Economic and Financial Market Commentary — April 2020
Integrity Financial Update:
Before we dive into the global impact of the COVID-19 (COVID) pandemic, we would like to take a moment to update you on our company’s status and business response measures during these unprecedented times. Integrity Financial is still operating at 100% capacity, as our strategic investments in technology over the years have positioned us well to continue providing the highest standard of service and guidance that you’ve come to expect from us. Whether it be over the phone, via email, or through teleconferencing, our entire team has managed to maintain the same level of client interaction and investment activity as before social distancing measures were enacted. While our team is operating remotely and we are not conducting in-person meetings at this time, our clients can feel confident that our infrastructure was designed to provide seamless continuity during emergency situations. Our advisors and operations team stand ready to provide first-class service, advice, and support as you navigate these challenging times. Finally, we hope that you have been able to enjoy one of our recent educational videos on our website (https://integrity.financial under the Education tab). Education is a hallmark of our firm, and we strive to provide excellence on that front. We would love to hear from you about topics that are of interest to provide further content and support as we navigate these challenging times together.
The COVID-19 Pandemic:
On 3/13/20, in response to the growing coronavirus pandemic, the US declared a national state of emergency and began implementing aggressive actions in the interest of public health and safety. Although these measures appeared to be necessary steps to support the general good, they have not come without significant economic and financial ramifications. Public health measures taken, in an effort to combat the coronavirus outbreak, have reduced economic activity to a near standstill, bringing the longest economic expansion ever recorded to an abrupt halt. After more than 10 years of sustained economic growth, it is likely that in Q1 and Q2 2020 the global economy will experience sharp declines in corporate earnings and production output. That being said, while there remains a great deal of uncertainty in the near-term, we believe there is strong evidence to suggest that economic and financial market “normalcy” will return in the long run.
As of 4/25/20, the data reported indicates that COVID has infected approx. 905,358 people in the US and 2.72 million worldwide, with fatality rates of 5.7% and 6.9%, respectively.i Although infection rates appear to be flattening, due largely to global social distancing initiatives, fatality rates are discernably higher than traditional flu pandemics and have steadily risen since the World Health Organization and CDC began tracking this data back in January.
While COVID clearly presents an unprecedented public health obstacle, it remains unclear as to how accurately existing data reflects the virus’s true contagion and fatality properties. One major reason is that efficient testing capabilities have been slow to develop. As such, global governments and health organizations have been forced to target their limited testing resources towards individuals exhibiting the most severe symptoms. As of April 15th, the US has provided tests for less than 1% of its population.ii This implies that existing data is likely understating actual infection rates, as it fails to capture those who have contracted the virus but are asymptomatic or their symptoms haven’t risen to levels warranting testing. That said, we would expect infection rates will continue to rise as more effective testing methods are introduced. The resulting increase in reported infections will likely lead to an overall decline in fatality rates. Further complicating matters is the belief that some nations are knowingly underreporting contagion and fatality rates for political purposes.
One country most likely to be engaging in this tactic is China, which was ground zero for the pandemic. Although these allegations are difficult to confirm, the nation recently revised its fatality totals in the Wuhan region upward by 50%. While data revisions are common during crises of this scope, the magnitude of China’s variation is suspicious, particularly when compared to the rest of the world.
Although it appears too early to meaningfully predict the severity and scope of public health consequences related to the coronavirus, we are learning more and more about the disease every day. While optimistic projections indicate vaccine completion is still 12-18 months away, enhanced social distancing measures have proven effective at limiting contagion. Additionally, the introduction of any new viable treatment alternatives could substantially reduce capacity pressures facing public health institutions and ultimately reduce fatalities.
Global GDP growth was originally expected to grow at 3% at the start of 2020. As a result of the global shutdown, GDP has now been revised downward to a projected -3.0%, which is a swing of approx. 6% from October 2019 and January 2020 estimates.iii The revised forecasts show growth declines among advanced economies of -6.1%, with emerging markets fairing a little better with declines of only -1.0% (-2.2% excluding China).iv Although recessions are technically defined as two consecutive quarters of negative GDP growth, the severity and pace of this downturn has led many to conclude that a global recession has already arrived.
