First Quarter 2020

It was an ugly quarter for stocks as COVID-19 progressed from a regional virus to a global pandemic. Equity markets experienced the fastest fall into bear market (defined as a fall of 20%) in history, taking 22 days vs an average of 86 days (Chart 1). The COVID-19 pandemic is a classic exogenous demand shock, tipping the global economy into recession. In response to the developing healthcare crisis and to slow the spread of the virus, countries have instituted social distancing and stay at home policies. This led to the first ever stoppage of non-critical economic activity. Initial jobless claims have exploded with over 10 million claims over the last two weeks vs. an average of 225,00 per week. Compounding the blow from the healthcare crisis was a cratering in the price of oil (See Box 1). The US and Canadian stock markets declined 35% (aided by margin calls and forced selling) from their highs and then bounced over 20% in a very quick time frame. While the volatility in the markets has been anything but pleasant, we must remember that at some point there will be a historic buying opportunity as crises always end. 

Stock volatility is typically a result of the fear of the unknown. Equity investors hate uncertainty and fear of a financial or liquidity crisis led to the sudden drop in stock prices. From Feb 27 till the end of the quarter, 19 of the 23 days saw moves of greater than 2%. This includes the biggest percentage gain in over 80 years, and the second biggest percentage loss since 1940. We expect a cessation of extreme volatility when we have a better idea of the shape and duration of the crisis. 

Bonds have a place in a diversified portfolio due their ability to provide stability during times of stress. They did exactly what they were designed for delivering a small positive return despite their low yields. During the final month of the quarter bond prices declined as corporate bond spreads widened. Elevated refinancing and repayment concerns drove the decline until the Fed stepped in to calm the markets. 

The current COVID-19 shock is akin to a natural disaster which generates a sharp but short-lived disruption. The hope is that we see a normal and rapid economic recovery. However, the global scale of the disruption is both unique and historic. Synchronized global downturns typically take longer to heal and production losses are rarely made up in full. 

We continue to grapple with the severity of the downturn and how long the economy will be closed for business. Investors are cognitively still trying to get their arms around these issues and the shape of the recovery. This time really is different, and not in a positive way. We are not overly optimistic of a quick return to the old ways. Countless individuals and companies will see their balance sheets take a hit as there will be little money coming in the door for two to three months. When life returns to “normal”, we will not see an immediate economic recovery to prior levels. It will take a while to rebuild consumer confidence and for individuals to return to their regular routines. Social distancing will remain in place for longer than is currently contemplated which will prohibit certain activities where many people congregate in tight confines. Individuals who saw a reduction in cash flows will also be hesitant to spend at pre-crisis levels until they rebuild a portion of their savings. The market has correctly priced in a recession, but we suspect the market has also priced in a swift recovery, which is not a foregone conclusion. 

On the positive side, stocks typically bottom four months before the end of a recessions. Recessions normally do not end with the end of bad data, but with a sequentially positive inflection of the bad data (i.e. data is less bad on a sequential basis or second derivative turns positive). Again, we are back to looking at the duration and depth of pain of the recession. 

Governments are pumping liquidity into the financial system by providing financing for businesses and wage supplements for individuals. The US alone is planning on over $2 trillion in support to soften the severity of the recession and prevent it from turning into a devastating liquidity or financial crisis. While providing a backstop for both individuals and businesses is positive, it will not make the recession any shallower or shorter. This recession is the result of a virus, and all the money in the world will not change that. Governments are ordering their populations to cease all economic activity and stay home for an indeterminate amount of time. Unfortunately, the pandemic needs to run its course. 

The Federal Reserve has also stepped in with bazooka. They have stated that they will do whatever it takes to help the American economy. For the most part, central banks have dusted off the playbook from the 2008/2009 crisis and further augmented what they did during that time period. This includes, but is not limited to, extending loans to businesses, purchasing unlimited amounts of corporate debt and introducing a new lending facility for the commercial paper market. These actions are designed to prevent a corporate liquidity crunch turning into a solvency crisis. They have been very quick to respond as the credit markets briefly froze in March. The Fed and most central banks have also significantly decreased their lending rates. Typically, the Fed using its unlimited balance sheet and “doing whatever it takes” to backstop the economy has been a buy signal for stocks. Government and central bank interventions are designed to ensure that individuals, small businesses and companies do not drown before they see the other end of the enforced shut down. 

While we are optimistic that we have seen the bottom, we are not as confident that we will not revisit the lows. Companies have yet to confess how bad it is and the impact on their finances. The current consensus is that this will last another two to six weeks, but we think that this is optimistic. While we believe the “lock down” will be lifted at some point this quarter, social distancing will be in place for the foreseeable future as there is currently no way to treat the virus.

Current predictions are that new COVID-19 cases will peak in most countries sometime in April. Social distancing is working. Unfortunately, we cannot simply declare victory and return to our normal lives. There is still no cure, vaccine or widespread tests. We do not know what proportion of people are infected without symptoms due the lack of extensive testing. As can be seen from countries that are past the peak of new cases (i.e. Singapore, Japan), lessening of restrictions might allow the virus to flare up again. 

We believe the best course of action is risk mitigation. Having said that, some companies stock prices were pricing in a severe recession and their stocks were buyable. To reiterate, we need to be selective about which companies we buy and at what price. Client portfolios have cash, but we will be very discriminating on how we invest the money. 

We adhere to the adage “that the better that we can define the problem, the closer we are to the bottom”. We know that COVID-19 is an insidious disease, that is easily spreadable, and has lower mortality rates than other viruses. We know that the economy has shut down, and central banks and governments are throwing money at the economy to ensure that the current recession does not morph into something larger. What we do not know, is how long we will purposely impair the economy to contain the virus, what the recovery looks like, and when it will begin in earnest. We also do not know when there will be a vaccine or universal testing. Companies will report OK March quarters, and guide to ugly June quarters (if they provide guidance at all), but everything beyond that is unknown. Based on being able to quantify the present and the next three months, but nothing after that, we remain cautious and would look to put money into stocks on a pull back as the unknowns either are better defined or become a concern for investors. 

As always, we welcome your thoughts and comments.