Quarterly Letter 1Q 2020

In the meantime, government bond prices rose in a “flight to safety” move, as investors sought low risk assets amid the crisis.  This brought the yield on the benchmark 10-year U.S. Treasury bond down from 1.92% at year-end 2019 to only 0.70% by March 31, 2020.  The price of oil also made a dramatic move in the first quarter, plunging from $61 a barrel at year-end 2019 to $20, as falling demand from the weak global economy was compounded by a price war between Saudi Arabia and Russia.

Markets started the year on a strong note

As 2020 began, the stock market was in a solid uptrend, and news developments were generally positive.  In mid-January the Phase I trade deal between the U.S. and China was signed at the White House.  The deal provided a framework for a new, more positive relationship between the two countries, as China agreed to buy $200 billion of U.S. goods over the next two years.

Shortly after the China deal was signed, the Senate approved the U.S. Mexico Canada Agreement (USMCA) with strong bipartisan support.  These trade deals were expected to result in more jobs, more capital spending, and stronger economic growth in the U.S.  Many economists forecast that the growth rate of the U.S. gross domestic product (GDP) would increase to the 3.0% range for 2020.

Data released in January and February showed that the U.S. economy was healthy.  The unemployment rate remained extremely low at 3.5% and the monthly employment report in early February showed a gain of 225,000 jobs, far above estimates.  Retail sales were strong, consumer confidence was high, and housing starts rose to their highest pace since 2006.  Corporate earnings reports for the fourth quarter of 2019 were generally stronger than expected. 

The virus caused a market selloff in late February

At the end of January, initial reports from China indicated that a deadly virus was starting to spread and had already caused over 100 deaths.  Soon thereafter the World Health Organization stated that the coronavirus outbreak had become a global health emergency, the U.S. Secretary of Health and Human Services declared a public health emergency, and travel restrictions were put in place to limit flights coming to the U.S. from China.

Throughout most of February, however, the stock market was able to shake off worries about the virus, due to the strength of the economy and hopes that the medical problems could be contained.  But in the last week of February, the market plunged, as the virus rapidly spread around the world, with hundreds of cases appearing in countries such as Italy and Iran.

It became clear that the virus would soon become a pandemic which would disrupt global supply chains and have a major impact on the entire world economy, causing a complete rethinking of all economic forecasts and earnings projections for the year ahead.  Therefore stock markets around the world experienced one of their sharpest selloffs in history, which continued throughout most of March, as seen in the chart above.

Devastating impact on the U.S. economy

As the virus began to spread throughout the U.S. in March, major events were cancelled, professional sports seasons were put on hold, and schools were shut down around the country.  Factories and retail stores were closed and people were told not to visit bars and restaurants.  Small businesses closed their doors and began laying off workers.  Many states issued lockdowns, or stay at home orders for the non-essential workforce, and these “shelter in place” orders now affect over 200 million Americans.

All of this has had a very destructive impact on the economy, and most forecasters expect a huge drop in GDP growth in the second quarter, along with millions of job losses.  Despite the fact that the unemployment rate was recently at historic lows, many predict that unemployment will temporarily spike to the 15% range, or even to Great Depression levels of 20% or 30%, in the months ahead.  In late March the number of weekly unemployment claims skyrocketed to 3.28 million.

Government Policy Response

As the economic crisis worsened, Congress took action and in late March passed a historic fiscal stimulus bill totaling over $2 trillion, delivering a comprehensive package of measures to help the economy.  The President and Congress wanted to “think big” on the stimulus bill, with the goal of spending whatever is necessary to support the U.S. economy.

Key features of the bill include:

• $260 billion in expanded unemployment benefits
• $500 billion in direct payments to individuals
• $400 billion for small business
• $240 billion for public health
• $150 billion for state and local governments

The IRS is expected to send money to millions of Americans in the next few weeks, with a typical family of four receiving $3400.  One of the bill’s major provisions involves lending for small business.  All small businesses will be able to obtain loans to meet their payroll and other expenses for two months, and if they retain their employees, the loan will be forgiven.

The Federal Reserve also adopted a “whatever it takes” approach, and is taking unprecedented action to help backstop the economy and keep credit available.  In late March the Fed set up several new lending facilities to provide loans to small business and buy corporate bonds. 

The Fed now has up to $4 trillion in lending power, based on 10:1 leverage on a fund of $400 billion.  This provides tremendous firepower for making loans to help small business and distressed industries, which should give markets confidence that the economy will not collapse.

