We have become accustomed to referring to financial and economic statistics in terms of where they stand "in the post-World War II period." That changed abruptly as the COVID-19 pandemic swept across the world, disrupting it like WWII. The nature of this global shock has three important dimensions: 1) the obvious epidemiological issues, 2) a sudden seizing up of financial market liquidity conditions, similar to the Global Financial Crisis, and 3) a "sudden stop" in economic activity to slow contagion. And if those problems were not enough for the world, Saudi Arabia and Russia decided in early March to start a global price war in the oil market. By the end of the first quarter, the price of WTI (West Texas Intermediate) crude oil fell below $20 a barrel.
As regular readers will know, we came into 2020 with a clear defensive posture in our asset allocation. That continues to be the case as we enter the second quarter. We will end this outlook with some comments on what we are watching over the coming weeks that might alter that view.
An unprecedented market impact
The financial damage done to risk assets beginning in late February is staggering. The onset of a bear market (-20%) in the S&P 500 took only 16 trading days. That was nearly twice as fast as the second fastest onset, which happened in September 1929. The one-day decline of almost 12% on March 16 was the third worst in the history of the index. We experienced 27 consecutive trading days without back-to-back positive returns. As the slope of the curve in new cases and deaths began to rise exponentially in Europe and the United States, funding markets ground to a halt. Rates for corporate paper spiked and overnight funding dried up. Safe-haven assets such as gold and long-dated Treasuries sold off as margin calls and forced liquidation caused investors to sell what they could, as opposed to what they wanted to.
All of this behavior had strong echoes of what occurred in the autumn of 2008. Fortunately, policy makers were able to dust off that crisis-era playbook and quickly implement new facilities to unclog the plumbing of funding markets during the second half of March, with the Fed promising unlimited QE and having their "whatever it takes" moment.* As of this writing, the full effect of those programs has not yet completely normalized the short end of credit curves, nor has it completely reversed, for example, the spikes in the LIBOR-OIS spread† or spreads in the corporate paper market. However, our estimate is that the Fed, ECB, and BoE are likely to expand their balance sheets by more than $6 trillion. With that, we expect these stresses to normalize relatively quickly over the coming weeks.
Policy has responded, but the effect is unclear
Governments have also recognized the severity of the various measures to slow the spread of the virus. The hit to GDP growth rates and employment around the world from locking down borders and forcing many service industries to close has required fiscal stimulus measures on par with wartime economies. The U.S. fiscal package is equivalent to almost 10% of GDP. Other countries have responded in kind.
The key question for financial markets remains whether these stimulus efforts are large enough to offset the enormous downside shock to activity and employment. Already, U.S. government leaders are discussing a fourth measure, focused on infrastructure spending, which could add another $2 trillion of stimulus along with future debt.
This uncertainty is clouded by many unknowns regarding the virus itself. We do not yet know if countries that were initially successful in their more draconian containment strategies will experience a second wave of infections as they "get back to work." Analyzing the strategies is complicated. There is a large dispersion in the specific measures put in place across countries and varied lags in their timeline. And while the size of the fiscal response in the United States is extremely large and reasonably well targeted, there remains the critical open question about whether its rollout is fast enough and constructed correctly. Its goal is to stem job losses in large pockets of service sector jobs and small businesses feeling the most impact from "stay at home" orders. With 9.9 million Americans filing first time unemployment claims in the last two weeks of March, the early evidence is not encouraging. Until either a promising treatment is found or a vaccine is widely available, the idea of daily life returning to "normal," let alone opening borders and resuming flights, seems wildly hopeful in the near term.
Eyes on credit markets and public health
However, markets are forward-looking, and so our playbook for the second quarter is as follows. We believe that, first, funding markets need to be fixed and liquidity in the credit markets needs to normalize. The evidence on this front in the final trading days of March was encouraging. Next, the stimulus to the corporate sector, small businesses, and unemployed workers needs to be deployed. Congress and the Administration took a frustratingly long time to act, but with the signing of the CARES act on March 27, that process looks to be in motion as well. Still, seeing how much economic, earnings, and default pain is priced into risk assets is like viewing a mosaic rather than a clear picture.
We enter the second quarter with a reasonable amount of investor capitulation and a washout of sentiment. That is a necessary but insufficient condition to add risk back to the portfolios. We also expect that this credit cycle, even if its timeline is more compressed than previous cycles, will likely follow the pattern in which credit markets recover before equity markets. Finally, with so many of the world's pharmaceutical and biotech companies now working tirelessly to defeat this common enemy, we believe any progress on the medical side of what is ultimately a medical problem will also be a signal that risks may have shifted back toward a more balanced posture.
*In July 2012, the president of the European Central Bank helped resolve the European bank crisis by declaring that the ECB would do "whatever it takes to preserve the euro."
†The LIBOR-OIS spread is the difference between the rates on LIBOR (bank lending) and overnight indexed swaps (a swap of variable-rate and fixed-rate obligations), and is a measure of the perceived health of the banking system.