Quarterly Economic Review: First Quarter 2020
The longest economic and stock market expansion in history has come to a sudden end. Coronavirus (COVID–19), the long-feared “black swan event”, has upended the capital markets, business activity and our daily lives. Since mid-February, equities and other risk-oriented investments have suffered large price swings reminiscent of the most damaging market crashes from the past. Forced selling by leveraged funds and investors panicked by the news cycle sent all but the very safest investments spiraling downward. The spike in stock market volatility was unprecedented. Circuit breakers temporarily halted trading in U.S. stocks, liquidity dried up in the bond markets and money market funds struggled to meet redemptions. A dispute between Saudi Arabia and Russia over oil production also spooked markets, sending energy prices tumbling.
The global economy and stock markets appeared to be on solid footing prior to the coronavirus outbreak. However, there were warning signs of economic fragility. Global trade and manufacturing had slowed and corporate leverage had risen to uncomfortable levels while earnings growth stagnated. Today, much of the world is quarantined, shutting down schools, factories and small businesses, creating both supply and demand shocks unprecedented in scope and depth. Governments worldwide have stepped up efforts to stabilize economies through stimulative monetary policies and increased spending. The U.S. Federal Reserve reduced rates to zero and injected liquidity into the financing and bond markets. Congress has moved forward with an emergency spending and tax cut package that will benefit consumers and businesses. With interest rates already at very low levels, governments are being forced to explore new types of asset purchase and spending programs.
The coronavirus has derailed global economic growth and weakened the financial positions of consumers and corporations. In the capital markets, low yields on government debt limit future fixed income returns. Market volatility is likely to remain high and there may be further periods of large declines and inadequate liquidity. However, the equity markets will eventually settle at a place where equity valuations are reasonable as the outlook for corporate earnings stabilizes. The huge fiscal and monetary stimulus from governments will provide a buffer worldwide. Large scale shifts from bonds to stocks as portfolios are rebalanced and opportunistic investors pursuing bargains will also be a tailwind for the stock markets.
The duration and magnitude of the current crisis is unknowable until the durability of the pathogen is clearer and there is a timeline for the widespread use of better treatment options and a vaccine. We are living through a historically stressful time with our families, our livelihoods and our future prosperity at risk. The Summit investment team continues to closely monitor investment portfolios in light of these challenges with a long-term view. We urge investors not to make significant changes to portfolios based on emotions as timing decisions almost always hurt long term returns.
One of the most enduring economic expansions in history took a dramatic turn over the first quarter of 2020. The shift was almost entirely due to the rapid spread and subsequent containment effort of the novel coronavirus. Before the outbreak, much of the global economy was on track for a positive, albeit slow, pace of expansion. After the virus, there are many uncertainties pertaining to global growth for which data released over the coming weeks will provide important insights.
So far, the coronavirus’ impact on the economy has been far reaching. Global supply chains have been disrupted with uncertain timelines for coming back online. Demand for core commodities, such as oil, has fallen off a cliff. This has only been further exacerbated by a price war between Russia and Saudi Arabia. Consumption has been impacted from many angles as new health-focused social norms (like social distancing) have stopped select industries (such as travel and hospitality) dead in their tracks. Layoffs and furloughs within these hardest hit sectors have already started and the unemployment rate is rising quickly.
While these scenarios depict a grim picture of the world, many of the disruptions are likely temporary in nature and are creating extensive pent-up demand. Once the health crisis is contained, its foreseeable that the recovery in growth could be sharp.
The Weekly Economic Index measures the expected change in GDP incorporating a number of factors such as unemployment claims and gasoline sales. Recent readings have fallen to lows not since reached during the 2008 Financial Crisis. This reflects the abrupt halt in economic activity in many areas of the country.
Following a period of lower readings, leading economic indicators (LEIs) had stabilized and started to improve at the end of 2019. While this was an encouraging sign coming into 2020, the effects of the coronavirus are likely to push future readings meaningfully lower, thwarting any recovery in the short to medium-term.
The impact of the coronavirus is already showing up in economic surprise indices. This reflects a variety of economic readings that are coming in well below prior forecasts. Such readings are likely to be volatile in the coming weeks as the economy fully digests the effects of the shutdown.
Manufacturing data fell from barely in expansion territory (50.1) in February, to contraction territory (49.1) in March. Manufacturing activity has seen a steep decline in new orders and production stemming from the coronavirus. Non-manufacturing (services) data was trending higher but came down, although it remains in expansion territory.