In the US, annual GDP growth is forecasted at -5.9% for 2020.v The virus’s impact on consumer spending will be a significant factor in assessing the recovery timeline, as consumption accounts for nearly 70% of annual domestic GDP. Therefore, it’s reasonable to assume a strong correlation between the duration of our current recession and how long it takes for consumers to return to the robust pre-pandemic spending habits, which have been largely responsible for extending our historic expansion in recent years. Currently there are substantial headwinds to consumer spending, including mandated economic lockdowns, resulting unemployment spikes, and the potential for individuals to sustain certain social distancing practices even after quarantine directives are lifted. Though it is difficult to predict, the public’s fear of contracting COVID will likely be significantly assuaged by the development of vaccines and new treatment alternatives.
At present, benchmark crude prices, as measured by the West Texas Intermediate (WTI), are currently $18.27/bbl, which reflects a 70% decline for the year, and well below the $40-$50/bbl breakeven level for domestic oil producers.vi This is largely due to historic declines in demand as a result of the economic shutdown, coupled with a recent Russia/OPEC oil price war. Under normal circumstances, the latter alone would have likely been enough to stunt economic growth for the year. Set against the backdrop of a global public health crisis, it has served to exacerbate an already volatile financial picture that has substantially hampered both equity and fixed income markets simultaneously. However, an agreement last week among OPEC+ nations to cut production by 9.7 million barrels per day seems to have prevented the worst effects of this crisis from further threatening the oil industry, at this time.
Fortunately, the United States is far less energy dependent on foreign reserves than at any other time during previous global downturns. While this is generally good for consumers, the domestic oil industry is also the largest it has ever been in the history of our country. Prior to this pandemic, US oil companies accounted for 470,000 domestic jobs. As such, a sustained slowdown or delayed recovery in commodity prices is a significant headwind for this industry, and thus the domestic economy as a whole.
Although activity has stalled across the entire economy, some industries have experienced more acute deterioration characteristics than others. Industries that have been hit particularly hard include retail, entertainment, travel, and hospitality. In 2019 these sectors accounted for 19% of domestic GDP and 20% of domestic jobs.vii Although 1st quarter earnings data is still forthcoming, it is largely expected that these industries, due to their direct exposure to social distancing practices, will experience substantial profitability shortfalls in both Q1 and Q2 2020.
According to the US Bureau of Labor Statistics, US unemployment jumped from 3.5% in February, to 4.4% in March (25.7% quarterly increase), the highest rate since August 2017.viii Unfortunately, this trend is likely to continue throughout Q2 2020. While some leading economists forecast unemployment rates could climb as high as 30% during the pandemic (levels not seen even during the Great Depression), some are a bit more optimistic such as Goldman Sachs predicting a peak rate of approx. 15% and JP Morgan’s economist predicting a high of 8.5%. Although unemployment will likely spike again in Q2, worst-case projections might be averted due to stipulations in the fiscal stimulus package recently passed by Congress (see “Monetary/Fiscal Response” for more details), which allow repayment forgiveness to businesses receiving stimulus benefits if used to maintain payrolls throughout the crisis. Even if unemployment rates do not reach all-time highs, they are likely to grow significantly in the months ahead. As of 4/16/20, approx. 22 million Americans had filed for unemployment insurance. Unemployment is a lagging indicator, which means the peak impact typically occurs after the initial introduction of the macroeconomic events. As such, even though the current shutdown is temporary, high unemployment could remain well after the public health ramifications related to COVID are neutralized.
Amid the virus fears and market turmoil, the federal government appears committed to pulling out all the stops to prop up the economy. Specifically, there were two important actions taken by the Fed and Congress designed to support both the financial markets and the business community as a whole. On 3/14/20, the Fed announced it would inject up to $1.5T into the economy via the extension of short-term collateralized loans to financial institutions. The goal of this measure is to ensure that treasury markets continue to function smoothly, as demand for these securities is rapidly increasing due to investor concerns over safety. Additionally, the Fed cut interest rates down to their lower bound (0-0.25%) in an attempt to prevent equity markets from irrationally bottoming out.
