Market Commentary – Q1 2020

  • Stock market volatility will likely remain for at least the remainder of the year as markets digest the economic impact of the COVID-19 pandemic
  • S&P 500 still is not cheap relative to historical bear market levels, although US small cap and foreign stocks appear cheap
  • Maintain a disciplined asset allocation, preserving safe liquidity, in order to mitigate further downside risks

What a different world we face today than at the end of last year. The shutdown of the global economy due to the COVID-19 pandemic created a recession that threatens to surpass that of 2008-2009. In response, governments announced a massive amount of fiscal and monetary stimulus, but the length of the recession remains uncertain as long as the coronavirus remains unchecked. The S&P 500 fell approximately 34% from its February 19 peak to the low on March 23. This set the dubious record of being the fastest 30% decline in the history of US markets, surpassing anything seen in the Great Depression or in the 2008-2009 Global Financial Crisis. US small cap stocks declined by over 40% from the February peak through March 23, while non-US stocks, both developed and emerging, delivered similar performance to the S&P 500. Markets rallied from the March 23 lows, ending the quarter with major indexes down 20-25%. Across the global equity markets, growth stocks held up better than value.

The underperformance of value during this downturn primarily stems from the outperformance of technology, which dominates growth portfolios. The large tech companies face far less business interruption risk than main street businesses and generally have better balance sheets. However, as the economy emerges from this interruption, value stocks may shine. A recent study from investment boutique Verdad1, examined eight periods since 1974 where the spread on high yield bonds spiked above 6.5 percentage points, identifying them as periods of financial distress (as stated above, current high yield spreads are above 10 percentage points). The paper examined what areas of the financial markets performed best coming out of this environment. The winner, by a wide margin, was small cap value stocks, which, on average, delivered over twice the return of the broad market. Small cap value stocks also handily outperformed high yield bonds and distressed debt. A study of individual stock performance indicates cheap stocks with high operating cash flow provided the best risk / return metrics. While highly leveraged companies also outperformed coming out of these periods, the general outperformance of value stocks was not dependent on having exposure to companies with risky balance sheets.

The bond markets also experienced volatility not seen since 2008. We restrict client safe liquidity holdings to hold only investment-grade bonds. Furthermore, we limit BBB-rated securities, the lowest credit rating still considered ‘investment grade’ so that the majority of holdings is rated ‘A’ or better. Nevertheless, liquidity driven selling, particularly redemptions from bond ETFs (which we have never been fans of), drove prices down on even the highest quality corporate bonds. BBB-rated corporate bonds, not surprisingly, performed the worst, returning -7.5% YTD. Higher rated corporates outperformed with A-rated corporates returning -0.7% and AA- rated corporates returning +1.4%.

High yield bonds (corporate bonds rated below BBB), after a first quarter decline of 12.7%, now offer an interest rate spread above Treasury bonds of comparable maturity of over ten percentage points. While we have opportunistically allocated to high yield in the past, we have not found the risk / return profile attractive for several years. The decline in values reflects an expected increase in defaults. According to Moody’s, credit losses on high yield bonds exceeded 7% during both the 2001 and 2008-2009 recessions2 . If this occurs again, the current 10% yield on junk bonds would net an investor something less than a 3% return. The risk in investment grade corporate bonds is concentrated in BBB-rated bonds, which comprised over half of the universe prior to the downturn. While nearly 2% of BBB-rated bonds defaulted during the 2008-2009 recession, the default rate on A-rated bonds was 0.64% over that two year period.

Municipal bonds, even the predominantly A-rated or better portfolios the comprise clients’ safe liquidity allocations, also experienced volatility. The Bloomberg Barclays Municipal Bond Index declined by over 10% from March 9 through March 20 before recouping most of the loss. This nearly matched the 11% decline in the index following the failure of Lehman Brothers in September 2008. Short term municipal bonds also suffered declines, but of less magnitude. While state and local budgets will be strained by the loss of tax revenue from the pandemic, municipal bonds have fared better than comparably rated corporate bonds in past downturns. Defaults in municipal bonds rated ‘A’ or better remain extremely rare. Defaults that do occur tend to be obvious, as was the case with Detroit and Puerto Rico.

This flight to safety drove Treasury Bills to negative yields and required the Federal Reserve to step in to support both the money market and bond market. The Fed, moving farther and faster than it did in 2008 after the collapse of Lehman Brothers, extending the support beyond the government and mortgage markets to directly purchase investment grade corporate debt supporting ETFs and mutual funds dealing with record outflows. Additional steps include relaxing banks’ regulatory capital requirements on expected credit losses and encouraging financial institutions to offer ‘small dollar’ loans to consumers and small businesses impacted by the epidemic. Foreign central banks announced similar interventions with the European Central Bank initiating similar bond purchases and Japan going one step further and directly purchasing equities. Central banks in developing countries such as Poland, Colombia, the Philippines and South Africa also announced liquidity programs to purchase government and corporate bonds.

When the COVID-19 pandemic will peak in the US remains uncertain, but hopefully will happen within the next few weeks, leaving the country shut down at least through early May. While we remain optimistic, a reasonable worst-case scenario would involve a full economic recovery taking 3-5 years. Preserving safe liquidity to provide for spending needs for this risk should remain a priority. Eventually, the economy will recover and current pricing levels, while not as cheap as 2009, do support the outperformance of risky assets over a 5-10 year time horizon. Our best guess is that the US economy will begin to grow again late this year or early next year. An overhang of excessive corporate debt will likely translate into an anemic recovery. There will not be an “all- clear” signal notifying investors that it is safe to buy stocks again, rather one should continue to own the equity of high quality companies that can weather a longer than expected downturn. As we saw last month, a 20% rally occurred from the March 23 low, well before any indication that the pandemic had peaked and the economy had begun to recover. Expect similar levels of volatility going forward, we may see new lows and equally sharp rebounds before this ends. As we review client portfolios, we generally will not make rebalancing recommendations other than some minor adjustments within existing holdings of risky assets. Instead, we continue to emphasize the importance of maintaining an adequate liquidity reserve. Given the complexity of this situation, we will continue to provide more frequent updates on our outlook for the economy and markets.


1 https://verdadcap.com/featured-thinking
2 Source: Moody’s 2017 Default Study