Leveraging lessons from the last financial crisis and beyond, many global central banks have acted swiftly to enact record breaking stimulus packages. These efforts were primarily oriented at ensuring adequate financial liquidity and ‘bridging the gap’ of unemployment as jobless numbers around the world ballooned. In the U.S., legislators across the aisle came together to pass the $2 trillion CARES (Coronavirus Aid, Relief, and Economic Security) Act. The multi-faceted Act is unprecedented for its size and scope and includes new relief methods such as mailing checks to Americans with earned incomes below certain thresholds. Despite its size, there are already discussions for numerous follow-on efforts.
So far, the effect of the coronavirus on different areas of the economy has been varied. Inflation will likely be lower in the short-term, although its uncertain how it will trend longer-term. Prices for consumer expenditures like gas have come down dramatically, while prices for other items, such as groceries and personal care items, have risen. Growing unemployment is also likely to lessen wage pressures, which had risen over the past several years. The effect on corporate profits, on the other hand, appears more apparent. Most analysts and economists are predicting a dramatic decline in earnings over the second quarter reflecting the large fall-off in business activity and consumer spending. Last, the U.S. Dollar has seen heightened volatility and demand reflecting its status as the global reserve currency. U.S. Dollar strength is persistent even against an unprecedented amount of stimulus and growing domestic unemployment.
Recent inflation numbers have come down marginally. The longer-term impact of the coronavirus on inflation is somewhat unknown. Prices for a variety of consumer goods is on the rise but is partially offset by falling wages and oil prices. Massive amounts of monetary policy could cause inflationary pressures down the road.
Recent monetary policy moves from the Federal Reserve have translated to the expansion of its balance sheet to a record $5.86 trillion. Notably, this figure is well above levels reached during the 2008 timeframe in terms of a percentage of GDP.
The U.S. Dollar rose recently as investors took shelter in what’s still considered the core global reserve currency. While its value relative to other major currencies has risen, price movement has been volatile and is likely to remain this way as new policy and economic data is released.
Following ‘mid-cycle’ adjustment cuts last year, the Federal Reserve moved swiftly and aggressively to help offset the impact of the coronavirus by cutting rates to near zero. The Fed has also stepped up asset purchases to provide liquidity and help stabilize fixed income markets.
Employment and Consumer
Entering 2020, the unemployment picture in the U.S. was sustained near it’s lowest level in roughly 50 years. This dramatically and quickly changed given the broad decline in financial markets and extensive amount of social distancing being exercised worldwide to combat COVID-19. Workers find themselves in one of two camps — those people who can work remotely and those people who need to work with other people. The former group are more likely to retain their jobs, as long as economic demand warrants it, but the latter group are at higher risk of losing work time and pay. Since this market downturn is expected to be short-term in nature (up to a year or less), some companies may even consider “labor hoarding”, or keeping some people on the payroll as a more affordable solution than finding new employees once the economy rebounds. Given all of this, it is still very likely there will be a sharp increase in unemployment figures, which may be more evident in the April report (to be released in early May). As a warning for what may come, the highest weekly initial jobless claims of all-time were released covering the last two weeks of March totaling 10 million people, or 3.8% of the entire U.S. working-age population.
COVID-19 has already made it’s presence known within the consumer sector, as anyone who has been confronted with an empty grocery store shelf of a commonly accessible good can attest to. Online sales for some affordable items has increased, only to be abruptly met with decreased sales of some brick-and-mortar expensive items. More essential spending like consumer staples and utilities have weathered the downturn better than others. Existing consumer spending levels may be constricted even further as the potential economic downturn deepens. However, the largest factor in determining how the consumer has reacted already and will continue to react is the level and duration of unemployment.
After remaining slightly above 200,000 for at least the past year, initial weekly jobless claims has skyrocketed into the millions for the last two weeks. A stark reminder of the impact the virus is having on overall employment.
The broad level of consumer confidence wavered quite a bit during the last three years, and took a sharp nosedive in March, as investor’s fears manifested themselves over ongoing virus concerns.
Jobless claims were more widespread in states with impacted revenue streams – Hawaii for tourism and Michigan for automobile manufacturers. Likewise, those states with less impacted revenue streams fared better.
After 10 consecutive years of a declining unemployment rate, March’s figure slightly increased indicative of the COVID-19 impacts. This rate is expected to drastically increase soon as more data is factored in, and will be possibly much more pronounced in April’s report.
