Monday Market Review March 23, 2020
Economic news last week was largely dwarfed by the dramatic efforts in progress by Congress and the Federal Reserve to stem the tide of economic and financial market damage from coronavirus-related shutdowns. Other released data included weaker retail sales and manufacturing indexes, while housing data exceeded expectations.
Global equity markets experienced their worst week since the financial crisis, with medical and economic fallout from the coronavirus expected to drive the world economy into recession. Bonds were also mixed, with U.S. treasuries providing some safe haven benefit, while corporate bonds suffered as spreads widened, particularly in mid- and lower-quality issues. Commodity values also fell, led by new multi-year lows in oil prices due to Russia-Saudi production and policy conflicts.
U.S. stocks experienced their worst start to the week since 1987, with the overall week sharply negative across the board, as estimates for the economic damage resulting from coronavirus-related shutdowns steadily worsened. Initial assumptions of a -5% to -10% GDP decline for Q2 have since eroded to near -25%, which would rank among the single worst quarters on record, near some of the depths of the Great Depression.
News and market reaction has been alternating on a daily basis, with deteriorating expectations tempered by news of Federal Reserve and now Congressional action to provide fiscal aid to affected businesses and workers, in amounts upward of $1 trillion. These are critical pieces of legislation, with efforts appropriately directed toward bridging the window between government-mandated shutdowns of consumer activity/manufacturing and eventual recovery. Financial markets have been amenable to this news, as expected, assuming the aid is perceived to be large enough.
By sector, defensive consumer staples was the only group that earned a positive return last week, while most other segments solidly lost ground in double-digits. Energy and financials were among the worst performers, down nearly -20%. Hard-hit sub-sectors also included hospitality and airlines, as travel of all kinds has dried up for the time being. Real estate also performed poorly, in keeping with expectations for far weaker business activity—particularly for retail, which will suffer under social isolation standards.
Liquidity is a key factor in all markets, but especially assets viewed as ‘low risk’ such as U.S. treasury debt and some larger-cap stocks as well, with bid-ask spreads widening, and less depth, which has resulted in choppier execution levels, slower fills, and generally smaller trading amounts. Volatility levels spiked (measured by the VIX index touched 80, not seen since the financial crisis), as a variety of computer-based strategies, such as risk parity and momentum models all sold stocks at once—exacerbating the decline.
Foreign stocks lost ground also, but fared better overall than U.S. equities, although interest rate cuts and massive stimulus (a 750 euro bond-buying program) helped stem the negative sentiment as the week wore on. Relative to other assets, European and Japanese stocks fared flattish in local terms, but gave up a few percent when returns were translated to U.S. dollar terms. In emerging markets, China continued to fare decently as the number of COVID-19 cases has fallen and some manufacturing/retail operations have come back on line. However, other economies sensitive to global growth, such as commodity exporters like Brazil and Indonesia suffered with losses of -20% or more in some cases.
U.S. bonds have continued to behave unusually, with stimulative Fed actions re-steepening the yield curve. Rising rates caused negative returns for bonds as well, which was historically unusual in periods when investors have fled risky assets for safe ones. Government debt fared better, especially with promises of government purchases of treasury and agency mortgage bonds, while corporate lost significant ground (some funds down -10%)—a pace not seen since the Great Recession a decade ago. This was a far worse outcome due to a variety of factors, including lower liquidity than in years past, and slower market functioning based on traders working from home. Credit spreads widened in response to expected difficult economic conditions and strain on borrowers’ ability to pay back interest and principal. This is particularly true in areas such as high yield, where higher-risk issuers such as energy, gaming, and retail have been particularly challenged by recent events.
In investment-grade markets, there is a much higher proportion of corporate bonds rated BBB than in years past. BBB is the notch right above high yield, and stress in this sector has worried some about a downgrade of some names to BB—affecting markets on various levels in addition to spread widening. The ‘line in the sand’ separating investment-grade and non-investment-grade lies between BBB and BB, so institutional investors required by mandate to only hold the former could be forced sellers should these bonds become the latter. This has been a worry in bond markets for some time, but only came to fruition last week from a performance standpoint. Bid/ask spreads have widened in a variety of areas of corporate fixed income, particularly in exchange-traded funds (ETFs) and munis, where investors have taken ‘cheap beta’ for granted—easy liquidity, although underlying bonds in indexes are transacted far less frequently (if ever, in some cases). Consequently, corporate bond ETFs fared worse than their active counterparts in some cases due to forced selling.
Foreign bonds offered a similar experience, with developed market government down upwards of -5%, while emerging market bonds (a ‘risk’ asset) fell closer to -10% on the week.
