The darkest month
What news could force markets to retest or even make new lows?
Our Top Market Takeaways for April 3, 2020.
The darkest month
COVID-19 is devastating human lives and the economy. Globally, there are well over one million confirmed cases, and over 50,000 fatalities. In the United States, new cases are still rising, and the tri-state area (New York, Connecticut and New Jersey) is the new epicenter of the outbreak.
The economic toll is apparent as well. Almost 10 million Americans (a staggering 6% of the workforce) have already filed initial jobless claims. That number will rise despite the best efforts of the Federal Reserve and federal and state governments to soften the economic blow. Policymakers will likely do more, but right now, the path of the virus is the variable that matters most.
Given the trajectory of new cases, it seems likely the death toll in the United States will only get worse from here, and April is likely to be one of the darkest months in American history. In that sense, it seems insignificant to forecast where markets might go from here. But the outbreak has caused the first recession since the Global Financial Crisis, and many investors have seen the value of their assets decline. It is our job to provide advice during these uncertain times and to help ensure our clients remain on track to reach their goals.
After the trading day on Thursday, the S&P 500 was 15% above its lowest level of ~2,190, reached on Monday, March 23. Likewise, U.S. investment grade and high yield credit spreads are still below their peak levels reached the same day. While markets have been boosted in the short term, the news on both the human and economic costs of the outbreak will likely continue to get worse. While this is certainly bad news, it is not a surprise for markets: Such bad news has already become the new normal. For risk assets to make new lows, we think the situation will have to deteriorate further than what markets expect. Below, we list the scenarios we believe are not reflected in asset prices, and which could cause them to retest or make new lows.
Line chart shows the S&P 500 Index compared to the High Yield Index Spread (basis points) from March 1 to April 2, 2020. The chart highlights that while the S&P 500 Index has increased in the second half of the month, high yield spreads have decreased.
Social distancing lasts into the summer
Social distancing is causing a staggering drop in economic activity and wages. However, the immediate market response to the release of the U.S. jobs reports (and other timely measures from around the world, such as purchasing managers indices) suggests to us that markets might be willing to give a “pass” to data releases over the next month. What may be more important than actual economic data is the path of the virus.
In a white paper released last weekend, the American Enterprise Institute argued that social distancing measures should only start being relaxed on a regional basis after a minimum of 14 days of decreasing new cases. Given that new cases are still growing in the New York City area, and most public health officials seem to believe the rest of the country is a matter of weeks behind that, it seems like social distancing will be the norm for most of the country into May. However, current market pricing suggests to us that investors are expecting a return to a semblance of normalcy by the beginning of June. If the virus necessitates social distancing into the summer, markets may need to reflect that more negative outlook.
Bar chart shows the number of daily new confirmed COVID-19 cases in the United States from March 2 through April 2, 2020. The chart highlights that the number of cases increased rapidly from March 15 through the end of the month.
The support programs enacted by the CARES Act are insufficient
Congress passed a record-sized stimulus bill in record time in March, but it could still not be enough to fully support the economy. Specifically, the provision of loans/grants for businesses will face challenges in getting the money to where it needs to be.
First, there is no telling how many businesses will actually sign up for Paycheck Protection Program loans. After that, there will be operational hurdles to actually disbursing the funds from participating banks to businesses. The inverse problem also exists: The program may be too small if there is excess demand for the loans. The Federal Reserve, backed by the Exchange Stabilization Fund, is also ready to extend loans to businesses, but the terms (such as not being able to reduce payroll by more than 10%) may be too onerous for businesses to accept.
Finally, states and municipalities are under a severe amount of stress, and their revenues are plummeting (e.g., freeway tolls, sales taxes, etc.). Support for states and local governments will likely need to be included in the next fiscal package, or else they will need to stop spending in order to meet budget targets.
We still believe the fiscal package is likely to help bridge the gap in cash flows while the economy is shut down, but if businesses decide not to take the loans, and state and local governments are strapped for cash, it could mean more business failures and more austerity, which could lead to a slower eventual recovery.
It is easy to think of second- and third-order negative impacts that could cause asset prices to fall further. A disruption to the food supply chain could cause panic buying and empty shelves in grocery stores. Real borrowing rates may not fall despite the Fed’s best efforts because the stress in the system is even greater than we think. The many young, unprofitable companies that make up a larger and larger share of market capitalization could fail. Bipartisanship could rear its ugly head, inhibiting an already needed “Phase 4” fiscal stimulus package. The economic hardship could catalyze a resurgence of populism. The virus could accelerate deglobalization. Finally, the risk of a “second wave” of the virus later in the year cannot be ignored.
Our portfolios are positioned to account for all of these risks. We have our largest underweight to equities since the Global Financial Crisis, and a full allocation to core fixed income. We are taking risk where we see the most value, and have the highest confidence we will earn a commensurate return. Credit spreads are suggesting significant defaults, but we think the Fed's programs will be effective at backstopping borrowers across the economy. That is why we recently added to high yield debt.
We are defensive for a reason. The coming weeks and months will be full of challenges for not just the economy, but for all of humanity. However, it is not time to abandon a plan that is aligned with your goals. Eventually, the medical professionals, hospital staff, scientists, virologists, public health experts and researchers will solve the problem of COVID-19. The world will be a better place then, and asset prices will reflect it.
All market and economic data as of April 2020 and sourced from Bloomberg, FactSet and Gavekal unless otherwise stated.
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