On the fiscal policy front, Congress passed a $2.2T stimulus package aimed at directly supporting American consumers and businesses. While some industries have been specifically targeted for “bailout” relief ($58B earmark for airlines), the vast majority of funds are intended to provide relief to the average worker via beefed-up unemployment benefits, as well as to businesses of all sizes via direct lending opportunities. The primary goal was to prevent both business and individuals from the worst financial ramifications resulting from the pandemic, and essentially provide a life raft for the economy to lean on until the crisis is abated.
Perhaps just as important as the size of the relief package set forth by government institutions, is the speed with which the government has responded to the current crisis. During the GFC, one of the key takeaways was that quantitative easing measures take time to rollout and filter through the global economy. Therefore, despite being well intentioned and ultimately beneficial over the long-term, those measures were less helpful in curbing the initial extreme economic and financial shocks caused by the GFC, resulting in a longer than optimal recovery period. To their credit, government leaders appear to have learned this lesson loud and clear, as demonstrated by their aggressive actions at the start of the outbreak.
While the government’s intervention has been received well by investors, as evidenced by record-setting performance in equity markets, its ability to sufficiently support our economy until the shutdown ends is still unclear. This is primarily due to a lack of visibility into how long it will take to contain the virus enough for economic activities to resume without significant public safety risks. That being said, Congress is currently in the process of passing another supplemental stimulus package, further signaling their willingness to support economic activity throughout this crisis with the intention of shielding both businesses and consumers from the worst effects of recession. The downside of all these stimulus measures, is that the future tax burden in the US is likely going to increase as the national debt has grown beyond $22 trillion, not including the most recent stimulus packages.
Financial Markets Overview:
Due to the unique causes of the current financial downturn, both equity and fixed income markets alike experienced significant initial price shocks, as investors everywhere responded to COVID uncertainties by rushing to “safe havens” (cash and treasuries) in late February and March. However, as tensions have cooled, and we continue to gain more perspective and data regarding the potential economic impact of the pandemic, investors seem to be dipping their toes back into markets much earlier than they did during the Great Financial Crisis.
In late February and through March, investor concerns surrounding the Coronavirus grew considerably, causing equity markets to sell-off rapidly in favor of safe havens. Since 3/9/20, equity markets have shattered all previous single day loss records, including 8 of the 10 worst days in the Dow Jones history (range: -3.6% to 12.9%). Similarly, the S&P 500 index also tumbled, hitting its low point on March 23rd when it was down nearly -31% YTD. As of 3/31/20, the S&P 500 registered losses of -19.6% for the quarter and -7.0% in the 12 months. However, during this same period, equity markets have also set all-time daily gain records. Since the March 23rd low, the S&P 500 has grown by 18.3%, and currently sits less than 15% off its all-time highs and down just -2.5% YoY and -11% YTD.ix The recent uptick appears to largely be driven by three things that have cultivated optimism around the public health and economic outlook. Specifically, government intervention measures, flattening infection curves, and recent news about new treatments and therapies have resulted in two consecutive weeks of market gains, including the S&P 500’s best single week return of 12.1%, since 1974.
One other important observation is that while there are certain economic sectors that are more directly impacted from the COVID fallout, equity market correlation is currently very high. As of 4/3/20, correlation between S&P 500 sectors stands at 0.92, nearly twice the historical average of 0.50. This means that while the underlying fundamentals across sectors are varied, the relative impact the crisis has had on stock prices across sectors is relatively similar. While unlikely to remain at these levels, strong correlation metrics likely reflect both the large degree of macroeconomic uncertainty, as well as the substantial influence that investor sentiment and irrationality is contributing to market volatility. As more tangible data of the economic impact begins to emerge, we believe it is likely that some of this uncertainty and sentiment-based influence will be offset by prudent fundamental analysis.
