Market Update: March 24, 2020

Headlines Have Deteriorated

We are now 10 days into the government’s sudden and draconian pivot to shutting down the economy in an effort to prevent the global coronavirus (COVID-19) pandemic from overwhelming our health care system and its brave first responders. The scale of human suffering, especially amongst the elderly and vulnerable in countries with frailer health care systems, is staggering in this day and age.

New York state, now officially accounting for over 5% of infections worldwide, has become Ground Zero for this crisis, like it did in 2001 after it was blindsided by stunning, previously unthinkable, terrorist attacks. The effectiveness of the policy response to “flatten the curve” of this health crisis in New York is a key leading indicator. It will help determine when capital markets become comfortable with the idea that the situation is sufficiently under control so they can begin to focus on fundamentals again and the indiscriminate selling can abate.

This bleak situation has been compounded by a collapse in oil prices emanating from Russia’s decision not to toe the OPEC party line to restrict production before the oncoming health-care-related demand shock. The causes and consequences of this opportunistic geopolitical move will attract greater attention when the world returns to some semblance of normalcy.

Over the last couple days of horrific headlines, economic data and expectations from these two exogenous shocks (a global health care pandemic and an oil price crash) have entered a breathtaking vortex. Daily headlines of increases in the rate of infections amongst the most vulnerable as testing in the United States becomes more pervasive is combining with the potential economic catastrophe facing so many American families living paycheck to paycheck.

Weekly jobless claims are going to spike this week and will likely shatter previous all-time highs by over 3x. Whereas the peak in 2008 was around 695,000, we expect this week’s claims may register around 2 million nationwide. It is hard to believe we were celebrating 50-year-low unemployment rates just three weeks ago.

A Swift Federal Response

Unlike 2008, the Federal Reserve and administration have acted quickly to blunt the potential of this sudden economic shock to become a systemic liquidity and solvency crisis. Acknowledging that it will take some time to recognize when the rate of new coronavirus infections has begun to slow, they are using all their policy weapons to ensure capital markets are functioning and to stimulate economic demand in an effort to limit the economic fallout.

The Fed’s response on Monday morning was bold and decisive, as it decided to bypass the option of using a bazooka in favor of a howitzer. Specifically, the Fed committed to:

• Unlimited purchases in Treasury and mortgage-backed securities. The Fed will also begin to buy corporate and municipal bonds.
• Facilitating the flow of credit to municipalities by expanding the Commercial Paper Funding Facility (CPFF), both reducing pricing and now including high-quality, tax-exempt commercial paper.
• Establishing two facilities to support credit to large employers.
• Establishing a “Main Street Business Lending Program” to complement efforts by the Small Business Administration for small- and medium-sized businesses.

Fortunately, the banking system is far better capitalized today than it was in 2008; as such, it is in a much better position to digest losses. While an economic recession this year is now a given, we do expect these remarkably aggressive Fed actions to ameliorate concerns that there may not be enough liquidity for markets to function.

As of this writing, Congress is still urgently debating fiscal stimulus. Unlike 2008, there is broader agreement that effective fiscal stimulus needs to be timely, targeted, and temporary in nature. While there is now bipartisan consensus on the scale required, they are still deciding upon the details. The fiscal stimulus package may now amount to $2 trillion, around 10% of GDP--double the size most expected at the end of last week.

There appears to be Congressional consensus around four broad components of legislation that will limit unemployment by getting cash into the hands of distressed businesses and consumers as quickly as possible. These components include:

• Aid to small businesses, including loan access and loan forgiveness. The Federal government will backstop revenues to temporarily stop-gap the divide. In essence, the government will pay for workers to stay on businesses’ payrolls.
• Guaranteed loans for corporations. This piece of the legislation is designed to provide liquidity to companies.
• Supplying equity capital in companies. The potential list is long and not likely to happen to all companies. Those with national security implications, such as Boeing, will be near the top of the list. There will be conditions, such as limiting these companies’ ability to buy back their stock in future and capping their executives’ compensation.
• Tax refunds for individuals. Note that it remains unclear which consumers will be aided.

Implications

History shows that event-driven recessions caused by exogenous shocks (e.g., the September 11 terrorist attacks), can be severe. However, they tend to bounce back more quickly than recessions that are more cyclical (e.g., 1981-1982) or structural (e.g. 2008-2009) in nature. In other words, the loss of economic output and jobs in 2020 could be worse than a typical cyclical or structural recession, but it is likely to end more quickly.

Longer-term, the underlying trend towards greater globalization that has underpinned increasingly integrated supply chains over the last two decades is being rethought. These questions started with the tariff war that erupted in 2018, but they are intensifying during this health care crisis. There will be structural implications for global economic growth and inflation, especially after so much monetary and fiscal policy stimulus has been implemented to shore up economies in the short-term.

In the aftermath of the Global Financial Crisis (GFC), the sectors that became most reliant on government support (e.g., the financial industry) never became market leaders again. That is something to keep an eye on as the details of fiscal stimulus are announced and portfolios are positioned to capitalize when the economy begins to recover.

Market Conditions and Investment Policy Update

It is imperative to remain disciplined during such violent and unprecedented capital market movements. Our process is designed to lead us to make unemotional decisions.

Cash Management

We spent the first week of the crisis helping clients shore up their first line of defense against uncertainty. For those who have spending needs from their portfolios, we have topped up cash reserves and ensured there are sufficient short-term, fixed-income investments and access to credit to see through the next two years without having to disturb other areas of portfolios. This cash policy has always been the starting point of our process and has minimized the risk of permanently impairing capital. Several clients have provided us with more information on their investments held outside of Balentine. The more context our relationship managers have, the sharper advice we can give as we are able to take a holistic view on cash-flow needs across our clients’ entire balance sheets.

