Economic Update 3-23-2020

• Economic news last week was largely dwarfed by the dramatic efforts in progress by Congress and the Federal Reserve to stem the tide of economic and financial market damage from coronavirus-related shutdowns. Other released data included weaker retail sales and manufacturing indexes, while housing data exceeded expectations.
• Global equity markets experienced their worst week since the financial crisis, with medical and economic fallout from the coronavirus expected to drive the world economy into recession. Bonds were also mixed, with U.S. treasuries providing some safe haven benefit, while corporate bonds suffered as spreads widened, particularly in mid- and lower-quality issues. Commodity values also fell, led by new multi-year lows in oil prices due to Russia-Saudi production and policy conflicts.

U.S. stocks experienced their worst start to the week since 1987, with the overall week sharply negative across the board, as estimates for the economic damage resulting from coronavirus-related shutdowns steadily worsened. Initial assumptions of a -5% to -10% GDP decline for Q2 have since eroded to near -25%, which would rank among the single worst quarters on record, near some of the depths of the Great Depression.

News and market reaction has been alternating on a daily basis, with deteriorating expectations tempered by news of Federal Reserve and now Congressional action to provide fiscal aid to affected businesses and workers, in amounts upward of $1 trillion. These are critical pieces of legislation, with efforts appropriately directed toward bridging the window between government-mandated shutdowns of consumer activity/manufacturing and eventual recovery. Financial markets have been amenable to this news, as expected, assuming the aid is perceived to be large enough.

By sector, defensive consumer staples was the only group that earned a positive return last week, while most other segments solidly lost ground in double-digits. Energy and financials were among the worst performers, down nearly -20%. Hard-hit sub-sectors also included hospitality and airlines, as travel of all kinds has dried up for the time being. Real estate also performed poorly, in keeping with expectations for far weaker business activity—particularly for retail, which will suffer under social isolation standards.

Liquidity is a key factor in all markets, but especially assets viewed as ‘low risk’ such as U.S. treasury debt and some larger-cap stocks as well, with bid-ask spreads widening, and less depth, which has resulted in choppier execution levels, slower fills, and generally smaller trading amounts. Volatility levels spiked (measured by the VIX index touched 80, not seen since the financial crisis), as a variety of computer-based strategies, such as risk parity and momentum models all sold stocks at once—exacerbating the decline.

Foreign stocks lost ground also, but fared better overall than U.S. equities, although interest rate cuts and massive stimulus (a 750 euro bond-buying program) helped stem the negative sentiment as the week wore on. Relative to other assets, European and Japanese stocks fared flattish in local terms, but gave up a few percent when returns were translated to U.S. dollar terms. In emerging markets, China continued to fare decently as the number of COVID-19 cases has fallen and some manufacturing/retail operations have come back on line. However, other economies sensitive to global growth, such as commodity exporters like Brazil and Indonesia suffered with losses of -20% or more in some cases.

U.S. bonds have continued to behave unusually, with stimulative Fed actions re-steepening the yield curve. Rising rates caused negative returns for bonds as well, which was historically unusual in periods when investors have fled risky assets for safe ones. Government debt fared better, especially with promises of government purchases of treasury and agency mortgage bonds, while corporate lost significant ground (some funds down -10%)—a pace not seen since the Great Recession a decade ago. This was a far worse outcome due to a variety of factors, including lower liquidity than in years past, and slower market functioning based on traders working from home. Credit spreads widened in response to expected difficult economic conditions and strain on borrowers’ ability to pay back interest and principal. This is particularly true in areas such as high yield, where higher-risk issuers such as energy, gaming, and retail have been particularly challenged by recent events.

In investment-grade markets, there is a much higher proportion of corporate bonds rated BBB than in years past. BBB is the notch right above high yield, and stress in this sector has worried some about a downgrade of some names to BB—affecting markets on various levels in addition to spread widening. The ‘line in the sand’ separating investment-grade and non-investment-grade lies between BBB and BB, so institutional investors required by mandate to only hold the former could be forced sellers should these bonds become the latter. This has been a worry in bond markets for some time, but only came to fruition last week from a performance standpoint. Bid/ask spreads have widened in a variety of areas of corporate fixed income, particularly in exchange-traded funds (ETFs) and munis, where investors have taken ‘cheap beta’ for granted—easy liquidity, although underlying bonds in indexes are transacted far less frequently (if ever, in some cases). Consequently, corporate bond ETFs fared worse than their active counterparts in some cases due to forced selling.

Foreign bonds offered a similar experience, with developed market government down upwards of -5%, while emerging market bonds (a ‘risk’ asset) fell closer to -10% on the week.

Commodities showed declines across the board, with economic activity slowing sharply. With minimal losses, precious metals and agriculture prices held up better than industrial metals and energy. The price of crude oil fell by another -30%, reaching lows around $20/barrel during the week, before recovering to just under $23. The price/production war between Russia and Saudi Arabia continues, with U.S. shale producers seemingly caught in the middle, although U.S. political pressure has ramped up. There is irony in that weak oil prices pressure U.S. exploration and production firms especially—and notably credit markets as such firms tend to be heavily levered and represent a heavy constituent of high yield bond markets. But, at the same time, lower energy prices generally ease some of the cost stress on consumers and businesses at a challenged time (if transportation was at a normal level).

Sources:  LSA Portfolio Analytics, American Association for Individual Investors (AAII), Associated Press, Barclays Capital, Bloomberg, Deutsche Bank, FactSet, Financial Times, Goldman Sachs, JPMorgan Asset Management, Kiplinger’s, Marketfield Asset Management, Minyanville, Morgan Stanley, MSCI, Morningstar, Northern Trust, Oppenheimer Funds, Payden & Rygel, PIMCO, Rafferty Capital Markets, LLC, Schroder’s, Standard & Poor’s, The Conference Board, Thomson Reuters, U.S. Bureau of Economic Analysis, U.S. Federal Reserve, Wells Capital Management, Yahoo!, Zacks Investment Research.  Index performance is shown as total return, which includes dividends, with the exception of MSCI-EM, which is quoted as price return/excluding dividends.  Performance for the MSCI-EAFE and MSCI-EM indexes is quoted in U.S. Dollar investor terms.

The information above has been obtained from sources considered reliable, but no representation is made as to its completeness, accuracy or timeliness.  All information and opinions expressed are subject to change without notice.  Information provided in this report is not intended to be, and should not be construed as, investment, legal or tax advice; and does not constitute an offer, or a solicitation of any offer, to buy or sell any security, investment or other product. 

FOR ADVISOR USE ONLY – NOT FOR DISTRIBUTION TO THE PUBLIC WITHOUT PRIOR APPROVAL FROM YOUR RESPECTIVE FIRM’S COMPLIANCE DEPARTMENT