Housing and Commercial Real Estate
The U.S. housing market had been on an upswing coming into 2020, supported by lower mortgage rates, a strong labor market and healthy home builder activity. The coronavirus has thrown a wrench in what could have been a strong year for residential real estate. The Federal Reserve’s actions to stabilize the sector have had a rocky start and mortgage rates have been volatile. Mortgage providers could not handle the upsurge in loan applications that followed the Fed’s rate cuts. In addition, the Fed’s purchase of mortgage backed securities (MBS) and the resulting fall in rates was larger than expected, making it difficult for mortgage providers to effectively hedge against the risk of rate changes. As the unemployment rate rises and incomes fall, mortgage payments will become more uncertain and defaults could rise significantly. Home builder activity also shows signs of a decline which will dampen new homes sales in the coming months. Lower mortgage rates and improved affordability may help the housing market to rebound once the health crisis has passed.
Commercial real estate has been shaken by the quarantines and business closures imposed by governments in the wake of the coronavirus outbreak. Valuations were high in some real estate sectors, but operating income and debt levels were healthy.
Going forward, operating income will be impacted by a decline in rental income as tenants miss payments, although the recently enacted CARES Act should help support tenants. Real estate funds, which have recently experienced large inflows of capital, may hold back on further acquisitions until the current health crisis has passed and some have even backed out of existing deals. Infrastructure, which tends to be less economically sensitive than other sectors, has been more stable. Public REITs have been unusually volatile as long-term interest rates have moved up and down.
Despite Fed interest rate cuts, mortgage rates were volatile in the first quarter. A refinancing wave and limited buyer demand for MBS kept mortgage rates elevated until Fed purchases brought rates back down.
Although U.S. home price gains have recently accelerated, the coronavirus is expected to stifle sales activity and curb prices. Lower mortgage rates and improved affordability may help the housing market to eventually rebound.
Mild weather over the winter was a positive for builders, but the coronavirus clouds the 2020 outlook. New permits slumped in February after reaching a 13-year high. Housing starts fell due to a weak multi-family sector.
Public REITs have been devastated by the coronavirus outbreak. Operating income will be impacted by a sharp decline in rental income as tenants miss payments. Some REITs have cut or eliminated dividend payments.
The first quarter marked the worst period for stocks since the depths of the 2008 financial crisis. While the magnitude of the decline has so far been less severe, the pace was unprecedented with the S&P 500 Index falling more than 30% in just over a month from its all-time peak. Most prevalent during this tumultuous time is the unprecedented level of volatility. Over the last several weeks, there have been many of the largest percentage moves ever recorded for markets. The Cboe Volatility Exchange Index or more commonly known as the VIX, a barometer for market volatility, touched its highest level since 2008. The equity market downturn was also widespread, as most major developed and emerging market indices have entered bear market territory by shedding at least 20% off of recent highs.
Within the U.S., larger and more defensive stocks generally outperformed in a relative context. Larger-caps were aided by more durable business models and better capitalized balance sheets. Growth held a firm grip outperforming value as many of the worst performing sectors (energy, financials, industrials) are larger constituents in value-oriented indices. Airlines and similar transportation stocks were negatively impacted as their demand levels fell upwards of 90% throughout March. Sectors that fared better during this crisis include essential items needed to survive (consumer staples and utilities) and information technology, a core component to many during the vast social distancing efforts.
Defensive sectors fared best, marginally speaking, considering their necessity in the current pandemic. On the contrary, financials and industrials suffered under the flight to quality. Energy was the unfortunate victim of drastically decreased demand and the oil price war.
Similar to recent history, large- and mid-cap equity outperformed small-cap equity and growth exceeded value. Interestingly, value has tended to shine coming out of previous bear markets.
The VIX reached levels not seen since the 2008 Global Financial Crisis. While it hit exceedingly high levels, it typically does not remain elevated for long periods of time.
All regions globally declined for the quarter as the pandemic caused sweeping concerns everywhere. The U.S. Large-cap indices decline of 20% was the worst since the 4th quarter of 2008.
Fixed Income And Alternative Markets
The sudden and dramatic shift into the safest assets made U.S. government securities the only place to be during the first quarter. Virtually all other bond sectors experienced losses as higher credit spreads, a drought in bond market liquidity and technical selling caused a challenging environment for fixed income investors. Hedge funds overall declined much less than equities, but most strategies, including those with low market exposure such as market neutral and arbitrage, posted losses. Commodities remained highly volatile, led by the energy sector, which was hampered by a power struggle between Russia and Saudi Arabia to control the supply of oil. Oil prices staged a rebound at quarter-end on hopes that the two countries would reach an agreement. Fears of a global recession and a slowdown in demand caused most commodities to plunge in value. Even gold, a popular safe-haven asset, was volatile due to periods of technical selling, although it had risen in value by quarter-end.
