First Quarter, 2020

We’re Here — We are in the midst of a healthcare crisis and a financial crisis. The combination of a rapidly spreading novel coronavirus and dramatic swings in global financial markets creates unprecedented challenges. These challenges will continue for some time. They affect our employees and their families, our clients and their families and our communities. We are committed to helping in every way we can.

In the past few weeks, we have successfully transitioned to a fully functioning new work environment. We have created a daily firm-wide internal communication to inform employees about rapidly changing economic and market activity as it relates to our clients, their portfolios and our thinking. We believe that providing our investment, trust, planning and relationship teams with real-time information that they can then use to inform their thinking and share with clients is critically important at this time. They are reaching out to you and you should not hesitate to reach out to them.


A First Quarter of Firsts

The S&P 500 ended 2019 at 3,231. In the first six weeks of 2020, the index rose 5%, reaching an all-time closing high of 3,386 on February 19th. At the peak, it appeared economic data was strong, unemployment was at multi-decade lows and consumer confidence was high. By March 12, only 16 trading sessions later, we were in a bear market and, likely, a recession. By March 23, the Index had fallen 34% from the peak. The market recovered some, but the S&P 500 still ended the quarter down 20% from the start of the year and the Dow had its worst first quarter in its 135-year history.

Whole sections of the economy have closed in a way that hasn’t happened since WWII. The next few quarters could result in some of the worst GDP numbers since the Great Depression. On the supply side, production has been impaired by workers’ inability to get to their jobs. The Bureau of Labor Statistics estimates that less than 30% of U.S. employees can work from home. On the demand side, workers have less to spend and almost nowhere to spend it.

Economies and markets, like individuals, have a hard time dealing with uncertainty, especially when the stakes are this high. The speed and magnitude with which policymakers have responded in recent weeks is unprecedented. This will not necessarily reduce the short term pain felt by large swaths of the economy, but it has provided important ballast to financial markets. The Federal Reserve and other central banks have rewritten existing rule books by expanding balance sheets by trillions of dollars, providing unlimited liquidity to the banking sector and setting up programs to backstop stressed parts of financial markets, all with heretofore unseen speed and scale.


Economic Indicators

This recession, unlike prior recessions, was caused by deliberate policy decisions aimed at restricting the spread of disease, rather than a gradual build-up of financial imbalances. As a result, it should not be surprising that economic data, instead of declining gradually, is falling off a cliff. On March 26, weekly unemployment claims showed an off-the-chart increase of 3.28 million newly unemployed workers, an all-time record that far eclipsed the previous high of 659,000 in 1982. And the true increase in unemployment is certainly understated because many state websites lacked the bandwidth to handle the volume of applications. In addition, under then existing rules, the self-employed and those working in the gig economy did not qualify for unemployment benefits (this was rectified in the CARES Act). Approximately 32 million people, or almost 20% of the U.S. workforce, are employed in retail, hospitality and air transportation. Second order impacts, from dentists to hair dressers to dry cleaners, could affect almost half as many more. The St. Louis Fed estimates that Q2 unemployment could be as high as 30% with a GDP decline of approximately 50%.

The abrupt halt in economic activity is global. Open Table is the primary restaurant reservation system in many countries. Open Table tracks the number of seated diners in some 60,000 restaurants that use its reservation system. The following table shows that in a span of less than two weeks, global restaurant dining went from business as usual to a virtual standstill. 

Who are the few foolhardy souls who think they still need a reservation to get a table at an empty restaurant?


A Liquidity Crisis

It wasn’t just the dramatic decline in economic activity that rattled markets. A scramble for cash and volatility across asset classes led to a breakdown in market functioning, even in large liquid markets like U.S. Treasuries. Investors sold what they could, if they could. The day record-breaking unemployment claims were released, the S&P 500 climbed 10% in response to tentative signs that liquidity was returning to some fixed income markets.

Although the situation has moderately improved, the global economy is still facing a cash shortage. Companies are tapping credit lines at a time when banks would normally be looking to increase their own cash reserves. The demand for cash has caused LIBOR, repo and commercial paper spreads to surge. And it’s not just any cash. As the world’s reserve currency, the U.S. dollar is in increasingly short supply driven by global demand.

U.S. consumers were in relatively good shape coming into this crisis, but many corporations were not. Prior to the downturn, half of the $7 trillion investment-grade corporate debt in the U.S. was BBB rated, only one notch above a “junk” or “highyield” rating. Many prominent issuers have been downgraded due to reductions in revenue and cash flow projections. More downgrades will come. This will add significant supply to the high-yield market just as demand is drying up.

It is crucial that this temporary liquidity crisis does not become a solvency crisis with rising bankruptcies and even higher unemployment. The secondary damage would be more difficult to heal than damage from a temporary fall in spending. Central bankers led by the U.S. Federal Reserve Bank seem set on preventing a systemic financial problem. If a program doesn’t have the intended effect, they seem willing to tweak it or increase the size. In a world of fiat money, we believe central banks will be able to prevent wide-spread funding-related problems, but it’s a risk. We don’t expect spreads to revert to pre-crisis levels in the short- or even medium-term.


