30 Apr Q1 2020 Market Commentary
Director of Investments Todd Jones, MBA, CAIA®, weighs in on the current financial environment, critical market trends to watch, and what it all means going forward.
Here’s what Todd is talking about this quarter:
- The COVID-19 event-driven recession
One of the most volatile quarters on record
The positive similarities between now and 2008
Following on the heels of a very positive year for financial markets and the global economy, Q1 2020 has turned out to be nothing short of unprecedented. The impact on our families, communities, and country has been profound. Several weeks ago we had reason for cautious optimism that the coronavirus might be contained to China, it is now obvious to all that this is not the case. As the first quarter progressed, the epicenter of the coronavirus crisis moved from China to Europe and now to the United States leaving economic and health devastation in its wake. The quarter was unprecedented not only for the movements in financial markets (which experienced a full year’s worth of volatility in three weeks) but also from an economic perspective (where the entire global economy ground to a halt).
Coming into 2020, our base-case assumption for the global economy was for a low but stable growth environment anchored by both the Chinese and United States economies. Until early February, incoming data relating to the US economy was showing a strengthening in economic growth driven by a rebound in the manufacturing and services sectors. Yet, this reacceleration was brought to a halt, first in China and then the United States, as it became clear that the most effective way to contain Coronavirus (COVID-19) was to enact social distancing and shelter-in-place measures. Fast forward to mid-April, and we are now starting to see the extent of economic damage showing up in incoming economic data. Needless to say, none of it is positive……yet. However, in our view, what’s makes this particular recession different is that this is an event-driven, and not cyclical or structural, recession. We’ve referenced the definition of each in a footnote below.
As noted in the chart above, the difference between an event-driven recession and the other varieties is important as the length and time to recovery is dramatically shorter on average. Whether or not this COVID-induced recession will play out as described above is still in question, however, this does give us a template to adjust off in the event new information becomes available. The key variable is how long the economy will remain closed. What is clear, however, is that “normal” will look very different on the other side of this recession. Everything from consumer spending patterns, to vacations, to remote-working all will be rethought.
Financial Market Observations/Outlook
Turning to financial market performance, Q1 2020 has been a quarter for the record books on many fronts.
In the equity markets, the S&P 500 (red) experienced its fastest 30% decline in history (eclipsing both 1929 as well as 1987) rebounding slightly to end the quarter down ~20%. Small-company stocks, represented by the Russell 2000, fell even more than large-company stocks, ending the quarter lower by 31%. International and emerging market equities closed the quarter down roughly the same amount at -24%.
Notably, Q1 2020 also ended up being one of the most volatile quarters on record (as measured by the VIX index in blue) with volatility surging from a pre-crisis level of 15 and topping out at 85; a rise of more than 400%!
Using the return numbers above as a proxy, our positioning in equity markets coming into 2020 was the appropriate portfolio construction. Our long-held overweight to US large stocks, over both small and International, added relative value to our equity performance. Additionally, our Investment Committee took the opportunity in late March to rebalance accounts when equity prices were near their trough. This rebalance involved reducing fixed income positions that had moved to a relative overweight and adding to equity positions that were underweight. Looking forward we anticipate continuing with our current allocation as large company earning are likely to be more resilient in the face of economic uncertainty.
Where do equities go from here? As Yogi Barra once said, “predictions are difficult, especially about the future”. However, if we pull out the recession playbook for equities, one would find that in 2020 the S&P 500 has followed the pattern of the previous two recessions (2001, 2008) relatively closely: dramatic sell-off (-31%) followed by a sharp recovery (+20% so far) all with significant volatility (>60 on the VIX index). If the current pattern holds, then we should expect a “re-test” of the March 2020 lows at some point in the near future, followed by a range-bound market for the foreseeable future. This is our current base case assumption. The good news, however, is that these types of environments are ideally suited for skilled active management. As performance trends in early April would suggest, active managers are starting to demonstrate the benefits of security selection once again. We see opportunities only improving in active strategies from here.
Turning to the fixed income markets, the recent volatility seen in both the investment grade and municipal bond markets have been nothing short of historic as well. At one point in March, the iBoxx investment grade bond index (in blue) and the Barclays aggregate municipal index (in red) were down -17% and -12% respectively as bond investors dumped higher quality non-treasury securities. Yet, fearing a repeat of the 2008/2009 Great Financial Crisis (GFC), on March 23rd the US Federal Reserve correctly identified stresses building in the credit markets and announced a flurry of new market support programs. These support measures, which included the outright purchases of bond exchanged traded funds, effectively disrupted the steep decline in select bond markets and brought stability back to an otherwise fragile situation.
The outlook for bonds has been nuanced for at least the last 3 years in my opinion. While low interest rates make allocating to high quality US Treasury securities difficult, events like March of 2020 continue to demonstrate their value in diversified portfolio given they were one of only a few assets to post a positive return during the month. That said, our preferred way to access the benefits of high quality, yet with higher yields, has been to allocate to active strategies that focus on government-backed mortgages, government agency bonds, and higher quality corporate debt. Further, over the last 18 months we have been gradually reducing our weighting to non-agency mortgages and lower credit quality debt fearing that market participants were pricing these, more risky securities, to perfection. Price movement of these riskier securities during March would indicate this was the prudent course of action.
Finally, it is worth mentioning that we continue to avoid riskier segments of the bond market, specifically emerging market debt, due to the uniquely vulnerable position many emerging market countries find themselves in from a currency standpoint. If yields in any of the categories mentioned above get dramatically higher from here, we’ll re-evaluate our position.
In all, from a client perspective, we recognize that the current juncture in financial markets can feel a lot like starring into the abyss. If I had to characterize the sentiment in the market, I would say that today (April 2020) feels not too dissimilar to October/November of 2008, right after Lehman Brothers collapsed. After that event occurred, many investors felt that there would be no coming back for the US economy from such an epic collapse. For a few months after that event, markets were extremely volatile (check), political rhetoric was highly charged (check) and government intervention was heavy (check). But toward the latter part of February and into early March 2009 market dynamics began to change: (1) emerging markets began to rally, (2) fixed income yields began to rise, and (3) volatility (represented by the VIX) began to come out of the equity markets and was well off its highs. Today, two out of the three above have come to pass. While these are not pre-conditions to signal the all clear these historical reference points are raising the probability that we are closer to the bottom of this economic slowdown than the beginning.
Todd Jones, MBA, CAIA®
Gratus Capital is an SEC-registered investment adviser. Registration with the SEC does not imply any level of skill or training. Our ADV documents are available upon request. The opinions expressed are as of January 2020 and may change as economic conditions vary. The information provided is not intended to be relied upon as specific investment advice and is not a recommendation, offer or solicitation to buy or sell any securities. Examples provided are based on current market conditions, and there is no guarantee that any applicable condition will remain in place. Portfolio holdings are subject to change at any time and may differ materially in the future from case studies presented. No graph or chart by itself can be used to determine which securities to buy or sell or when to buy or sell them. As with any investments, past performance is not a guarantee of future results. There is no guarantee that any investment strategy will achieve its objectives, generate profits or avoid losses.
 Source: Envestnet