Coronavirus and the Economy
COVID-19 pushed the economy into bear market territory faster than any other time in history. Our experts provide an in-depth analysis and market review of the first four months of 2020.
Paul Dickson, Director of Research
Mark Stevens, Chief Investment Officer
May 7, 2020
To call the first four months of 2020 “eventful” would be an understatement in the extreme. Arguably, there has never been a period of such economic and market volatility in modern times. More dramatic than the market sell-off at the end of the dot-com era and more rapid than the financial crisis of just over a decade ago, the COVID-19 crisis is one for the record books.
While initially slow to make much of an impact, by March, the pandemic led to a broad shutdown of the U.S. economy to contain the virus. Considered transitory in nature, it brought the economy to a standstill, and the ultimate consequences will depend on the evolution of the recovery and the rapidity with which the pandemic is brought to heel. An unprecedented response by the U.S. Congress and the Federal Reserve has staunched the potential downside impact, and additional efforts continue to be announced to bolster the economy. These are expected to set something of a floor to the downside and prime the economy for recovery once the crisis has passed. However, the pandemic is global, and as individual countries start to slow its growth through public policy and eventual treatment, continued vigilance will be necessary for quite some time.
Thanks to unprecedented government intervention in extending credit and backstopping the economy, a much deeper downturn and market collapse were averted. On March 27, Congress passed the CARES Act, a $2 trillion relief package designed to help displaced workers and small businesses. Components of the bill included:
- Financial assistance to large companies and governments to provide loans to businesses and municipalities
- Paycheck Protection Program (PPP) to provide temporary assistance to small businesses, preventing the need to lay off employees
- Direct taxpayer benefits and the extension of unemployment benefits
- Aid to hospitals and other healthcare providers
- Tax incentives primarily related to payroll tax
Policymakers added another $483 billion to the PPP program on April 24, essentially replenishing the fund and expanding support to specific hospital and healthcare initiatives.
Rivaling the fiscal efforts of the government have been those of the Federal Reserve. In addition to lowering policy rates to near zero and engaging in a new round of Quantitative Easing (bond-buying), the Fed has launched (or is in the process of launching) several programs to support the credit markets which had essentially seized up. The domestic programs initiated by the Fed to date are:
- Municipal Liquidity Facility: To provide direct financing for municipalities, easing the burden of interest payments and maturities
- Main Street Lending Program: The terms of the facilities were only finalized on April 30, and the infrastructure is presently being created
- Commercial Paper Funding Facility (CPFF): To restore normalcy to the Commercial Paper Market
- Primary Dealer Credit Facility (PDCF): To provide liquidity to the bond market
- Money Market Mutual Fund Liquidity Facility (MMLF): Broaden its program of support for the flow of credit to households and businesses
- Primary Market Corporate Credit Facility (PMCCF): To provide loans in conjunction with Congress’ CARES Act
- Secondary Market Corporate Credit Facility (SMCCF): To purchase bonds on the secondary market to provide liquidity
- Term Asset-Backed Securities Loan Facility (TALF): To support the flow of credit to consumers and businesses
- Paycheck Protection Program Liquidity Facility (PPPLF): Allows banks to use a portion of their PPP loans as collateral for loans from the Federal Reserve
In total, the Federal Reserve’s balance sheet has grown from $3.7 trillion in September 2019 to $6.6 trillion presently on a combination of quantitative easing and the new credit facilities.
At this time, most of the economy remains on lockdown, and most states stay in some form of “stay-at-home” and social distancing orders. As such, most of the economy remains at a standstill, with nearly 20 million Americans showing up on jobless rolls and tens of millions of others temporarily out of work, waiting out the crisis. Roughly 30 million Americans have filed initial unemployment claims since mid-March alone.
Because the recognition of the severity of the pandemic came late in the quarter, Q1 GDP growth showed an annualized contraction of only 4.8%. Estimates for growth in Q2 have varied wildly. According to market economists surveyed by Bloomberg, the median estimate for growth in the second quarter is a decline of 27.5%, but that includes such forecasts as those of Barclays and JP Morgan at a full 40% contraction and Citibank at a negative 27.7%. In most cases, these sharp declines are countered with a significant recovery in Q3, but estimates vary significantly. The median figure for Q3 is a 10% rate of growth, but Barclays estimates 25%, while UBS only expects 2.0% (following a 32% decline in Q2 so quite pessimistic). The broad range of outlooks is due to the uncertainty surrounding the pace and timing of the economy reopening, as well as any success or setbacks in confronting the pandemic itself. For the full calendar year, the median forecast for GDP is a decline of 4.2%, which would exceed the worst of the financial crisis.
