April 1, 2020
In a note last fall discussing why a recession did not appear imminent, we asserted that “with roughly 70% of the American economy related to consumption, the only way the economy would slip into recession is if consumers pulled back.” What we didn’t foresee — and, frankly, what no one imagined — was a systematic shutdown of the commercial life of communities across the country and many parts of the world due to restrictions to combat the spread of COVID-19.
Before the outbreak of the coronavirus pandemic, the outlook for the U.S. economy remained largely promising. While corporate profit growth was slow in 2019, Wall Street analysts were still anticipating earnings to rise roughly 9% on revenue growth of nearly 5%.1 Therefore, it’s not surprising that up until mid-February, domestic stocks rose more than 5% year to date, after advancing more than 31% in 2019.
Then everything changed.
The Economic Fallout of Coronavirus
By February, it became abundantly clear that COVID-19 could not be contained to China or Asia. By early March, policymakers in the U.S., Europe, and other regions around the world concluded that the only way to slow the pandemic — and to give healthcare systems a fighting chance to care for the ill without being overrun by waves of new patients — was to force social distancing. That effectively shuttered restaurants, resorts, bars, malls, hotels, movie theaters, sports arenas, and non-essential offices throughout numerous countries. Those efforts were accompanied by travel restrictions on international flights and cruises.
While the best hope to reduce the fatal impact of the virus, this effort represented the biggest disruption of economic activity since World War II. In many ways it was even more disruptive, as large swaths of the consumer sector — which are typically expected to rescue the broader economy from a slowdown, not cause one — were frozen, leading to a record spike in short-term unemployment and threatening small businesses throughout the country. This didn’t just slam the brakes on the retail, transportation, and hospitality industries, it put the broader economy into reverse.
It’s too soon to know how big a hit the economy will suffer, but worst-case scenarios have begun to emerge. In March, Goldman Sachs forecast that U.S. gross domestic product could contract by 34% in the second quarter, although they expect a 19% growth rebound in the third quarter. The Federal Reserve Bank of St. Louis went even further, hinting at a potential 50% drop in U.S. GDP this quarter, coupled with an unemployment rate that could balloon to 30% in the coming months.
The Financial Markets
The stock market, which hit an all-time high on February 19, started to deteriorate before the normalcy of everyday life began evaporating. While this is not a financial shock like in 2008, the mass postponement of purchases, coupled with the massive uncertainty for millions of furloughed workers and small business owners, makes this crisis feel as large and enveloping as the financial crisis more than a decade ago. If consumer spending falls materially as pandemic-related mitigation efforts unfold, corporate profits will see significant, albeit temporary, declines.
As the impact of social distancing began to come into focus, the stock market slide accelerated. The S&P 500 index of U.S. stocks crossed into “correction” territory — referring to a 10% drop — in just six trading days. It took only 10 additional trading days after that for U.S. stocks to plummet into an official bear market, or a decline of 20% or more from a recent peak, marking the fastest descent from record high to bear market in history. By comparison, it took 43 days for stocks at the start of the Great Depression to fall more than 20% from their all-time high in 1929. And in the most recent bear market — the global financial panic that began in October 2007 — stocks didn’t officially hit a bear market for 184 trading days.
Virtually every asset, with the exception of cash and U.S. Treasury securities, got hit in the first quarter. International developed equities were off 23% for the quarter and emerging market equities were down 25%. Crude oil prices experienced their biggest drop since 1991, thanks not only to concerns about the coronavirus’s impact on the global economy, but also to a price war that erupted between Saudi Arabia and Russia over how to contend with sinking prices amid the COVID-19 crisis.
Risk assets, such as small-company stocks and high-yield bonds, were particularly affected in the first quarter, largely because of those two market disruptions. Small stocks are disproportionately exposed to retailers while companies in the energy sector play a disproportionate role in the junk bond market. Energy bonds make up roughly 11% of the high-yield market, and already a number of high-yield energy issues are trading at distressed prices.
Given these circumstances, markets will need time to consolidate around the recent lows.
To address the liquidity crisis and maintain solvency in the financial system, the Federal Reserve acted swiftly to lower interest rates, bringing the target for the Federal Funds rate to 0% to 0.25% after two emergency FOMC meetings in March. The Fed also resumed the quantitative easing program that it utilized in the 2008 financial panic, buying a variety of agency, corporate, and ultimately municipal fixed income assets.
Central bankers and policymakers globally have reacted to this disruption with much more urgency than they’ve reacted to past crises, providing unprecedented monetary and fiscal support. The goal has been to make sure that the demand shock caused by coronavirus shutdowns won’t lead to a financial crisis, as millions of workers and business owners struggle to pay their rent, mortgages, and other loans, with cascading effects on the credit markets.
In late March, Congress passed a $2 trillion economic relief and stimulus package that casts a lifeline to workers, small business owners, and other affected sectors of the economy, including restaurants, airlines, and healthcare systems. The program is massive, as it equates to roughly 10% of GDP. Included in the package are one-time payments of up to $1,200 for individuals and $500 per child, and up to $600 a week in unemployment insurance — over and above what states offer — for up to four months. The legislation also set aside hundreds of billions of dollars in loans and loan guarantees for businesses and municipalities harmed by social distancing efforts.