Commodities showed declines across the board, with economic activity slowing sharply. With minimal losses, precious metals and agriculture prices held up better than industrial metals and energy. The price of crude oil fell by another -30%, reaching lows around $20/barrel during the week, before recovering to just under $23. The price/production war between Russia and Saudi Arabia continues, with U.S. shale producers seemingly caught in the middle, although U.S. political pressure has ramped up. There is irony in that weak oil prices pressure U.S. exploration and production firms especially—and notably credit markets as such firms tend to be heavily levered and represent a heavy constituent of high yield bond markets. But, at the same time, lower energy prices generally ease some of the cost stress on consumers and businesses at a challenged time (if transportation was at a normal level).
Thought of the Week
These are difficult times, not only from an economic and investment standpoint, but a community one as well. This societal strains and uncertainty over depth and timeframe of the current pandemic add to the volatility in financial assets. Keep in mind, though, as we’ve mentioned in prior notes, that these periodic shocks are far from abnormal. In fact, they’re healthy checks on risk-taking, and allow a reset of expectations and re-pricing of risk.
If it were easy to take risk and invest in stocks (or real estate, corporate debt, etc.), such as if they moved in a positive direction 100% of the time, everyone would be doing it. Everyone would own high-risk assets, likely all the time, and that constant buying pressure would buoy prices to such an elevated level that valuations based on underlying fundamentals would no longer be logical. This would ruin their positive expected returns for the future, and increase fragility to the point where, instead of remaining somewhat resilient, the smallest snowflake would trigger an avalanche. Rather, periodic smaller avalanches help the mountain retain its stability. But sometimes, if the conditions are right, avalanches can be stronger than expected, and even become so extreme, and investors so disenchanted, that risk assets become cheap again. The unamusing irony is that this becomes the time when no one wants the same asset at a discounted price that they once coveted at a much more expensive price only a month earlier.
It is important for investors to take a step back and view these events in proper context. It’s the risk in stocks, and the potential for these types of drawdowns and volatility, that keep markets efficient. If they were simple, and always consistent, riskier assets would act like short-term bonds, and likely not even keep pace with inflation or earn enough to reach other goals. The uncertainty creates the opportunity. (Although the reminders aren’t ever pleasant.)
(+) The Federal Reserve and Congress have announced a variety of measures (details in negotiation in several cases) intended to help bridge the gap in far slower business activity during the coronavirus epidemic, for certain key industries, small businesses, and workers, as well as help maintain adequate liquidity for the trading of important financial assets. A few key items are summarized below. In short, the government appears to be pulling out all the stops, including many items from the 2008 toolkit.
§ Fiscal: proposed stimulus package of initially $100 bil. (now up to $1 tril. possibly), consisting of direct payments to taxpayers, loans to small businesses (under the condition they must keep employees on payroll), and funding for healthcare, food assistance, and other targeted segments affected. This package (now to be potentially even larger in its final form, per updates over the weekend) has not yet been agreed-upon by Congress.
§ Monetary: Federal Reserve rate cuts, direct purchases of treasuries and agency mortgage backed securities in another round of quantitative easing.
§ Structural/Market Function: Fed direct lending to corporate borrowers under certain criteria, money market mutual fund liquidity consisting of collateralized loans backed by commercial paper. This resulted from investors beginning to move way from ‘prime’ (corporate) money market funds into government/agency funds as the week wore on.
(-) Retail sales for February fell by -0.5% on a headline level, below forecasts calling for a 0.2% increase. When removing the negative impact of auto, gasoline and building materials, however, core retail sales were flat, compared to an expected 0.4% increase. Revisions to several prior months were positive by up to a half-percent, which was a positive. As expected with the impact of virus-based activity and closures, non-store/online spending rose by 0.7%, although overall food/beverage and personal care sales were little changed.
(-) The New York Fed Empire manufacturing index fell by a dramatic -34.4 points to -21.5, back to 2009 levels, and representing the largest monthly decline in history. This contrasted with a less severe expected drop down to a still-positive 3.0 level. Underlying components were similarly weak, with new orders, shipments and employment all falling to negative territory. Prices paid fell but remained positive, as did delivery times (not usually looked closely at), and business conditions six-months out.
(-) The Philadelphia Fed manufacturing index reversed by a sharp -49.4 points to a contractionary -12.7 in March, below the still-expansionary 8.0 level expected. Under the hood, new orders fell the deepest, into contraction, as did shipments and prices paid, but remained in expansion. Employment fell a bit, but also remained expansionary. Business conditions 6-months forward fell by -10 points, and also remained significantly expansionary at an index level of 35. No doubt, these regional indexes will probably reflect changing (negative) sentiment in manufacturing as the weeks and coronavirus-based economic environment progress.
(-) Industrial production for by 0.6% in February, which surpassed forecasts calling for 0.4%. Utilities were the primary drive of the headline number, up 7%, manufacturing production was little changed, and business equipment production and mining each fell (the latter related to oil extraction). Aerospace production declined, with a continued negative impact from Boeing 737 MAX slowdowns. Capacity utilization ticked up 0.2% to 77.0%.