Bond market recovers from a seizure in credit
Treasury yields began to drift lower early in 2020, and that decline quickly accelerated as the market reacted to the economic impact of COVID-19. Two emergency rate cuts, aggressive Fed purchases of Treasury securities and a general flight to safety pushed short-term yields to near zero. The yield on the 10-year Treasury dropped from 1.92% at the beginning of the year to .64% by April 30, well below the previous all-time low of 1.36% on July 8, 2016.
Amid the initial panic over the economic impact of the pandemic, credit markets were disrupted significantly. Corporate and municipal bond yields rose dramatically due to a rush to safety and liquidity on the part of market participants. Even very short-term markets were disrupted, leading to the Federal Reserve to intervene by cutting rates and buying short-term Treasury obligations to inject liquidity. Eventually, Congress would approve additional tools for the Fed to intervene and stabilize most of the bond market.
While the recession’s full extent is still being priced in, bond yields are now reflecting the impact on creditworthiness rather than that of illiquidity. The Bloomberg Barclays U.S. Intermediate Aggregate Index rallied 1.2% in April and posted a total return of 3.7% year-to-date. High Yield (-8.8%) and Municipal Bond (-1.9%) markets have suffered the worst in terms of performance. Junk bonds saw some recovery in April (4.5%) as the Fed’s support for the markets also included the ability to purchase High Yield ETFs. The Municipal Bond Market (-1.9%) continues to struggle as worries mount over the impact of the recession on public finance. There is a political fight over whether the Federal Government should provide additional aid to the states most impacted by the virus.
A bull and bear market in less than 35 days
Propelled by a remarkably resilient economy, the S&P 500 reached an all-time high of 3386.15 on February 19. Growing evidence that COVID-19 was now a worldwide pandemic then pushed markets lower at a record pace, entering bear market territory (down 20%) in only 16 trading days, the quickest bear market in the history of the S&P 500 Index. With social distancing the only defense, sporting events were canceled, schools closed, businesses shuttered and people were asked to remain at home. As it became clear that this new world would last months and not weeks, the sell-off accelerated, pushing the S&P 500 down 33.9% by March 23 from the all-time high.
The aggressive Fed response and the $2.2 trillion relief package helped spur a 30.17% rally from that March low, leaving this market with a unique distinction of experiencing a technical bear market (a decline of 20%), and bull market (a rise of 20%), all in 35 trading days. The momentum led to a 12.8% rally in April and left the S&P 500 Index down 9.3% for the year. Small-Cap stocks (Russell 2000) were down 21.1% in the first four months, 11.8% lower than the S&P 500. Investors typically shun risk in a bear market, and small caps weaker balance sheets and lower profitability make them riskier. Additionally, the bulk of the fiscal stimulus/relief was targeted to small businesses (500 employees or less). Small-cap companies that trade on an exchange seem to be stuck in the middle, too big to benefit fully from relief yet too small to have a fortress balance sheet.
Year-to-date, growth stocks (Russell 1000 Growth) outperformed value by a whopping 17.1%. While growth has outperformed for some time, it was especially evident during this bear market as Technology and Healthcare (traditional growth sectors) were expected to be less affected by the pandemic or the work-from-home directive in place for much of the nation.
Developed International (MSCI EAFE -17.8%) and Emerging market (MSCI EM -16.6%) equities generally underperformed the U.S. through April. U.S. fiscal and monetary support was far greater than the rest of the world and proved to be a significant boost to U.S. equity returns during the explosive rally since March 23.
The divergence in returns of the S&P 500 economic sectors gives a better picture of the anatomy of this sell-off. In addition to Technology and Healthcare, companies that provide essential products (consumer staples) or essential services (utilities) performed the best. Despite a 29.8% rally in April, Energy (-35.7%) was the worst-performing group year-to-date—not only hit by a halt in economic activity but also directly hurt by the price war between OPEC and Russia that pushed oil down as low as $11.57 per barrel. While the Consumer Discretionary sector (-2.7%) shows “better-than-market” returns, if you strip out Amazon, which is nearly 24% of the sector, the Consumer Discretionary sector would be down 14%. This seems more logical given that some of the areas hardest hit by the pandemic (retailers, restaurants and lodging) are part of this sector.