Concerns remain that the recent rebound in equities may be a little premature, given that earnings and economic data have yet to be released across a broad swath of industries and sectors. There still exists a strong possibility that equity markets will retreat again over the near-term should data paint a more negative picture than currently anticipated. This is particularly true if the mandate shutdowns are prolonged and if societal and economic reengagement occur more slowly than is currently priced in. However, market performance over the last two weeks has been encouraging and may be an indication that investors understand that economic downturns, while resulting in near-term financial difficulties, can also provide significant long-term investment opportunities.
International Markets have experienced similar trends but continue to exhibit lower overall valuations than US markets. The ACWI ex-US index posted losses of -23.4% in Q1 and -15.6% over the last year. As of 3/31/20, the index carried a forward P/E ratio of 12.3x, compared to 15.4x for the S&P 500.x This implies that, at the moment, international equities (particularly in emerging economies) appear to be “cheaper.”
Fixed Income Markets
Bond markets were also hit hard by COVID panic and the “flight to safety” sentiment, as investors sold off corporate and high-yield debt in exchange for treasuries. On 3/9/20, US treasury yields dropped below 1% (0.70% as of 3/31/20) for the first time ever due primarily to coronavirus fears, coupled with a developing oil market price war between Russia and OPEC. More specifically, the increased demand for Treasuries caused a liquidity crunch in those markets that rapidly drove price declines until the Fed intervened with its monetary stimulus measures. The Bloomberg Barclays Aggregate Bond Index ended Q1 up 3.1%, with a 1-year return of 8.9%, while the High Yield sector were down -13.1% in Q1 and -7.5% over the last 12 months.
Although nominal Treasury yields have fallen to historic lows (real yields of -1.67% as of 3/31/20), corporate and high-yield spreads have significantly increased YTD.xi In Q1 2020, Moody’s estimates spreads between the 10-year Treasury and investment grade corporate bonds expanded from 2% to a peak of 4.3% (on 3/23/20, a 118% increase), before settling into its current level of 3.3% (as of 4/16/20, a 66% increase YTD,).xii The move was even more pronounced among high-yield debt, where spreads peaked at an increase of 300% (as of 3/23/20), and still remain roughly 135% higher YTD (as of 4/16/20).xiii
While fixed income will continue to be an important part of investment protection strategies, it will be equally as important for investors to limit yield-chasing tendencies and to opt for a diversified, high-quality fixed income portfolio.xiv Additionally, accredited investors may want to consider private credit opportunities for alternative exposure to fixed income, as it embodies a more active, fundamental analysis and tends to be less correlated to public markets.
All this information leads an investor to ask, where do we go from here? Our firm’s perspective is one where we balance the fundamentals of investment analysis with the behavioral finance reactions of the public to crisis. As we have seen, the initial reaction in the public equity markets was sudden and severe, resulting in significant losses and initial anxiety. Warren Buffet, one of the greatest investors of all time, said “Most people get interested in stocks when everyone else is. The time to get interested is when no one else is. You can’t buy what is popular and do well.”
With that said, we would recommend that investors who are able to discipline themselves to hold-on through the recovery, no matter how long it takes, take advantage of the current “buying opportunity” both in domestic and international equity markets. Additionally, for those with systematic contributions to a 401(k) or IRA, we highly recommend staying the course and potentially even increasing your contributions to take advantage of the market correction. The use of dollar-cost averaging, by making systematic and periodic investments, can be a useful tool to re-enter the market, or place new funds into the market.
