Market Update: March 20, 2020
Last Wednesday, March 11th, the NBA became the first sports league in the United States to suspend play as a result of the ongoing coronavirus (COVID-19) pandemic. Many are pointing to the NBA’s action as the “Lehman Brothers” moment of this crisis. It echoes the harrowing events of 2008, given the sense of panic caused by the immediate rush of other institutions to do the same, as well as the violent reaction from capital markets (Figures 1-2).
Figures 1-2. The market decline accelerated after news broke of the NBA suspending its season.
2020 ≠ 2008
Despite what many pundits are saying, we do not believe 2008 is analogous to what we’re currently experiencing. In 2008, the financial system was systemically overleveraged, and the global economy was in a solvency crisis, teetering on the brink of permanent structural impairment. This is simply not the case right now. Today, as a result of the authorities’ decision to call a halt to non-essential economic activity to prevent the pandemic from overwhelming our healthcare system, the economy is facing a severe demand shock, which has led to a liquidity crunch. This demand shock has been exacerbated by the sudden collapse in oil prices at the same time, which has put the energy sector under severe distress.
While these shocks will have a permanent impact on certain industries and companies, it should not create permanent structural impairment of the broader economy. Additionally, the government has acted swiftly, particularly the Federal Reserve, having seemingly learned from its sluggish responsiveness and inconsistent policy response in 2008.
Following the NBA’s unprecedented announcement, the S&P 500 Index moved by triple digits over the ensuring five days (-9.5%, +9.3%, -12.0%, +6.0%, and -5.2%, respectively), thus marking the most volatile one-week period since, and including, 2008. We believe this is a result of forced liquidations of leveraged investors, such as those in “carry” and “risk parity” trades. The telltale signs of a liquidity squeeze have appeared in the form of increased strength in the U.S. dollar and higher interest rates accompanying the equity market declines.
Where Are We Headed?
- GDP will undoubtedly contract in the second quarter, with some estimates putting the decline as high as 10%. Although that sounds like a breathtaking loss in output, a decline of this magnitude is not unprecedented. A similar drop, which occurred during the 1958 recession, may be the most comparable; that was a sharp, but relatively short recession. The economy experienced a swift 10% drop in GDP in the first quarter of 1958, followed by a modest and then sharp rise to recovery. Therefore, there is also precedent for a sharp snapback on economic dislocations.
At this point, we do expect Q2 GDP to be down sharply even though U.S. economic data figures were picking up momentum earlier this year. Recently, the New York Fed Manufacturing Index signaled a steep drop on account of both shocks (the coronavirus quarantines and oil prices coming down). As such, both the consumption and investment components of GDP will be sharply weaker. The odds of at least a short, sharp recession in 2020, are now very high—whether we experience a consecutive decline in Q3 will depend on how quickly businesses can resume production after temporarily idling.The capital markets’ most recent and emblematic comparison is 1987, owing to the trajectory and speed of the equity market decline (Figure 3).
Figure 3. The ongoing decline continues to parallel what we saw in 1987.
- The Fed continues to take considerable action to increase liquidity and decrease interest rates, but there is not much more it can do (though not because of a lack of firepower) since monetary policy is unlikely to stimulate demand in the current environment. However, the Fed’s actions are meaningful because they essentially provide bridge loans to stem the liquidity concerns which come with fear. The steps they took last Sunday were bold and decisive in the face of the health care policy response the government pivoted towards late last week.
- Importantly, we have seen developments in the two major areas crucial for the crisis to abate: a) targeted, temporary, and timely fiscal stimulus, and b) advances in a medical solution.
- The government is aggressively pursuing economic stimulus. The first stimulus of $8.3B solely addressed health issues. The second amounts to around $100 billion, as we explained earlier this week. The third stimulus, currently under consideration, would have to be at least 1% of GDP to substantively move the needle. Our research indicates the value of the latest package could be upwards of $1T and could include check issuance of $1,200 per adult. We view the initial details positively as they indicate politicians understand the gravity of the situation and are uniting to aggressively address it.
- Far more important is the notable movement on the medical front. While monetary and fiscal measures are important and necessary, the reality is that this will end when the virus is under control. When the capital markets sense that, economic recovery will ensue, as has been the case historically. The markets are not as concerned about things getting better as they are with matters getting worse at a slower rate. We see this in Chinese equity markets, as they already show signs of a rebound even though the problem has not completely dissipated. The same can be expected here, and the combination of monetary and fiscal policy (to bide time), and medical advancements (to solve the problem), are putting us on that path. Yesterday, the White House Coronavirus Task Force’s daily update focused on important drug developments currently under consideration for fast-track FDA approval.
- The economy is temporarily shutting down to avoid overburdening the healthcare system while drugs, therapies, and potential vaccines are vetted. Though painful in the short-term, it’s the only way to get ahead of the situation long-term. In the interim, the Fed will continue to supply liquidity to capital markets while fiscal policy should bide time for the medical community to develop a treatment or vaccine.
- While Congressional Democrats and Republicans are working together on fiscal policy, the President has surrounded himself with CEOs who can surgically attack the economy’s vulnerabilities to ensure fiscal stimulus is most properly targeted and, thus, most effective.
Implications for Investment Policy
- Our model-driven approach guides every investment decision we make at Balentine. Staying grounded will help us navigate until markets are able to put the pandemic in the rearview mirror. Equities have gone from modestly expensive to solidly inexpensive relative to bonds when considering dividend yields, even if earnings expectations are set to decline further. Credit spreads have widened, but most of the distress is confined to the energy sector. The yield curve continues to steepen; it normally does the opposite, inverting in a significant and sustained way ahead of a recession. While commodity prices have fallen in sympathy with all assets, they have not dropped to the degree one would expect in advance of a protracted recession. For further details regarding how markets lead the economy, see our blog post “Are Recession Red Lights Flashing?“
- Though it’s natural to want to make comparisons to previous collapses, the reality is that this situation is unprecedented. As such, Balentine’s first line of defense is our cash policy, which dictates two years worth of annual spending be held in cash and fixed income for portfolios from which distributions occur. While such a policy might not seem useful the vast majority of the time, just like the home insurance policy you own but never wish to use, it is your first line of defense when signs of stress emerge.
- The world is full of investment opportunities with asset classes falling at historic trajectories, but there is no rush to jump in with both feet. Dislocations of this caliber take time to sort themselves out, and opportunities with the highest possible reward also come with the highest possible risk. As such, extensive due diligence is required, and Balentine’s Investment Strategy Team is deep into this process. In the meantime, we continue to look for tax-loss harvesting opportunities and other ways to drive additional value within portfolios.
Accelerated FDA approvals and progress toward possible treatments pave the way to brighter days ahead. It’s quite possible that markets have already bottomed and are beginning to price in recovery. The coming days will have headlines of more infections, mandatory lockdowns, and businesses shutting down. However, as soon as we start to see signs that the health crisis is under control, markets will resume trading on fundamentals and it will be time to capitalize on these opportunities. As always, our unemotional, model-driven approach will help us navigate during these challenging times. Please be on the lookout for an upcoming blog post focused on taking advantage of the things investors can control.
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