Volatility in Perspective

Volatility is high in all asset classes. The speed at which markets are moving is only seen during historic events. Based on the following chart, current volatility dwarfs volatility in all prior crises going back to the Great Depression.

Bear markets are usually volatile and bottoming is usually a process. The following accounts for every single trading day during the Great Financial Crisis.

We expect volatility to continue at least until fixed income markets are fully functioning at more normal levels and we can better estimate the duration of the economic shutdown. Equity markets will likely need some certainty that large economies have the spread of COVID-19 under control before risk assets can mount a sustained rally from current levels. 


Assessing the Timeline

This recession is different from other recessions in that shutting down the economy is a deliberate policy choice, a necessary step to slow the spread of the coronavirus, not the result of financial imbalances. Provided that the number of new infections around the world stabilizes during the next two months, growth should begin to recover in the third quarter. China is a useful template to assess the likely path forward. China seems to have COVID-19 under control, with most provinces not reporting new cases for several weeks. But as data come in, it is clear that China is seeing a 40-45% contraction in services activity from pre-crisis levels and a 30-35% fall in manufacturing activity. Activity is normalizing, but slowly.

In the U.S. the economic damage from the economic shutdown is potentially so large that it cannot be sustained for more than a few months without some irreversible economic damage. So the issue is: what will be the criteria for shifting from more extreme to less extreme controls? We believe the general roadmap is probably very tight controls for a few months, followed by fewer but still pervasive controls for up to a year.

Author Tomas Pueyo created a framework for evaluating these options. There are four categories of measures presented in descending order of how extreme and essential they are to keeping the spread of the virus low. The measures in Category 1 will almost certainly need to stay in place for a considerable period of time. The measures in Category 4 should be eliminated first. The measures in Categories 2 and 3 represent areas where regional jurisdictions will make different decisions.


Category 1: High Impact Measures with Low Cost:

  • Testing
  • Contract tracing
  • Hand washing/public hygiene

Category 2: High Impact Measures with Substantial But Moderate Cost:

  • Restrictions on gatherings above a certain size
  • Travel restrictions

Category 3: Low/Medium Impact Measures with High Costs:

  • Closing conferences
  • Closing sports
  • Closing clubs

Category 4: High Impact Measures with Unsustainable Costs:

  • Closure of schools and universities
  • Closure of bars and restaurants
  • Closure of most non-essential services and businesses
  • Stay at home orders


Portfolio Management

Our investment themes haven’t changed. Three themes which have been some of our mainstays will be even more relevant as various aspects of a post-pandemic environment take hold. Within molecular medicine, it is likely that there is some genomic basis to explain why certain people have extremely adverse reactions to COVID-19 and others are largely asymptomatic. Age and preexisting conditions are factors but do not appear to be the only factors. We expect the pandemic will lead to an acceleration in genomic research as it pertains to COVID-19 and viruses more broadly. Our investments in companies focused on genomic related testing, logistics and therapy development should see higher growth rates. Further, some of the political pressure on the healthcare sector should be alleviated as these companies step up to the urgent needs. Similarly, our investments related to heterogeneous computing and technology should benefit from their role in facilitating remote working models even after work from home is no longer mandated. Finally, our automation related investments should benefit as companies are forced to rethink some of the more manual steps in their production processes and adapt workflows to better manage inventory throughout supply chains.

We are not market timers. We do not believe that market timing is an investment skill that can be successfully executed with precision or repeatability. Over the last 20 years, which represents over 5,000 trading days, if an investor missed the ten best days in the market, an investment in the S&P 500 would have forfeited 60% of the total return for the entire period.

Prior to the end-of-month market rally, the S&P 500 dropped 34% over 23 days. Typically, the transition from a bull market to a bear market takes about ten months. This time, it took 16 trading days. Whether the market bottom is behind us or in the near future, we believe current market levels represent relatively good entry points that will reward investors with adequate liquidity and a long-term investment horizon. Investors who bought equities between the fall of 2008 and spring of 2009 saw investments double in less than five years.

For most clients with balanced portfolios, we will use liquidity to opportunistically rebalance equity percentages at least to allocation levels prior to the precipitous decline. For many clients, we will also initiate planning and risk tolerance conversations to consider increasing overall equity allocations at opportune times over the next quarter. Finally, for clients with other outside liquid asset classes, we think shifting to equities is worth consideration.

Fixed income allocations will be viewed as a source of funds if and when bonds trade at fair value. In normal times, we view fixed income as ballast against volatility and downside risk, a source of liquidity and a yield vehicle to fund recurring spending needs. In the current environment, all three have been impaired. Unlike bond mutual funds and ETFs, our clients own individual high quality bonds that can be held until maturity, so principal is not impaired and unrealized losses are not realized. We think fixed income’s role as ballast against volatility and downside risk, and as a source of liquidity, will return to normal. However, we do not think yields will be particularly attractive for the foreseeable future and we favor equities over bonds for their return potential.