Market Update: March 13, 2020

As volatile as the markets have been, Thursday took things up a notch, with both the MSCI ACWI and the S&P 500 Index falling 9.5% and asset classes selling off sharply. As of Wednesday morning, our base case was that we would have one quarter of GDP contraction and would bounce back in a “V bottom,” thus avoiding a recession. However, in the aftermath of the market’s reaction to President Trump’s address on Wednesday evening, we believe there is now an increased chance of recession.

The market’s concern is the Trump administration is downplaying the seriousness of the coronavirus situation (and the oil price shock), and that, even after passing $8.3 billion in relief legislation, Congress has underestimated the magnitude of the issue. We believe Thursday’s market action delivered a message that more is required, and it seems today that Washington has received the message.

This said, we do not expect fiscal proposals to be a panacea, regardless of their magnitude. Stimulus may stem the tide, and it will certainly help to engineer a softer landing, but the real panacea will come when the market senses progress on a medical cure either via an antiviral drug or vaccine. This will likely come with time—at least several months, if not more. As such, we must remain patient and recognize that the volatility experienced over the last three weeks will likely continue if uncertainty persists. Currently, every new positive data point is greeted with euphoria while every new negative data point is greeted with angst. However, when the market senses more certainty—even if the certainty is negative in nature—it will adjust and volatility will settle.

Let’s review two important ideas which should be reinforced repeatedly during these volatile times:

1. This entire episode was brought about by one exogenous shock (the coronavirus) compounded in succession by another exogenous shock (the oil price collapse).
2. Historically, exogenous shocks, regardless of their nature, are fleeting, leading to stability in relatively short order.

Using the historical template we outlined on Wednesday’s call, we’ve seen similar shocks that took time to stabilize and right-size, but none delivered structural impairments to the markets: 1950 (Korean War), 1955 (Eisenhower heart attack), 1962 (Cuban Missile Crisis), 1987 (Black Monday), 1998 (Asian Currency Crisis), 2011 (Eurozone Debt Crisis), and 2015 (China Stability).

The current crisis is not 2008. We are not in the midst of a structural financial crisis whereby the entire global financial system is at risk. This is a temporary demand shock, albeit a potentially large one, compounded by an oil supply shock. We liken this more to the 1987 crash, which bottomed about two months after Black Monday and took about 19 months to regain pre-crash highs. An indexed comparison between the current decline and the 1987 decline is shown below.

Figure 1. The 1987 crash took ~400 trading days (~19 months) to recover to its previous level.

Source: FactSet

The below summarizes several key points to bear in mind during this market volatility:

• We are monitoring important recession indicators: high-yield spreads, yield curve, and commodity prices. These indicators continue to point to the U.S. not entering a recession:
• High-yield spreads have widened, but the vast majority is within the Energy sector. The spreads of other sectors have also widened; however, these spreads remain below 2016 levels and well below 2008’s all-time highs.
• Commodity prices have remained relatively benign, a sharp contrast to 2015 and early 2016. This is especially true of copper, whose price movements are one of the most reliable leading economic indicators.
• Despite the overall rate declines across the yield curve, it remains mostly positively sloped. The exception is at the short end of the curve, where rates are pinned because of the Federal Funds rate. We expect the Fed to alleviate this disparity with a cut at its March meeting next week, even with February’s emergency rate cut. The market is now pricing in a 75% chance of a cut to 0.00% and a 25% chance of a cut to 0.25%.
• For this to get worse, there would have to be additional credit contagion of a large magnitude. With the Global Financial Crisis fresh in policymakers’ minds, we believe legislators are on top of the situation, both monetarily and fiscally. Recall in 2008, an episode of such magnitude had not occurred in many people’s lifetimes, so it was understandable that policymakers were slow to recognize the scope of the issue.
• In addition to stronger fiscal stimulus, the market needs to see signs that the rate of increase in the virus is slowing and that the economic effects are declining more slowly. Things do not necessarily have to be getting better, merely just worse at a slower rate; capital markets will lead the virus and economic recovery. This is the template which has played out in China, and we expect no different in the U.S.
• Regardless of whether what we endure is technically a recession or not, there will be fallout. There will be bankruptcies. There will be liquidation. This is an important part of capitalism and allows for creative destruction. Companies which have not adapted or are financially tenuous are eliminated in a Darwinian process which allows the stronger to survive and for new companies and industries to arise from the wreckage.
• With sentiment waning, we’d like to highlight a number of positive data points:
• Highly-automated testing kits developed by Roche received emergency FDA approval.
• Congress and the White House are coming together quickly on a bill. Treasury Secretary Steve Mnuchin announced this morning the department will do “whatever it takes” to help ailing industries via liquidity measures and, when appropriate, financial assistance.
• Social distancing in the U.S. has been proactive and quick. Remote working and school closings have begun, sporting events have been cancelled and leagues have been shut down, while states limit the number of people permissible at public gatherings.
• Bond yields are rising, a sign that fear in the market may be abating
• Correlations between equities, the U.S. dollar, bonds, and gold are breaking down.
• All of these point to the U.S. looking less like Italy and a lot more like South Korea. But we, as a country—both citizens and the government—must remain vigilant. The short-term pain and disruptive effects of social distancing are likely the price we must pay to beat this virus and prevent more damage in the long run.

Note that these observations contemplate current data. As data changes, this analysis is subject to change. We are available to answer any questions you may have. As we all deal with the gravity of a health pandemic, we are open for business and our Investment Strategy Team continues to seek opportunities to capitalize on this fluid situation.