2020 1st Quarter Update
Top Headline for Q1: “COVID-19”
As we’re all aware at this point, the COVID-19 pandemic has affected our lives in unprecedented ways. Our thoughts go out to those families afflicted with the illness and the many healthcare professionals who are bravely working to help them. We hope that all of you are safe and finding comfort among friends and family.
As would be expected from such a crisis, corporate equity and bond prices have been under tremendous strain. The pandemic led to the fastest bear market (i.e., 20% decline) in US stock market history with the S&P 500 Index falling 35.4% between its intraday high on February 19th and its intraday low on March 23rd before recovering to finish down 20% for the quarter. This drop marks the worst quarterly drop since the Great Recession and officially ends the 11-year bull market run.
General Market Update
US Equities: Along with the S&P 500 Index being down 20.0%, the Nasdaq Composite was down 14.2% and the Russell 2000 Index finished down 30.9%. According to Dow Jones Market Data, the Dow had its worst first quarter in its 124-year history. There was no safe-haven in the equity market during this downturn as widespread “panic selling” caused declines in all sectors of the market. It is noteworthy that there were significant differences by sector and size. As evidenced by the Russell 2000 Index performance, the market is, probably correctly, assuming that the economic downturn will be harder on small companies. In the large company space, dire economic forecasts led to more pronounced drawdowns in cyclical sectors such as Industrial and Energy. And, as one would expect, we’re seeing massive drawdowns in areas directly hit by the lockdown such as retail, hospitality and airlines. One factor contributing to the rapid overall decline was the fact that corporate earnings were already projected to be flat for 2020 before the outbreak. Of course, the pandemic has led to near constant downward adjustments in analyst earnings projections such that corporate profits are expected to show a substantial decline year-over-year from 2019 to 2020.
International and Emerging Market Equities: International equity markets performed even worse than the US market as the number of COVID-19 cases and deaths climbed at alarming rates in several European countries. The Schwab International Equity ETF, which holds stocks of developed markets excluding the United States, was down 23.2% in Q1 and the Schwab Emerging Markets ETF was down 24.4%. International markets continue to trade at much lower earnings multiples relative to the US - nearing record lows after the most recent decline.
Fixed Income and Credit: The economic fear hitting the equity markets also appeared in bonds where rampant selling led to substantial drawdowns in corporate bonds and long-term treasuries. Corporates were hit especially hard as economic fears led to uncertainty over defaults. In fact, long-term “investment grade” corporate bond averages spiked down over 25% and remain well below Q1 highs. Continued volatility is expected as rating agencies rush to digest economic information and adjust bond ratings appropriately. Many downgrades have already occurred and more are expected. The Federal Reserve’s announcement that they would be buying corporate bonds appears to have been critical in stabilizing the market. Long-term treasuries saw a more moderate downward spike during the sell-off but recovered quickly and rose to new highs as investors favored the security of government-backed loans and government bond buying created upward pressure.
A Look Ahead
Regarding the US stock market, it is likely that volatility is here to stay for a while. Economists are still assessing the economic impact as the virus continues to spread. Many more negative headlines are expected as companies continue to adjust earnings downward and various federal governments release negative economic data. For example, on April 2nd we saw weekly unemployment claims in the US spike to over 6 million which is 10X worse than anything we had seen before the virus. On the positive side, the US Government has met the unprecedented circumstances with unprecedented aid. The Federal Reserve has deployed massive amounts of stimulus including (1) dropping interest rates back down to a target range of 0 - 0.25%, (2) resuming “quantitative easing” with the purchase of treasury bonds, mortgage-backed securities and corporate bonds and (3) injecting liquidity into the banking system via increased re-purchase operations and reduced liquidity requirements. The President and Congress also moved quickly to pass trillions of dollars in aid that is intended to directly benefit those workers and employers that are most affected.
It’s important to note that market volatility and panic selling is nothing new. In recent history, the overall US equity market fell over 50% during the “Great Recession” and “Dot-Com Bubble” before recovering to new highs. American corporations have historically proven resilient at adjusting to new demands and growing earnings in the long run. Our belief is that equities continue to be a great long-term investment but that more near term volatility, and possibly further drawdowns, can be expected as negative economic information is released and digested. Large companies with strong balance sheets are well-poised to emerge stronger from the crisis. Interest rates are likely to remain low for an extended amount of time and quality companies should be able to borrow at very attractive rates – thereby reducing cost of capital and improving long-term margins. Some small highly-leveraged companies may face difficult times ahead as high-yield bond rates are likely to remain elevated leading to a challenging funding environment for that group. If rates remain high and funding is tight, bankruptcies among Russell 2000 constituents are expected.
The next 3-6 months should be interesting for the corporate bond market as it fights for price stability. Poor economics and continued uncertainly are weighing it down while the zero-interest-rate policy and government buying creates upward pressure on prices. If the government continues its commitment to ad hoc buying, short-term stability is likely to be maintained until economic clarity emerges. It looks to us like bonds of companies with good balance sheets are underpriced while the high yield market may suffer further damage. While shorter-term government bonds will continue to be used as shelter from the volatility, longer term bonds will likely see price swings as investors assess the inflation impacts from the stimulus. Looking long-term, it continues to be tough to get excited about the long-term bond market. Interest rates have returned to historical lows and record-breaking stimulus is likely to, eventually, push inflation higher. As such, it feels like longer-term bonds are set up for downside risk.
We will continue to monitor market conditions and rebalance portfolios where opportunities present themselves. If you have any questions, or if we can help in any way, please do not hesitate to contact us.