The recovery has begun, but the outlook remains uncertain
The longest bull market in history has unceremoniously ended—and in only three weeks nonetheless. Historically, recessions are cyclical in nature and are typically a result of ridding the economy of excesses. In 2008, a mortgage crisis and an over-leveraged financial system caused the recession. Unwinding the excesses and re-training a displaced workforce took years. Today, the recession is not cyclical or systemic, and it doesn’t require a redistribution of labor. This one is different, and the response, as well as the ultimate recovery, will also be different.
First, policy action this time around has been more aggressive. The Fed revisited its 2008 playbook by providing much-needed liquidity to financial markets. The difference this time is that they provided more of it, and did it much quicker. The same goes for fiscal policy. Policymakers have tripled the size of the financial support and took only a few weeks to do it. Also, fiscal support in 2020 doesn’t come with the same moral hazard. In 2008, taxpayers were bailing out over-leveraged financial institutions to avoid economic calamity. This time it is bailing out individuals/businesses due to no fault of their own. That makes future stimulus measures easier if necessary.
Second, according to Morningstar, Inc., roughly 70% of US GDP is from “essential” businesses (or suppliers to essential businesses) and have, at least in part, been exempt from executive orders. These include agriculture, utilities, construction, logistics, healthcare, public services and a large swath of manufacturing. The hardest-hit sectors (mining, retail, transportation, arts and entertainment, hotels and restaurants, and miscellaneous services) account for only 15% of GDP, and roughly half of these businesses were at least partially open. While only 15% of GDP, these sectors represent nearly 30% of U.S. employment, so that GDP could rebound much quicker than employment.
Lastly, the inevitable recovery will be based on when the economy is allowed to resume—not when it is able. The geographical footprint of the virus in the U.S. would lead one to believe that the resumption of economic activity will be gradual, just like the spread of the virus. This makes the timing and velocity of the recovery predicated on science and politics, and less on economic data. Measures to stem the spread of the pandemic have started to work, and the pace of new cases has begun to slow in the hardest-hit areas. Many economists believe the economy will be reopening by the third quarter and that a subsequent bounce in economic activity should be expected. With the growth rate of the virus slowing, there are reasons to be hopeful.
All of this makes a recovery quicker, and we see that in the markets already. During the 2008 Financial Crisis, it took more than a year for the markets to bottom, and then an additional 150 trading days (217 calendar days) to retrace 50% of the previous high. Since the February 19, 2020, peak, the market fell 34% in 24 trading sessions and retraced 50% of the downside within another 15 trading days.
The market is the ultimate barometer of investor sentiment. We have just experienced a powerful rally and stocks are “only” down 9.6% year-to-date. There is a certain level of optimism built into stock prices. While progress is evident, risks remain.
The pandemic could return, and many virologists believe there is a strong likelihood of this. While there are some 90 vaccines in the works and human trials have begun on a handful, we are still many months away from having one proven to work and even further from mass distribution. Broadly available testing and quarantining those infected will likely be a better litmus for when the economy can return to normal. Another wave of the pandemic is a concern if a resumption of economic activity proves premature.
The financial system remains fragile and dependent on central bank support. Given the size and scope of economic and financial market disruptions, the Fed may find it challenging to prevent stress in the riskier segments of the market. This will also make it harder to apply historical metrics to value markets and discriminate among companies. In such an environment, a focus less on individual securities and more on asset classes seem warranted. We recommend that investors use market volatility to improve the quality of their portfolios without changing their risk profile. Consider using the market decline to further diversify portfolios into other asset classes that offer significant long-term investment opportunities but have lagged U.S. large-cap equities.
The current pandemic is undoubtedly a serious turn of events, but regardless of the path that it takes, it will prove to have been a transitory development, the effects of which will fade with time. There may well be changes to public policy and certain supply chains in the wake of these events. Greater vigilance over infectious diseases is likely. Certain conditions may prove permanent and select industries will be more damaged than others. However, conditions will eventually ease, and the economy will ultimately recover.
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