asia as it battles a second wave of infections, with over 17,000 cases.
The Heftiness of a Hefty Price Tag
To win the war against the virus and mitigate the risks of a deep global recession, governments around the world will need to coordinate policies to prevent and reduce the impact of multiple waves of the virus being passed around the world. Globally, there has already been $8 trillion of stimulus packages put into effect. In the U.S., the efforts on the part of the Federal Reserve and Congress to mitigate the risk of further economic deterioration are thus far impressive. The massive amounts of stimulus from Washington have been necessary, and Fed Chairman Powell’s recent statements indicate that the Fed and Congress are prepared to do more, while stating that these policies “will come with a hefty price tag.”
As a percentage of GDP, the Fed’s balance sheet expansion, which is now over $6.5 trillion, combined with stimulus packages from Congress, will make COVID-19 cost approximately a quarter of overall GDP. The U.S. federal budget deficit is expected to go over $3.8 trillion, assuming there are no more plans for additional stimulus packages. As shown below, it is estimated that the deficit as a share of GDP will reach 18%, the highest level since World War II, when the deficit reached 27%. In addition, federal debt held by the public now surpasses GDP and is expected to climb to 107% of GDP by 2023, higher than the levels reached during World War II when federal debt reached 106% of GDP.
The government’s ever-increasing spending and the Federal Reserve stepping up its role as lender of last resort calls into question whether the historical separation of “church and state,” specifically the independence of the Federal Reserve, will inevitably blur. The implementation of monetary financing policy, the concept that central banks directly lend money to their governments, in order to ensure a coordinated and effective recovery of the economy seems to have become a more explicit expectation. With the profound impact the COVID-19 pandemic is expected to have on the economy, fighting potential deflationary risks by way of direct purchases of government debt may become an option to be considered, as Japan has utilized for the past several decades. But the trade-offs could be significant; combating deflation in the near-term could cause high inflation in the longer-term through the creation of excess money. In addition, mixing the Fed’s ability to control the money supply with potentially misaligned and shorter-term political agendas and incentives may have a price that is not worth paying in the long-run.
From the perspective of members of our communities as well as investors, we are witnessing a crisis that is unique in both speed and depth of impact. Although we are hopeful that the worst is behind us, as investors we are prepared for the possibility that markets reverse course once again and potentially retest March lows. Given the level of uncertainty that remains regarding the path of the virus as well as the direction of markets, our approach to managing portfolios has been one of preparation and patience. With the dry powder that we raised in portfolios during the fourth quarter of 2019, we rebalanced portfolios to take advantage of buying assets at significantly discounted prices, and we remain patient in waiting for additional opportunities that may present themselves. Notwithstanding the strong rally over the last few weeks, investors should be prepared for more volatility ahead as the economy struggles and the COVID-19 virus continues pushing economies, markets, and communities into unchartered territory.