Although the sharp drop in interest rates was a positive for Treasuries, Treasury Inflation-Protected Securities (TIPS), and government mortgage-backed securities, prices were at times volatile. 10-year Treasury rates dropped to an historic low of 0.4% and remained below 1% at quarter-end. TIPS yields declined as longer-term inflation expectations fell virtually to zero. In the credit markets, spreads spiked to recessionary levels, causing bond prices to fall. During recessions, credit fundamentals often deteriorate and default rates rise, particularly for highly leveraged companies. A huge technical sell-off in corporate and municipal bonds as investors piled assets into cash, contributed to the spike in bond yields (and fall in prices). Market liquidity was very poor and at times trading came to a virtual standstill, although the dislocations had abated by quarter-end. Emerging market debt was further hampered by the sharp rise in the U.S. dollar.
After a four-year decline, high yield spreads shot upward as the coronavirus crisis unfurled. Rising corporate leverage and a large weighting in the volatile energy sector led high yield to be underperform for the quarter.
Sovereign yields were volatile during the quarter. Yields sharply declined as interest rate cuts took effect, boosting prices. But widespread selling by investors to raise cash intermittently caused rates to spike.
A massive sell-off took place as investors scrambled to raise cash and grew fearful the coronavirus response and a recession would impair municipal finances. Municipal yields skyrocketed to unheard of levels before retreating.
After a strong 2019, oil prices plummeted, at times reaching $20 a barrel. The sharp reversal was triggered by falling demand, fears of a global recession and an uptick in supply following a dispute between Russia and OPEC.
Capital Markets Returns
This commentary was written by Craig Amico, CFA®, CIPM®, Senior Investment Analyst, Noreen Brown, CFA®, Director of Portfolio Management and Steven Melnick, CFA®, Senior Investment Analyst at Summit Financial, LLC., an SEC Registered Investment Adviser (“Summit”), headquartered at 4 Campus Drive, Parsippany, NJ 07054, Tel. 973-285-3600. It is provided for your information and guidance and is not intended as speciﬁc advice and does not constitute an offer to sell securities. Summit is an investment adviser and offers asset management and ﬁnancial planning services. Indices are unmanaged and cannot be invested into directly. The Wilshire 5000 Total Market Index measures the performance of all U.S.-headquartered equity securities with readily available price data; the Standard & Poor’s 500 Index (S&P 500) is an unmanaged group of securities considered to be representative of the stock market; the MSCI EAFE Index (Europe, Australasia, Far East) is a free ﬂoat-adjusted market capitalization index designed to measure the equity market performance of developed markets, excluding the U.S. and Canada; the MSCI Emerging Markets Index is a free ﬂoat-adjusted market capitalization index designed to measure the equity market performance of emerging markets; the Bloomberg Commodity Index measures the performance of an unleveraged, long-only investment in commodity futures that is broadly diversiﬁed and primarily liquidity weighted; The HFRX Global Hedge Fund Index is designed to be representative of the overall composition of the hedge fund universe; the Bloomberg Barclays U.S. Aggregate Bond Index is a market capitalization-weighted index comprising Treasury securities, Government agency bonds, mortgage backed bonds, corporate bonds, and some foreign bonds traded in the U.S.; the Bloomberg Barclays Global Aggregate Ex U.S. Index measures the performance of global investment grade ﬁxed-rate debt markets that excludes USD-denominated securities. The Bloomberg Barclays Municipal Bond Index covers the U.S. dollar-denominated long-term tax-exempt bond market; created by the Chicago Board Options Exchange (CBOE), the Volatility Index, or VIX, is a real-time market index that represents the market’s expectation of 30-day forward-looking volatility; The Dow Jones U.S.Real Estate Index is designed to track the performance of real estate investment trusts (REIT) and other companies that invest directly or indirectly in real estate through development, management, or ownership, including property agencies. Data in this newsletter is obtained from sources which we, and our suppliers believe to be reliable, but we do not warrant or guarantee the timeliness or accuracy of this information. Consult your ﬁnancial professional before making any investment decision. Past performance is no guarantee of future results. Diversiﬁcation/asset allocation does not ensure a proﬁt or guarantee against a loss. 04132020-403