Vigilare Wealth Management 2020 Q1 Commentary
The world as we know it has changed dramatically since our last writing. We had teased the possibility of a “negative” surprise having an adverse impact on what we considered was already a frothy stock market. Still, it would be inconceivable to surmise that unemployment could possibly be over 20%, and that GDP could contract by 40% by this summer (JP Morgan’s most recent estimates). The first quarter of 2020 ended up being the worst quarter for the markets since the fourth quarter of 2008. The average stock was down 25%, while the month of March was the most volatile month in the history of the stock market, even surpassing levels in the 1930s. The bond market also suffered reverberations as the global markets scrambled for liquidity. This, a result of an unprecedented government mandated shutdown of most economic activity to combat the spread of an insidious and relatively unknown virus pandemic.
If a hypothetical scenario had been drawn up to explain such a sudden collapse, most would likely point to a nuclear attack on a large population block or the start of a major world war. In a way this pandemic crisis is more pervasive. Fifty years from now, someone looking at historical data might “google” 2020 pandemic and infer a similarity in the depth and breadth of this contraction to the year 1930. The difference of course is that the economy in the 1930s continued to contract for multiple years (declining 50% from the peak) while our future path is still unknown. The length of the 1930s contraction was due to rampant speculation, underlying systemic problems, and lack of government involvement until the mid-1930s.
Today, there are distinct differences. Fortunately, our economy was firing on all cylinders at the onset of the crisis. The unemployment rate was hitting a 50-year low at 3.6%. The overall health of the U.S. economy was solid and there weren’t any systemic timebombs ready to hit a final countdown. Other than some fringe areas of the corporate debt market, there was little evidence of overinvestment problems or large asset bubbles. Most importantly, this depression/contraction was self-imposed (to combat a natural disaster) and not naturally triggered by fragilities in our economic system (although there are clearly fragilities in handling pandemics).
Building a Bridge
The financial crisis of 2008 has serendipitously served as a dress rehearsal for managing the current economic and financial fallout of this crisis. While the preparedness for the management of a pandemic has been lacking, our economic policy responses have not been. This has come in the form of both monetary and fiscal policy.
First, monetary policy response from the Federal Reserve (Fed) has been swift, along with being large in scale and broad in scope. The Fed has taken unprecedented emergency steps to maintain liquidity and keep the financial plumbing working. This includes cutting short-term interest rates to zero and committing to do what is needed to ensure liquidity. The Fed’s role of lender-of-last-resort is being put to the test. The Fed has pledged trillions (yes with a “T”) of dollars to support most areas of our debt markets. This includes: Treasuries, agency MBS, municipal debt, investment grade corporate debts, medium sized business financing, short term commercial paper, central bank dollar swaps, and more recently non-agency MBS, CLOs, CMBS, and non-investment grade debt (junk). This covers most, if not all of our major debt markets. The Fed could still do more. Additional measures could include increasing these existing facilities or by setting explicit interest rate targets/caps. The Fed could ultimately expand its asset purchases to include equities if conditions deteriorate further. There is precedent for this bold action. It has been done by the Bank of Japan in prior crises. Our view is that the Fed’s aggressive actions were necessary and without them we would be facing much a more dire financial outcome.
Second, the U.S. government has been quick to respond with a multi-trillion-dollar stimulus package in the scope not seen since the New Deal legislation of the 1930s. These stimulus efforts meant to target the affected workforce and small to medium businesses. We feel this is appropriate given that this was the first government induced slowdown in our history (not entirely true if you count Paul Volker’s Fed raising rates to kill inflation in the late 70s) and not anyone’s fault. This is in stark contrast to fiscal measures taken in 2008, which were more abstractly focused on bank rescues and credit markets. Without these wartime measures the extent of our economic damage would be significantly more dramatic and long lasting.
Likely Scenarios
There is no precedent or simple playbook for accurately forecasting the effect of shutting down a healthy economy for several weeks or months. Janet Yellen so eloquently (and presciently) stated that cycles of economic growth do not die of old age but are murdered. The question as we move forward will be when and how we will start to reopen the economy and then how quickly we will bounce back. Policy makers will have to weigh the risks lasting damage to the economy by maintaining a shutdown versus the cost of lives and containing and managing the pandemic (and managing the resources and capacity of our healthcare infrastructure). Again, we are lucky to have been dealt this blow when the economy was on a steady trajectory. It would be analogous to an individual with a stronger immune system contracting a virus versus a weaker person.
