The End of the Beginning

Now this is not the end. It is not even the beginning of the end. But it is, perhaps, the end of the beginning.
Winston Churchill

Equity markets continue to rally as the COVID-19 pandemic in the US and Europe appears to be peaking.  After the Federal Reserve stepped in to backstop the fixed income market last month and Congress passed what will likely be the first of many fiscal stimulus plans, the fear that had frozen financial markets dissipated.   A rally of over 27% in the S&P 500 ensued.

As of April 14, the S&P 500 year-to-date decline stood below 12%, bringing the index within a few percentage points of where it closed at the beginning of the fourth quarter last year.  Today, in the midst of the worst economic contraction since the 1930s, the index trades 20% higher than in December 2018 when the markets feared a mild recession was a possibility. The International Monetary Fund projects the global economy to shrink by 3% this year. Even in 2008 during the Global Financial Crisis, the world grew by 0.4%. 

While the rapid response of the Federal Reserve and Congress proved effective in preventing a financial crisis last month, fiscal and monetary policy can only provide support.  As this is a public health crisis, ultimately it must be resolved by public health policy.  In order for economic normalcy to return, people must have confidence in the safety of their health to go back to normal life.  2008 was a financial crisis; therefore, the actions of financial authorities could restore faith in the system. This is a public health crisis, and our public health authorities have so far provided little basis for confidence.  A vaccine remains 12-18 months away and any resumption of normal economic activity before then will depend upon effective testing, contact tracing and quarantine – a ‘test and trace’ policy, along with more effective treatment protocols.  While some progress has been made on treatment, we currently lack the equipment, infrastructure and political ability to implement proper containment procedures.  According to Bloomberg on April 11, the US has the capacity to do 110,000 to 135,000 tests daily, far short of the 1 million per day needed to effectively implement ‘test and trace’.

The markets appear to be pricing in a V-shaped recovery outside of a few hard hit industries such as airlines and hospitality.  However, the best case scenario now appears to be a limited economic reopening that will merely take us from a catastrophic recession to a severe one.  Normal economic activity will not resume as long as consumers and businesses believe the coronavirus continues to pose risks to their health and income. In the wake of this slowdown, bankruptcies will begin for highly leveraged companies.  The virus raises surreal questions such as whether bankruptcy proceedings can happen with courts closed.  This contraction of business activity will likely result in a prolonged downturn.  Dividends from S&P 500 companies, which declined by 26% during the 2008-2009 financial crisis and did not fully recover until 2012, will likely see a similar downward trajectory.

While the US and Europe appear to be more or less equally impacted by the pandemic, the impact on the developing world largely remains to be seen.  South Korea, Taiwan and Singapore demonstrated the most effective responses to the virus and have largely contained its spread.  Other developing countries will struggle with congested cities, poor healthcare infrastructure and a lack of borrowing ability.  Turkey, with 65K confirmed cases and 1,403 deaths as of April 14, appears to be on a similar trajectory to Italy.  Regardless of whether they contain the virus, the economies of commodity exporters such as South Africa and Brazil will face severe hardship.  Accordingly, we are recommending clients reduce exposure to broad emerging market mandates and instead focus on the Asian countries that so far have dealt with the pandemic better than the US or Europe.

All this will pass and the global economy will recover, but we are concerned that the outlook has swung too bullish.  Investors will likely see more volatility this year and next.  Opportunities will arise coming out of this downturn, but if past bear markets are any guide, making aggressive moves early is counterproductive.  Ultimately a lost year or two of earnings makes little impact on a high quality business not at risk of financial distress.  It may be the markets have simply discounted this scenario and assume that by, say, 2022 corporate earnings will be back to last year’s levels and then continue to grow.  However, this would require a belief that the recurring human psychology of fear that drove past bear markets no longer applies.

Likely, the world will never return to ‘normal’ following this pandemic.  Similar to the aftermath of 9/11, we will face increased frictions to travelling and congregating.  Large investments will be made to improve our capabilities to respond to biological threats.  Similar to how the European sovereign debt crisis emerged a few years after the 2008-2009 Global Financial Crisis, we will see the strain of this outbreak create new financial challenges in coming years.  Again like 9/11, our responses to biological threats will challenge existing notions of civil liberties vs communal safety.  On the positive side, we stand at the cusp of great advances in the biological sciences.  Enabled by fast and cheap genetic sequencing, artificial intelligence and other techniques, the next decade will likely see major advances in the treatment of cancers and genetic diseases, along with better techniques to deal with emerging new pathogens.  The existing trends of declining retail, increased online and home delivery and the monopoly power of large tech companies have all been reinforced by the pandemic.  Consumers may retrench, emphasizing saving over consumption.  Millions of workers will have to find new employment, perhaps in manufacturing operations returning to the US from offshore.  Given the poor public health response of the US relative to East Asia, we may see a period of underperformance for US markets.  Increased debt burdens and de-globalization may eventually lead to a re-emergence of inflation as economies recover.

In general, portfolios are built to weather this level of volatility.  We have focused on building equity portfolios with managers who are buying high quality businesses that can weather a prolonged downturn.  Portfolio managers continue to evaluate opportunities and are strategically making changes across their portfolio.  Comstock continues to monitor the manager’s implementation of their strategy while also helping each of you focus on preserving safe liquidity – high quality bonds and cash – sufficient for multiple years of future cash flow needs.  Given this environment, some changes will be advantageous and we will provide specific recommendations when those opportunities arise.  If the past is any guide, smaller cap and value stocks will lead the recovery.  Private deal activity will slow as buyers and sellers cannot agree on prices and we therefore see both limited new capital calls and realizations for private funds. 

Volatility also creates great opportunities for generational wealth transfer and we are actively working with many clients on this.  As markets and events change rapidly, we have adapted our reporting to be more timely and responsive.  Fortunately, working remotely and cancelling travel has actually increased our productivity and ability to respond to clients.

– Stephen C. Browne, CFA, CIO