Our team has experienced the 1987 Black Monday crash (equities down -20% to -29% in one day); the October 13th mini-crash (U.S. equity markets down -6% to -7% in 1989); the 1997-98 Asian and Russian debt crises which resulted in the blowup of Long-Term Capital Management; and the 2008 sub-prime credit financial crisis (U.S. equity markets down -48%). The 2020 COVID Pandemic market is a financial crisis like no other in so many ways.
Financial history is being made as we close out the second quarter and move into the back half of the year. Annualized 2Q20 GDP was down -32.9% Y/Y which makes it the worst quarterly performance since 1947. However, this unprecedented quarterly decline in GDP also included 4.8 million new jobs in late June and a fall in the unemployment rate from 13.3% to 11%.
The Federal Reserve printed approximately $1.6 trillion dollars (M2 up 25% Y/Y) which exceeded the $1.2 trillion of liquidity it provided in 2009. The U.S. Congress approved $3 trillion of fiscal relief to battle the current crisis which dramatically surpassed the 2009 fiscal support of $800 billion. Yields on bonds are at historic lows with the most recent 7-year US Treasury being issued at 0.43% and investment grade corporate bonds now trading at less than 2% yield to maturity.
Notwithstanding the economic collapse in 2Q20, companies which have reported earnings are enjoying a 75% “beat rate” of analyst expectations which merely underscores the uncertainty of navigating their respective market sectors against lower market forecasts.
However, the most jarring economic reality is the divergence between the real economy and how the U.S. equity markets are pricing in an expected recovery. How does one process the headlines of restaurants, retail stores, and certain businesses closing with U.S. equity markets up approximately +45% since late March? Also, how should investors think about bonds in an environment of 0% interest rates, removing both return and risk mitigation from investors?
We would point out several key observations to explain the current move in the financial markets. The impact of the Federal Reserve injecting massive liquidity into the financial markets and keeping interest rates so low has been a major contributor to the massive rally in U.S. and global equities. The markets did not need to debate the end of the bull market in equities nor the arrival of a recession. The COVID shutdown made that fact clear. Therefore, markets shifted to discounting the slope and speed of the recovery, and massive liquidity and zero interest rates supported unprecedented moves up in equities, notwithstanding some sectors being decimated. Liquidity + low interest rates + below Fed target inflation + uninvested cash fueled a huge shift into momentum equity buys.
The financial markets enjoyed a true V shaped recovery. It is worth noting that the speed of change in financial markets and the associated fiscal and monetary responses have shifted dramatically. It took nearly 43 months for the Fed to provide monetary relief following the Great Depression. In 2008, Congress did not provide fiscal relief for 6 months following the subprime mortgage collapse. With the COVID Pandemic both fiscal and monetary relief was delivered within one month. In addition, the resurgence of day traders with Robinhood accounts appears to have added to the momentum of upward price moves.
However, the real economy does not appear headed for a V shaped recovery like the financial markets have enjoyed. The initial fiscal support provided by the U.S. Congress will end soon and replacement measures are still being negotiated. Many states are experiencing spikes in COVID infections which is delaying economic activity. There is now talk among economists and strategists of a “K” shaped recovery with clear winners and losers but with muted overall full year GDP impact.
And on the horizon is the November elections which could certainly contribute to fresh market volatility. Even though mortality and severity rates do not seem to be rising with COVID infections, until there is an effective vaccine, the economy will continue to be impacted by changes in individual behavior resulting from the pandemic (i.e. higher savings rates, less travel, etc.).
What to do?
First, we expect to increase model allocation to equities versus fixed income over the coming months. While volatility has risen, the longer-term risk reward of the classic 60/40 (equity/fixed income) allocation has shifted. To attain equivalent expected returns over an investment cycle, a 70/30 asset mix may be required.
Second, our successful navigation of market volatility in March and April by targeting diversification and reduced levels of risk across all model strategies provides a cushion of positive return to withstand any modest immediate drawdowns in equity markets.
Third, we have maintained a healthy allocation to cash in most of our models and recently increased our allocation to XVZ which benefits from increases in equity volatility. We do expect COVID-related surprises, political drama, and domestic unrest to generate market volatility between now and year end.
Fourth, most of our model allocations benefited from a strategic rebalance into momentum (risk on) from minimum volatility (risk off). While this has helped performance given the 2Q20 rally, it has also generated modest concentrations to the FANG stocks (Facebook, Amazon, Netflix, and Google) and certain other technology related names. We are monitoring and exploring concentration reducing strategies.
The first half of the year has been a challenging period on many levels, and we expect the second half to bring its own unique set of issues, such that it is our view that market volatility will remain elevated for the remainder of 2020. During times like this it is important that we appreciate the near-term risks while staying focused on longer-term objectives. To that end, we continue to believe that a diversified, risk-based approach to asset allocation provides investors the best opportunity to remain invested through difficult periods and positions them to meet longer-term financial objectives.
We appreciate the trust that you place in us, and we pray that you and your families will stay safe and healthy during these challenging times.