(+) Existing home sales in February rose by 6.5% to a seasonally-adjusted annualized rate of 5.77 mil. units, which outperformed expectations calling for a 0.9% increase. Single-family represented the entirely of the increase, up 7%, while condos/co-ops were flat. Regionally, sales in the West rose nearly 20%, followed by the South, while those in the Northeast declined slightly. Existing sales are up over 7% from this time last year, which is considered solid growth. The median home price is up 8% from last year at $270,100. Home sales, which have been affected by low inventories, could be difficult to measure over the next several months with coronavirus effects (and associated business activity slowdown) dominating.
(0) Housing starts for February fell by -1.5% to a seasonally-adjusted annualized rate of 1.599 mil., outperforming the -4.3% decline expected, in addition to a positive revision for the prior month. Single-family starts rose by 7%, but a -15% decline in multi-family was responsible for the brunt of the decline. Regionally, a -40% drop in the Northeast and -20% in the West also surpassed gains in the other areas. Single-family starts are up 35%, while multi-unit starts have risen by nearly 50% over the past year. Building permits fell -5.5% during February, further than the -3.2% median forecast. Here, single-family rose 2%, while multi-family fell by almost -20%. Regionally, the Northeast and Midwest were responsible for most permit declines, although every area was in the negative.
(-) The NAHB homebuilder index fell by -2 points to 72 in March, falling a point below the drop of a single point expected. Current sales fell by -2, future sales by -4, and prospective buyer traffic by a point. Regionally, the Midwest gained 4 points, but all other regions experienced declines. It remains to be seen how homebuilding will be affected by the coronavirus, but expectations are for a tempering of activity.
(+) The Conference Board Index of Leading Economic Indicators for February rose by a meager 0.1%, led by weekly manufacturing hours and consumer sentiment, while building permits and ISM new orders pulled down the group. The coincident and lagging indicators rose 0.3% and 0.4% for February, respectively. On the leading side, the past six months experienced an annualized increase of 0.5%, which was slower than the annualized 0.9% gain over the prior six months. Naturally, this information has changed radically over the last month, so should be taken with a grain of salt at this point, as the March indicator will likely be less pleasant.
(+) The January JOLTS job openings report reversed course by rising 411k, to 6.963 mil., above the decline to 6.400 mil. expected. Job openings rose by 0.3% to 4.4%, the quits rate was flat at 2.3%, while the hiring and layoff rates each fell a tenth to 3.8% and 1.2%, respectively. Despite the strong news from two months ago now, it is likely employment numbers will show a sharply negative impact in coming weeks to months.
(-) Initial jobless claims for the Mar. 14 ending week rose by 70k to 281k, exceeding the 220k level forecast by consensus. Continuing claims for the Mar. 7 week ticked up only by 2k to 1.701 mil., far below the 1.738 mil. expected. The jump in initial claims is likely the tip of the iceberg, as witnessed by the high claims numbers in coronavirus-affected CA, WA, and NV. Increasing shutdowns across the country in the restaurant, leisure, and other industries will put millions of Americans out of work. Technically, many are being ‘laid off’ rather than ‘furloughed’ so that they’d be eligible to claim unemployment insurance.
Have a good week.
Ryan M. Long, CFA
Director of Investments
FocusPoint Solutions, Inc.
Sources: FocusPoint Solutions, American Association for Individual Investors (AAII), Associated Press, Barclays Capital, Bloomberg, Citigroup, Deutsche Bank, FactSet, Financial Times, First Trust, Goldman Sachs, Invesco, JPMorgan Asset Management, Marketfield Asset Management, Morgan Stanley, MSCI, Morningstar, Northern Trust, PIMCO, Standard & Poor’s, StockCharts.com, The Conference Board, Thomson Reuters, T. Rowe Price, U.S. Bureau of Economic Analysis, U.S. Federal Reserve, Wall Street Journal, The Washington Post. Index performance is shown as total return, which includes dividends, with the exception of MSCI-EM, which is quoted as price return/excluding dividends. Performance for the MSCI-EAFE and MSCI-EM indexes is quoted in U.S. Dollar investor terms.
The information above has been obtained from sources considered reliable, but no representation is made as to its completeness, accuracy or timeliness. All information and opinions expressed are subject to change without notice. Information provided in this report is not intended to be, and should not be construed as, investment, legal or tax advice; and does not constitute an offer, or a solicitation of any offer, to buy or sell any security, investment or other product. FocusPoint Solutions, Inc. is a registered investment advisor.
Notes key: (+) positive/encouraging development, (0) neutral/inconclusive/no net effect, (-) negative/discouraging development.