The longest bull market in U.S. history ended abruptly in the 1st quarter with the onset of the highly contagious COVID-19 pandemic. While the U.S. markets were able to endure a trade war with China, a presidential impeachment investigation and the geopolitical uncertainties surrounding Brexit and Middle Eastern tensions, almost no one anticipated that the advanced U.S. economy would meet its greatest challenge in the form of a virus.
Early in the quarter, fears of the virus were more subdued as the Chinese city of Wuhan and its respective Hubei province were forced into a lockdown to stop the spread of the contagion. However, fears began to escalate in late February as the lockdown in China become more widespread and Italy’s Lombardy region became the focus of the pandemic’s progression. On March 13, the severity of the virus came to light in the U.S as President Trump declared a national emergency causing many investors to feel a level of anxiety that they have not had since the 2008 Financial Crisis.
To combat the spread of the virus, many states began to adopt similar self-quarantine policies as European countries which caused an unprecedented forced seizure of the global economy. The uncertainty surrounding the severity of the pandemic as well as the duration of keeping economies closed created a tremendous level of market volatility for March.
Broad equity markets were down sharply for the quarter with the S&P 500 posting a 20% decline while the S&P 600 small-cap index was down over 30%. It is important to note that it took the S&P 500 only 22 trading days to fall over 30% from its record high reached on February 19, making it the fastest drop of this magnitude according to data from Bank of America Securities.
During the second half of the quarter, the stock market experienced several other noteworthy firsts in history including:
- The S&P 500 hit the circuit breaker and triggered trading halts four times.
- The Nasdaq Composite Index suffered its largest one-day percentage decline ever.
- The Dow Jones Industrial Average posted its biggest weekly gain since 1938.
(Sources: marketwatch.com 3/16/20, WSJ 3/27/2020)
The uncertainty surrounding the outlook for the economy as well as the extreme volatility that spread through all areas of capital markets prompted large fiscal and monetary policy responses from both the U.S. government and Federal Reserve.
These actions helped to quell investor fears while the country deals with containing the spread of COVID-19 and attempts to gather more visibility on the gradual reopening of the economy.
FEDERAL RESERVE TO THE RESCUE
Following its March 3rd decision to cut rates by 0.5%, The Fed lowered its target interest rate again on March 15 by a full percentage point to zero and Fed Chair, Jerome Powell provided guidance that rates would remain at this level “until we’re confident that the economy has weathered recent events and is on track to achieving maximum employment and price stability goals.” To further bolster market liquidity and price stability the Fed revived its Quantitative Easing (QE) program, pledging the purchase of $500 billion of U.S. Treasury bonds and $200 billion of government mortgage-backed securities over the coming months. With the equity markets failing to react positively to this initial pledge, the Fed provided additional unprecedented stimulus on March 23 by stating that it would make its QE purchases open-ended and that it would expand its bond purchases to commercial mortgages, investment grade corporate bonds, high yield bonds as well as some areas of the municipal bond market. They also lowered bank reserve requirements and created corporate lending facilities to assist with small and medium business lending as credit markets were showing signs of distress. This “whatever it takes” policy helped to alleviate some of the disorder in both equity and fixed income markets as the quarter ended.
THE CARES ACT
Shortly after the Fed’s bold monetary stimulus, Congress passes the $2.2 trillion-dollar Coronavirus Aid, Relief and Economic Security (CARES) Act to reduce the severity of the economic recession at hand. This is the largest economic relief package in U.S. history that will provide for the extension of unemployment benefits for state and local governments up to $250 billion, $500 billion in general corporate aid for large distressed companies, $350 billion in small business loans that will be facilitated by community banks and $140 billion for the U.S. healthcare system and virus testing.
Aside from extending individual unemployment benefits by $600 per week for four months in addition to state programs, the bill allows for the one-time stimulus of up to $1,200 for taxpayers and married couples will receive $2400 plus an additional $500 per child. However, the payments will only be made available for individual incomes up to $75,000 and $150,000 for married couples. The bill allows for employers to delay the payment of their portion of 2020 payroll taxes until 2021 and 2022. It also provides new guidelines for retirement account fund access by waiving the 10% early withdrawal penalty for coronavirus-related purposes and spreads the income tax liability owed on such distributions over a three-year period. 401(k) loan limits have also been increased from $50,000 to $100,000 and 2020 Required Minimum Distributions (RMDs) have been suspended.
US AND GLOBAL ECONOMY
Prior to the onset of the global pandemic, there was little to suggest that the U.S. and global economies would face a severe and abrupt contraction in the quarter. In January and February, the U.S. Conference Board Leading Economic Index, an index intended to forecast future economic activity, showed little deterioration as the index was up 0.2% over this period. It was not until March when the planned shutdown of the economy commenced causing many to anticipate a broad-based weakening in these leading indicators as the rate of unemployment was expected to jump substantially from February’s 3.5% level.