Given the extent of the economic and market damage we must operate under a bear-market recession historical context and consider the different possibilities. Here are some of the possible trajectories of the economic path:
- “V” shared recovery: Best case Scenario. In this scenario we are quick to reopen the economy and get back to a sense of normalcy. Most likely this scenario would occur due to a medical/testing breakthrough that changes many of the dire forecasts and quickly brings back confidence and exuberance in the economy. A mini boom akin to the end of WWII on the back of all the monetary and fiscal stimuli and excitement over prevailing.
- “U” shaped recovery: Takes longer to recover scenario. Reopening the economy will occur in phases. Employers will be reluctant to bring back all employees causing employment to come back at a stubbornly slower pace after an initial re-hiring wave. A timid consumer and business behavior. Some industries recover faster than others, while some outright struggle until summer testing and treatments advances inspire more confidence.
- “W” shaped recovery: Relapse scenario. There is an initial exuberance followed by some setbacks, economic or in the pandemic, which lead to second and third waves of contraction. Fiscal stimulus is not enough to cover the gap in lost income and some business are not able to reopen leading to lower confidence and prolonged/renewed CDC mandates.
- “L” shaped recovery: Worst case scenario. Policy makers underestimate the path of the pandemic and/or policy mistakes lead to prolonged economic stresses. With longer lasting closures, the damage becomes more permanent creating a negative feedback loop continues which makes it hard to jumpstart a recovery. Fiscal and monetary stimuli become less and less effective over time. Lack of confidence becomes more permanently imprinted in the public psyche.
In our view the “U” shaped recovery is the most likely outcome, but we need to be prepared for all four scenarios. Keep in mind the market is a discounting mechanism, so “U” scenario doesn’t necessarily infer months/years of downward markets. Even in the steepest of economic contractions market bottoms are formed before the worst of the economic pain is felt.
Next Steps
We are encouraged and a little surprised by policy actions. The U.S. government’s bold and aggressive responses have built us a bridge of Fiscal and Monetary policy to help get us across to the other side. While these actions are extremely helpful, is it important to remember that both Fiscal and Monetary policies are treating “symptoms” and not the cause of the problem. Ultimately, we need to conquer this health crisis before we truly transition to a state of new-normal. For this to occur we still need to: 1) bring down the number of deaths, I.E., flatten the curve, 2) Have an nationwide infrastructure of on-demand testing for virus and antibodies along with the robust data for analysis and decision making, 3) develop a viable treatment regimen to bridge the gap to a vaccine eventuality. Without meaningfully addressing all three of these areas it is difficult to see our population of consumers be confident enough to return to a semblance of normal activity.
Until there is more visibility in addressing the pandemic through these three points, we want to remain extremely defensive and focused primarily in the U.S. markets and larger-sized companies with strong balance sheets. There is no “bell” that is rung at the tops and bottoms of markets. There are however conditions which would give us some conviction that we are on more solid footing. These conditions are focused on our confidence in quantifying the duration and impact of the pandemic. Also, there is empirical evidence that investing farther away from the epicenter of a disaster leads to better performance, even well beyond the event. Today that epicenter is in industries most affected by mandated shutdowns and social distancing, and countries/companies that lack the infrastructure and resources to manage through leaner periods. We are of the belief that there will be a new-normal when the economy does recover, and this will have longer-term implications. We will see a shift in some behaviors which will shape and influence future planning and investment. These will lead to dislocations of capital and tremendous new investment business models and opportunities.
The longest bull market in history has come to an abrupt end. We are now in the middle of navigating the largest pandemic of our lifetimes. We are hopeful and optimistic that we are making progress towards defeating this natural disaster and are confident in our nation’s resolve and resilience, especially in times of crises. We at Vigilare are committed to doing our best to navigate through these unprecedented times and get us all to the other side.
Thank you for your trust.
The Vigilare Wealth Management Team
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