The Fed is also undertaking a program of unlimited quantitative easing, buying bonds and expanding its balance sheet, similar to the actions taken during the 2008 financial crisis.  However the recent emergency measures have been on a much larger scale.  After the 2008 crisis the Fed was buying $60 billion of Treasury bonds per month, but in late March it was buying $50 billion of mortgage-backed securities per day, or a total of $250 billion in one week. 

Thus the rescue package from the federal government totals roughly $6 trillion, including $2 trillion in direct assistance from the U.S. Treasury, combined with $4 trillion in potential lending power from the Federal Reserve (along with additional asset purchases).  This will provide urgently needed relief to companies and workers and is designed to prevent the economy from entering a major, long-lasting recession.  Due to the dramatic size and scope of the stimulus measures, the stock market rallied in late March, rebounding about 10% in one week.

Where do we stand now?

Currently the number of virus cases worldwide is approaching one million, with a death toll of over 40,000.  In the U.S. there have been over 190,000 cases and the death toll stands at roughly 4,000, but is rising rapidly.  Medical models and projections now suggest that the total number of fatalities in the U.S. is expected to be in the range of 100,000 to 240,000. 

Amid this grim situation, there have been a number of hopeful signs, both from medical research and from cooperation between government and the private sector.  Many companies are now producing large numbers of masks, ventilators and other medical supplies, and Abbott Laboratories has developed a new virus test that can produce results in as little as five minutes.  Various drugs and therapies are now entering clinical trials, and pharmaceutical companies have donated millions of doses of hydroxychloroquine, which appears to have potential in treating the virus.  The FDA has been cutting red tape to fast track the development of anti-viral therapies and vaccines.

Based on medical projections, President Trump has warned that the first two weeks of April will be very difficult with the death toll continuing to climb, before peaking sometime in mid-April.  The President recently extended the social distancing guidelines until April 30^th.

However the President has also said that the cure for the virus should not be worse than the virus itself.  A discussion has begun on the tradeoff between stopping the virus and the cost to the economy.  A major economic downturn normally leads to widespread medical problems, such as depression and suicides, as people lose their jobs and incomes.  Thus in the months ahead, decisions will be made on re-opening parts of the economy, perhaps starting in low risk areas, as determined by data from virus testing.

Market Outlook

Amid these unprecedented developments, financial markets are likely to remain volatile and news-driven.  The stock market has fallen so far so fast that it has priced in a lot of bad news, and has become very oversold by many measures (as seen in the chart above).  In late March the market recovered a bit based on the government stimulus package, but for the market to mount a more sustained recovery, investors will need to see a “light at the end of the tunnel” regarding the spread of the virus.

Currently the consensus view on the economy is that there will be a very large downturn in the second quarter of 2020, but the decline will only last a few months.  Then the third quarter will be a transition period, in which conditions start returning to normal, and then there will be a big economic rebound in the fourth quarter, as jobs are created and millions of people get back to work.  In this scenario, the stock market would rebound well before the fourth quarter, as investors anticipate the good news in advance.

But this forecast is subject to a high degree of risk and uncertainty, and there is a chance that the economic slowdown could last for more than just a few months.  The medical situation is still unfolding on a daily basis and we do not know when the number of virus cases will peak or how effective the therapies will be.  Similarly the economic situation remains very unclear.  The extent of job losses is very difficult to predict, as are the effects of the government rescue package.  Thus, while there is hope that the economy will recover in a few months, there is also a risk that it could enter a major recession and may not recover until 2021.  In this case the stock market could continue to decline. 

Conclusion

The coronavirus outbreak has been an exogenous shock to the economy, an emergency like a hurricane or other natural disaster, but on a much bigger scale.  The pandemic has affected public health systems throughout the world and caused major disruptions to the global economy and financial markets.  At this time the outcome of the crisis is unclear, and market volatility is likely to remain high.

In general, though, we can draw a few conclusions based on previous crises and bear markets.  It is important to take a long-term investment view, and to realize that this is not the time to sell stocks.  The stock market has already dropped about 30% from its highs, which is roughly the average market decline when the economy has a recession, so a lot of the bad news is already priced in.

Eventually the economy will recover from the current crisis and market conditions will start to improve.  For now, stock market valuation levels have come down, and high quality stocks are much cheaper than they were a few months ago.  Therefore the current market downturn is likely to be a buying opportunity when viewed from a long-term perspective.

In the meantime, the bond market has been rising, and bond prices have become very high by historic standards.  The logical investment conclusion from an asset allocation standpoint would be to reduce exposure to bonds and increase exposure to stocks.  Therefore we will be making some adjustments to portfolios in order to take advantage of this situation.  In summary, we will continue to monitor events as they unfold, and will take action as needed based on market developments.