Alternatives and Private Placements
Alternative investments and other guaranteed products have been the best performers during this crisis, and we continue to see opportunities here. Our firm has widely discussed and implemented ways to diversify and de-risk portfolios by integrating alternatives, such as private placements in credit, equity, and real estate for “accredited investors”. Although not every investor qualifies under the current SEC definition, the SEC did issue a press release in mid-December 2019 soliciting public commentary on amending the definition of “accredited investor.” This is good news, as the regulatory environment will likely open these investment strategies for those individuals with professional knowledge, experience, or certifications. Private equity, private credit, and global direct real estate have been choice investments of the high net worth community, as evidenced by the investment allocations of family offices. From 2011 to 2017, the allocation to private equity by single family offices has more than doubled from 18% to 38% of their investment portfolio. Simultaneously, the number of publicly listed firms in the U.S. has shrunk by 41% in the last 20 years.xiv In 1998 there were 7,500 companies listed on the public exchanges, and now there are only around 4,300. However, the benefits of alternative investments are not without risks, and manager selection and due diligence is crucial to success. Our firm will continue to educate our investors on private equity, private credit, and global real estate, among other alternatives as we proceed forward beyond this crisis.
For those that are seeking fixed income yield, private credit has stepped in to fill the void that the banks have left in the debt markets. Many family offices have been allocating to private credit in lieu of U.S. Treasuries. Our firm has been doing the same, as the low interest rate environment appears to be a persistent condition across the developed world.
Although we are not able to meet in person until the pandemic passes, our advisors are available and ready to meet virtually. Discussing your personal situation with your advisor is greatly encouraged during this time and will help craft and shape your financial plan. Please reach out and schedule a time to meet with one of our advisors directly and enjoy a consultation and investment analysis from the comfort of your own home. Lastly, times like these allow us to pause and think about what matters most and what we are most grateful for. As a firm, we truly value each of our clients and their families and would like to say thank you for supporting local business as they navigate new challenges daily. If you know of any individuals that are frustrated with their current financial situations, are unclear on their retirement plans, or are just tired of trying to do it themselves, please share our contact information and our advisors would welcome a complimentary conversation with them. We are grateful for the opportunity to serve you and your family, not only in the good times but also through times of crisis.
|Kristofer R. Gray, CFP®, CRPS, C(k)P®, MPA
|Andrew Mescon, MBA
VP of Strategy
Chief Investment Officer
Sources: i. CDC (domestic), WHO (global), ii. www.statista.com/statistics/1104645/covid19-testing-rate-select-countries-worldwide, iii-v. IMF – World Economic Outlook Chapter 1: The Great Lockdown (April 2020), FS Investments – vi. Q2 2020 Economic Outlook: Into the Unknown (4/3/2020), vii, x, xi, xiv. J.P. Morgan – Economic & Market Update (3/31/2020), viii. U.S. Bureau of Labor Statistics. “Employment Situation Summary.” (April 3, 2020), ix. seekingalpha.com/article/4337648-s-and-p-500-sector-performance-numbers, xii. fred.stlouisfed.org/series/BAA10Y, xiii. fred.stlouisfed.org/series/BAMLC0A0CM, xiv. Artivest – Diversity, Durability, and Dynamism (Spring 2020)
Disclosure: The opinions expressed are those of the Integrity Financial Corporation (“Integrity”) and should not be taken as financial advice or a recommendation to buy or sell any security. Integrity is a registered investment adviser. Registration does not imply a certain level of skill or training. Any forecasts, figures, opinions or investment techniques and strategies described are intended for informational purposes only. Past performance is not indicative of future results. Investing involves the risk of loss of principal. Investors should ensure that tey obtain all current available information before making any investment. Indices cited in the information above are intended to support the opinions expressed and are shown as general examples of market trends. It is not possible to invest directly in an index and the volatility of the index may vary from that of an investor’s actual account. Note that index performance shown does not take into account management fees, and is not intended to be indicative of future results. Additional information about our investment strategies, risks, fees, and objectives can be found in Integrity’s Form ADV Part 2. The opinions referenced are as of the date of publication and are subject to change due to changes in the market or economic conditions. There is no guarantee of the future performance of any Integrity Financial portfolio. Material presented has been derived from sources considered to be reliable, but the accuracy and completeness cannot be guaranteed. Nothing herein should be construed as a solicitation, recommendation or an offer to buy, sell or hold any securities, other investments or to adopt any investment strategy or strategies.