The Monthly View – April 2020

An update on the financial markets and the coronavirus

Imagine being chased through the woods by an angry bear. You manage to climb a tree, getting high enough so that the bear cannot reach you. You breathe a sigh of relief. You are out of harm’s way. Or so you think.
You look down, and the bear is waiting for you at the base of the tree. You have no weapons. You feel cold and hungry. It is getting dark.

This is the state the world finds itself in today. We have climbed up the tree. The number of new infections has peaked in Italy and Spain, the first large European countries hit by the virus. Hospital admissions in New York are falling. This, combined with a generous dose of economic stimulus, has allowed stocks to rally by 28% from their March 23 intraday lows.

Yet, we have neither a vaccine nor a cure for the virus. In short, the bear is still there, waiting for us to reopen the economy.

International Monetary Fund Estimates
As we wait, the economic damage continues to mount. The International Monetary Fund (IMF) baseline scenario foresees the global economy contracting by 3% in 2020, with advanced economies shrinking by 6.1%. This is worse than during the 2008/09 financial crisis. The IMF’s projections assume that the pandemic subsides in the second half of 2020, allowing containment measures to be relaxed. If the pandemic were to last longer than that, global output would fall by an additional 3% in 2020.

We have already seen that the sudden stop in economic activity has led to a dramatic surge in unemployment. U.S. initial unemployment claims have risen by a cumulative 22 million claims over the past four weeks.

The one piece of good news is that at least so far, temporarily laid-off workers account for the vast majority of the increase in unemployment. This is encouraging because it implies that in most cases, the ties that bind workers to firms have not been permanently severed.

Best Week for S&P 500 in 46 Years…But!

Despite the record number of unemployment claims, the S&P 500 had its best week since 1974. Risk assets generally have rallied thanks to a healthy dose of economic stimulus and mounting evidence that the number of new COVID-19 cases has peaked. Unfortunately, the odds of a second wave of infections remain high. In the absence of a vaccine or effective treatment, only mass testing can keep the virus at bay without further lockdowns. Such testing will become available, but probably not for a few more months.

The Effect of Stimulus

Investors have had a good reason not to panic-sell over the past six weeks: the government’s response to the economic crisis has thus far been both swift and aggressive. U.S. Congress and the White House took only about two weeks to draft and pass a $2.2 trillion economic stimulus package, the CARES Act, which expanded unemployment insurance, authorized $350 billion in forgivable loans to small businesses, and promised direct stimulus payments to most Americans, among other measures.

The Federal Reserve has been even more active than Congress. Besides cutting interest rates to zero on March 3, the central bank has vowed to inject trillions of dollars of liquidity into the economy to keep it afloat. Efforts include new direct lending programs to banks and corporations, and municipalities, as well as purchases of corporate bonds, mortgage-backed securities, commercial paper, and Treasury notes.

On April 9 alone, the Fed pledged an additional $2.3 trillion in lending on top of its prior authorizations, bringing its total commitment to at least $4 trillion. The Fed has already added more than $1.8 trillion to its balance sheet since March 1. By contrast, it invested less than $1.4 trillion during 2008 and 2009 together. These liquidity measure clearly had a positive effect on equity and higher risk fixed income markets.

Short Term More Cautious

Meanwhile, the global economy remains depressed.

As earnings estimates are revised lower, stocks could give up some of their recent gains. This puts investors in a bit of a difficult situation of what to do right now.

Economic growth is likely to recover in the latter half of 2020 as extensive COVID-19 testing make full scale lockdowns less necessary and the effects of fiscal and monetary stimulus make their way through the economy.

However, the short-term picture could easily be soured by news stories of continued shortages of medical supplies and delays in providing financial assistance to hard-hit households and businesses, not to mention dire corporate earnings performance. Bottom-up analyst earnings estimates still have further to fall. The Wall Street consensus expects S&P 500 companies to earn $142 per share this year and $174 in 2021. This could prove too optimistic.

On balance, we continue to favor global equities over bonds on a 12 to 24-month horizon. However, given the strength and the speed of the rebound in the past three weeks we are less convinced about the near-term (3-month) direction of stocks and we have turned more cautious.

In a typical bear market, we need to see a period of market stabilization before a more sustained market recovery can start.

Reducing Portfolio Risk

We fear that markets might be getting ahead of themselves as the global economic damage is real and severe. We therefore decided to partly de-risk portfolios this week by reducing exposure to small and midcap stocks and by selling USD denominated Emerging Market debt. We allocated the proceeds to cash and short dated Treasury’s which can be deployed on any major market weakness.