In March, the U.S. unemployment rate jumped to 4.4%. However, with most U.S. businesses ceasing operation in order to comply with social distancing mandates, it is now expected that weekly continuous jobless claims could reach over 20% of the workforce in the weeks ahead, a threshold last seen during the Great Depression. This will undoubtedly have a negative impact on housing as well as business and consumer sentiment in the quarters ahead.
Both international developed and emerging market economies had a similar experience for the quarter. Although manufacturing and service-based activity declined substantially in China and some peripheral Asian countries as the outbreak ensued in early February, the majority of Purchasing Managers’ Index readings for these economies in the month managed to register near 50. Where readings at or above 50 indicate acceleration. It wasn’t until mid-March that these readings began to drop precipitously.
US EQUITY MARKETS
Despite entering a bear market (being categorized as a 20%+ decline in equity prices), the S&P 500 index managed to end the quarter trading at a forward P/E of 15.5,below the 25-year historical average of 16.5. However, it is important to point out that this metric is assuming that earnings will be unaffected by stark drop in business activity for the quarters ahead. With analysts estimating that earning could drop by 10% to 30% for Q1 through Q3, this could put equity valuations well above the February levels if quarter-end price levels are maintained. Granted the unprecedented monetary and fiscal policies of the Fed and U.S. government should act as an interim backstock for equity prices as the current crisis is sorted out. Although this is more confidence in our long-term outlook for the market we still remain cautious on equities in the near-term due to the lack of visibility in corporate earnings.
Large-cap stocks managed to out-perform their smaller-capitalized peers for the quarter. Growth focused companies also outpaced value-oriented stocks by a similar degree. As expected, the more defensive sectors of the equity market such as healthcare, consumer staples and technology managed to decline the least as volatility peaked.
INTERNATIONAL EQUITY MARKETS
Both international developed and emerging markets were mainly in line with the returns delivered by U.S. large-cap stocks for the quarter. Emerging markets managed to outpace developed markets by a small margin as China’s market was surprisingly the best performing emerging country having only fallen 10% for the quarter despite its central role in the global crisis.
The broad international market as represented by the MSCI All Country World Index ex-US continued to trade at a 20% valuation discount to the S&P 500. As we have noted in the past, this disparity has primarily been a function of demographic and growth potential differences between the U.S. and the rest of the world. With U.S. monetary and fiscal policy being more coordinated than that of European countries, we do not expect this valuation gap to narrow any time soon.
FIXED INCOME MARKETS
The U.S. Bond market as measured by the Bloomberg Barclays Aggregate Index managed to deliver nominal returns even though markets were temporarily disrupted in March as credit conditions tightened. The Fed’s monetary action helped lower U.S. Treasury yields with the U.S. 10-year yield dropping to just 0.70% from the 1.90% level at the start of the year.
Investment grade, high yield and emerging market bonds all delivered mid-single digit to low double-digit losses for the quarter. These returns were far worse at the height of the March downturn. It wasn’t until the Fed announced its bond purchase operations later in the month to help lessen the losses in these riskier parts of the credit market.
Prestige’s fixed income positioning has been devoid of credit risk for well over a year as we have been anticipating a credit event (albeit not a virus driven one) to unfold. With bond yields in these risk sectors now higher and the Fed stabilizing credit markets, there may be some potential opportunities in these asset classes.
“it will be contingent on getting an initial treatment and vaccine to instill confidence in society as well as how quickly we manage to get people back to work” - Dr. Jeremy Siegel
The lack of visibility in corporate earnings over the next few quarters has made it difficult to justify markedly higher equity valuations from a pure fundamental perspective. The Fed’s monetary support has certainly given markets enough of a backstop while markets adapt to restarting the economy in the months ahead. But we still expect volatility to remain above average as markets adapt to the new environment. As for the speed of the recovery and return to normalcy, “it will be contingent on getting an initial treatment and vaccine to instill confidence in society as well as how quickly we manage to get people back to work” as per our recent economic update with Wharton School of Business Professor, Dr. Jeremy Siegel.
Much uncertainty still lies ahead for the U.S. economy and capital markets as we have never encountered a crisis leading to a widescale shutdown of the global economy and labor markets. There has been some anticipation that life prior to the outbreak will revert to normal as we begin the slow process of reopening the economy. However, we caution investors on embracing this view as it is still too early to assess how societal views will be affected in a post-COVID-19 world. It would be naïve to think that business and consumer habits will not be altered to some degree as we attempt to seek a new sense of normalcy in the recovery.
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