It has only been about 6 weeks since Federal Reserve Chair Jerome Powell spoke about how the US economy was on firm footing, anticipating a modest 2% GDP growth outlook for 2020. That seems like a distant memory now, as the Black Swan event arrived when the coronavirus hit hard in Europe, and particularly northern Italy, where a vulnerable population overwhelmed the healthcare infrastructure. Here in the US, it became clear that halting flights originating in China would be too little too late and that the longer it took to take necessary action, the more devastating the result. A functioning economy has been the trade off, with citizens and businesses feeling the blunt impact even as infections and deaths continue to rise. Millions of jobs, particularly in the restaurant, retail, and travel-related industries such as hospitality and entertainment have been lost in a matter of a few weeks. Although many of those jobs are expected to come back, monetary and fiscal authorities have been urgently trying to limit the economic fallout of a certain recession to prevent the devastation of a long-lasting depression.
The market panic escalated after Sunday, March 8th when Saudi Arabia, who’d been unsuccessfully soliciting Russia to continue oil production cuts, reversed course and increased production to essentially declare an oil price war. It was decided that it was an opportune time to increase the pressure on the American fracking industry, who have added large amounts of oil and gas supply over the last several years. The simultaneous demand shock due to the coronavirus and the decision to end the production limits created a perfect storm for oil prices, with the West Texas Intermediate oil price benchmark falling 25% from already depressed levels the following day. The coronavirus is by far the reason for the market decline, but the coincidental major price drop in oil too has had an effect on overall market prices.
The Federal Reserve (Fed) stepped in with two separate interest rate cuts, cumulatively cutting from 1.5% to 0% to immediately ease financial conditions, while expanding liquidity injections into short-term repurchase agreement markets. This did little to calm markets while Congress passed two coronavirus relief bills that included aid for the finding of a vaccine and beefing up unemployment benefits. By the time Congress passed a third, $2 trillion relief package that included one-time payments to citizens and support for affected corporations and small businesses, the Fed had pulled out all the stops by expanding accepted collateral, buying investment grade corporate debt, and lending to foreign central banks. The combination has driven the Fed balance sheet to new highs, though appears to have calmed the immediate liquidity scramble amongst broad markets. Pockets of distress remain as the length and severity of the coronavirus shutdown remain uncertain.
Equity markets were making new all-time highs mid-quarter, rising as much as 5% after a strong 2019 and applauding a phase 1 trade deal between the US and China. The outbreak of the coronavirus in China had been newsworthy in that it affected US supply chains and multi-national companies operating in China. Again, that all changed when liquidity became top priority for the first time since the 2008-2009 Great Financial Crisis, with all marketable assets coming under pressure. The major US equity indices had their worst quarter since 2008, with the S&P 500 finishing 19.6% lower with a nearly 34% peak-to-trough drawdown during the quarter. Small-cap US equities fared much worse, finishing Q1 down 30.6%, as revenues dried up alongside lending markets to create the perfect storm.
The global nature of the pandemic hit developed international and emerging markets alike. A near breakout of the US dollar versus global currencies threatened the whole system, and foreign businesses with dollar-based liabilities watched as orders dried up as well. The European Central Bank had its hands tied with respect to already negative interest rates, though continued to facilitate lending by incentivizing institutions to keep the spigots open. The Bank of Japan was already the largest holder of Japanese equity ETFs when they put the buying on hold at the end of 2019, though this policy was reversed and amplified as the government injected the equivalent of another $500 billion in fiscal relief. The near coordinated move of global central banks has let the US dollar remain strong despite a record amount of crisis spending in the US. Despite reports that the largest EM market economy, China, has made it through the worst of the virus-related storm (if you can believe their data), emerging market equity indices still had a very rough quarter. Developed international markets edged out emerging markets in terms of 1st quarter returns, with the iShares MSCI EAFE Index ETF (EFA) down 23.0%, and the iShares MSCI Emerging Market ETF (EEM) down 23.9%.
Fixed income markets also experienced large drawdowns during the 1st quarter. Even investment grade corporate bonds sold off alongside the more speculative high yield segment as liquidity became paramount and worries of default were spread across the credit spectrum. Municipal debt, backed by state and local governments, experienced a relatively large repricing due to the anticipated combination of rising unemployment liabilities and falling tax revenue. Federal Reserve action helped to add liquidity in these markets, becoming a buyer of last resort, while Congress included state and local governments in its third version of the relief program. The iShares iBoxx US Investment Grade Corporate Bond ETF (LQD) and the iShares iBoxx US High Yield Bond ETF (HYG) were able to rally off their lows and ended the 1st quarter with returns of -3.0% and -11.6%, respectively. However, the most intense part of the liquidity crunch came in mid-March when US Treasury debt sold off alongside equities and corporate debt, signaling an all-out race for liquid cash. The long-term iShares 20+ Year Treasury Bond ETF (TLT) drew down over 15% over the span of 7 trading days, though did recover to return over 22% during the quarter.
Like so many, while we did not fully predict the violent impact that the coronavirus would have on the economy and global markets, our tactical models had our clients prepared for the increasing probability of a pullback from recent exuberance. We believe that a continuation of the market volatility experienced in the 1st quarter is likely and there is still potential for retesting the prior US equity market lows (set March 23) and maybe even further downside as earnings estimates and risks are recalibrated during the economic shutdown. There will, however, as usual, be opportunities in this market, and we remain vigilant to avoid market turbulence and do what’s in the best interest for our clients’ investment portfolios while strictly abiding by our principles of Passion, Integrity, Vision, and Care.
Thank you for the opportunity to be of service and we hope that everyone stays healthy and positive in these trying times. Keep in mind, this is not a destination, it’s a transition.
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