As expectations for the U.S. fiscal stimulus package set in, the markets appear to have stabilized somewhat. However, major threats to the economy and markets will remain until the duration and impact of the economic slowdown and its impact on business solvency are well understood.
Assessing the impact of the COVID-19 pandemic in economic and market terms is a Herculean task, with rapidly changing information. To establish a baseline benchmark, investors need to recognize that the marketplace is at least two weeks behind the infection curve. It is hard to overstate the speed and magnitude of this pandemic on the global marketplace.
On March 27, a day after a G-20 video conference to discuss the pandemic, the International Monetary Fund announced a reassessment of growth for this year and next. They declared that a recession has taken hold of the global economy, and warned that it is as bad as, and possibly worse than, the Great Recession. However, the IMF also offered hope that 2021 would be a year of recovery.2 Viewing any forecast about economic growth must be accompanied by a healthy dose of skepticism as pictures of major cities around the globe reveal a consistently barren landscape, devoid of commercial activity.
Earnings expectations for U.S. companies have started to reflect the business paralysis that COVID-19 is inflicting on commerce. At the end of March, analysts forecasted that first quarter earnings would fall 5.2%, compared to the 4.4% growth they had anticipated on December 31, 2019. None of the 11 broad market sectors will escape the impact of the pandemic. Moreover, earnings growth during the current quarter will likely suffer more, as Wall Street expects a 10% drop in profitability with hard hits to energy, consumer discretionary, and industrials. Wall Street consensus estimates are that profit growth will return in the fourth quarter.3
While equities gyrated over the last month, fixed income markets battled a liquidity crisis not seen since 2008. Indeed, equity markets were in part taking cues from the fixed income complex. Extreme volatility hit money markets, investment-grade and high-yield bonds, and bank loans and structured credit. Panicked selling hit entire swaths of fixed income markets as dealers stepped back from their market-making functions. A combination of fiscal and monetary policy by Congress and the Federal Reserve has bolstered market confidence enough to settle market volatility and start to return a hint of orderly markets.
Included in the federal government’s relief package is unlimited support of important credit markets and the funding of a quasi-bank, which allows the Federal Reserve to operate, in the best tradition of a central bank, as the lender of last resort. Yield spreads, a measure of the risk premium that investors demand in return for their capital, are starting to fall as a modicum of confidence returns to markets.
While it is much too early to call the bottom in markets, we are cautiously optimistic that markets are in the early stage of forming a bottom. The policy responses over the past couple of weeks are important first steps. Investors will watch for key milestones — such as reaching peaks in different countries’ infection curves — to gain clarity on the duration of the pandemic, so they can best assess when the economy can begin its reboot.
Without a doubt, the maelstrom of crisis eventually also creates great investments. As the events of the pandemic have played out, we have been active in making sure we understand developments in markets and the risks that may lie ahead. We are also deeply engaged in identifying the opportunities that inevitably emerge when distressed sellers have to engage with the marketplace on terms that they neither set nor want.
The Importance of Adhering to Key Investing Principles
Fiduciary Trust has been serving clients for 135 years, and in that time, we have helped them navigate a variety of challenging markets during historic events such as the Spanish flu pandemic, the Great Depression, World War II, stagflation in the 1970s, the dot com crash, 9/11, and the global financial crisis. Through it all, our core investment principles — to maintain a long-term perspective and to avoid the traps of investing based on your emotions and behavioral biases — have demonstrated their value.
When investors find themselves in the middle of a market storm, it’s human nature to want to flee elsewhere — anywhere that feels safer. But the best course of action once the storm starts is often to hunker down and let the storm pass. Recall the Great Recession in 2008, which marked the worst financial crisis the country had faced since the Great Depression. Many investors capitulated and headed for the exits at the darkest moment of that crisis, going to cash at the end of 2008. Those who did, missed a large chunk of the market’s rebound in 2009 and never caught up to investors who simply stayed invested.
The truth is, investors can cause more damage by attempting to avoid risky markets than by staying the course. Between January 1, 1995 and March 30, 2020, for example, investors who stayed fully invested earned an annualized total return of 9.3%. However, those who missed the ten best trading days saw their returns fall sharply to 5.9%.
To be sure, it is difficult to stay calm when the markets are acting anything but tranquil. However, investors can take some solace in the fact that after most major selloffs over the past 30 years, stocks generally recovered within one to three years. In the few cases where that did not happen, stocks rebounded within three to five years. Indeed, over the past 70 years, a balanced portfolio of stocks and bonds, as illustrated in Exhibit D, has never lost money on a five-year rolling return basis.
At Fiduciary Trust, our focus is helping clients achieve their personal and financial goals, and protecting and growing their assets is an important part of that. Through applying a long-term, disciplined investment approach, we have helped clients weather past storms in the markets, and we are confident we are well positioned to navigate through the current turbulence and to the next upturn.
2International Monetary Transcript of press briefing by Kristalina Georgieva, Managing Director of the IMF, March 27, 2020
3Earnings Insight, Factset, John Butters, March 27, 2020
The opinions expressed in this article are as of the date issued and subject to change at any time. Nothing contained herein is intended to constitute investment, legal, tax or accounting advice, and clients should discuss any proposed arrangement or transaction with their investment, legal or tax advisers.