Money Market Funds

Some have also reached out to us about the safety of money market funds. We have long recommended the high-quality All Treasury Bond money market funds in portfolios for precisely this reason. That said, we believe there is a very low chance of money market funds “breaking the buck,” as they did in 2008, given safeguards implemented after the experience of the GFC in tandem with the Fed’s commitment on Monday to backstop the commercial paper market.

Tax-Loss Harvesting

For taxable clients, we used the extreme volatility to harvest tax losses in  portfolios to protect future taxable gains while ensuring that desired exposures are maintained and positioned for the eventual market recovery.

Diversified Portfolios

The starting point for investing in a diversified portfolio is very different than it was at the beginning of the year (as detailed in our 2020 Capital Markets Forecast). Importantly, based on the facts we know today, the coronavirus will not materially impact the long-term fair value of stock markets, unless the policy response is inadequate to help the economy and corporate sector get through the current period of distress. That means a diversified portfolio of bonds and stocks are now priced for higher expected returns than they were three months ago.

Tactical Asset Allocation

The opportunity set for tactical asset allocation to add value around these strategic allocations is one of the best we have seen over the last two decades. Spreads between asset classes have widened to historical extremes. While our portfolios entered last week overweight to equities, the areas we have been emphasizing (U.S. Growth stocks) and avoiding (publicly traded real estate, small cap stocks) mean that our equity exposure has held up relatively well to the broader market. Our quantitative models, which have stood the test of several market cycles, govern our decisions here. Today, these models are signaling to us that stocks have already become meaningfully cheaper relative to bonds, but not yet generationally cheap as they were in 2009. Whether that occurs will be determined by the extent to which earnings and dividends are likely to be cut by corporations in the next few weeks. The speed with which the stock market priced in a sudden and severe recession makes us believe that we should not sell equity exposure further at this time, and that it is too early to begin playing offense by capitalizing on areas that have become unduly punished during the waves of indiscriminate selling last week.

Looking Ahead

Our current base-case analysis (based on our projected decline in GDP and a likely contraction in the multiple of equity market capitalization to GDP) is that the S&P 500 Index could decline to between 2000-2050 before a bottom is decisively made. So, despite the optimistic tone of Tuesday’s market, we believe there is the possibility for more downside in the short term--though the majority of damage has already occurred, and the remaining downside is relatively limited. The point we wish to reiterate is that we have never subjectively tried to time the precise top or bottom of any market cycle; instead, we wait for the balance of evidence to confirm objectively when these have been reached.

As always, we cross reference our model’s stance by looking at other evidence that stock markets are beginning to stabilize and see through the near-term panic. “Historic” conditions are always present at major lows; examples include extreme, apocalyptic sentiment (e.g., we are seeing comparisons today to 1929 and the Great Depression). We also note that:

• The CBOE Volatility Index (VIX) has come down for six straight days, from its March 16 peak, even as markets have yet to find solid footing.
• Although high-yield spreads remain elevated in fixed-income markets, investment-grade spreads have begun to improve. Within high-yield spreads, signs of stability outside of the energy sector are beginning to emerge. Not only has the U.S. Treasury yield curve not inverted, it has steepened.
• Inflation breakeven rates are beginning to stabilize.
• Equity markets are showing initial signs of positive divergences, even as stock indices have made lower lows. “High beta” equities (those that are typically most sensitive to the broad market direction) have begun to outperform “low beta” equities. At a sector and industry level, we are seeing banks outperform REITs (publicly traded real estate), economically cyclical consumer discretionary stocks outperform more defensive consumer staples, strong outperformance from semiconductors, and strong underperformance in utilities (the sector most considered a safe haven).
• There is a contraction in the number of stocks making lower lows, which is a necessary, but not sufficient, condition for a market bottom to form. For example, while the ultimate lows in the GFC and the 1987 stock market crash were in March 2009 and December 1987, respectively, most stocks actually bottomed in November 2008 and October 1987.
• Commodity markets are beginning to cue off the fact that the Chinese economy is “ahead of the curve” in dealing with this pandemic by coming on-line again after shutting its economy down in mid-January.

Our emphasis on high-quality exposure in fixed income markets has been helpful in these tumultuous times. Highly liquid U.S. Treasuries have vastly outperformed, albeit with some volatility, from the flight of risk assets. Corporate (both investment-grade and high-yield) and municipals have sold off. The decline in the prices of municipal bonds is due to forced selling from mutual funds and the market repricing riskier issues as it struggles to determine which cities and states will make it through with no defaults. In this environment, we continue to emphasize implementing a municipal position with a high-quality manager that is not going to reach down the credit spectrum in search for yield.

Relative to the public markets, our alternative strategies have held up well. Our real estate fund has declined 5.5%, and our real assets position lost 6.7%, compared to the 31.8% decline in the S&P 500. From a yield perspective, these positions will play an important role going forward as zero interest rates and unlimited bond buying from the Fed will cause traditional forms of yield to be even more challenged.

For our private capital allocations, the coming quarters may show a level of volatility as underlying funds and companies are marked-to-market; however, we are excited for the opportunities that these types of dislocations create for our recommended managers. They have confirmed that they have already seen this uncertainty forcing many that employ more leverage in their strategies to step back from the market. This allows our more-disciplined managers to step in opportunistically and provide active management to enhance value creation. They are keeping a watchful eye on secondary markets for avenues of capitalizing on distressed sales.