The Challenge of Complacency
Highlighting the Disconnect Between the Economy and Capital Markets
- Capital markets have responded favorably to massive monetary and fiscal stimuli, but this response may not reflect still-challenging economic fundamentals.
- Against this backdrop, complacent investors appear to be pricing in little risk of further market, economic, or public health setbacks.
- Some financial advisors are adding risk in anticipation of an eventual recovery, while others are trying to minimize further downside by buying investment grade debt.
As we look ahead to the summer months, the coronavirus pandemic continues to have a profound impact on the global economy and markets. In broad terms, capital markets have responded favorably to the extraordinary fiscal and monetary stimuli implemented by government and Federal Reserve policymakers. In many cases, key asset classes have posted strong rallies off the lows reached in March. Against this backdrop, it may be time to ask, “With all these positives, what could possibly go wrong?”
As data on the crisis have grown in both volume and reliability, we now have enough information to apply the Crisis, Response, Improvement, Complacency (CRIC) cycle originally developed in 2001 by Morgan Stanley analyst Robert Feldman.1
The coronavirus pandemic led to a dramatic public health response, including social distancing and widespread stay-at-home orders. These policies, in turn, created a sudden stop across wide swaths of the economy, with consumer demand plummeting sharply and pressuring the underlying economy. A secondary but nonetheless important issue is the oil glut caused by a combination of increased supply from OPEC+ nations and dramatically reduced global demand due to the coronavirus-related economic downturn.2
Over an extremely short time, policymakers responded with unprecedented fiscal and monetary policy measures designed to boost the economy and support capital markets. Total stimulus expenditures, including Congress’ $2 trillion-plus Coronavirus Aid, Relief, and Economic Security (CARES) Act, currently exceed $10 trillion and are expected to grow. Recently, the Federal Reserve announced a further stimulus package involving the purchase of up to $2.3 trillion in loans to support the economy. In addition, the secondary market corporate credit facility will now purchase below investment-grade bonds and exchange-traded funds (ETFs) for the first time ever in an effort to reduce high yield spreads. Additionally, OPEC+ reached an agreement to reduce oil production in order to shore up prices and avoid an industry collapse.
Capital markets rallied in response to the stimulus measures. In April 2020, for example, the S&P 500 Index saw its best monthly performance since January 1987. As shown in Figure 1, the Russell 1000 Growth Index fell only 1% for the year-to-date through April 30, 2020, while the S&P 500 Index lost just 9%. Within fixed income, high yield bonds and floating rate bank loans—both higher-risk sectors—have recovered most of their losses and are down only 10% and 7% year-to-date, respectively. On the public health front, containment measures appear to be working as the rate of increase in confirmed COVID-19 (the disease caused by the coronavirus) cases is slowing week over week resulting in increased calls for ending stay-at-home orders.
Key markets have rallied from coronavirus crisis lows
(Fig. 1) Select Index Performance: December 31, 2019 to April 30, 2020
Past performance cannot guarantee future results.
Source: Financial data and analytics provider FactSet. Copyright 2020 FactSet. All Rights Reserved.
While there has undoubtedly been some good news on the public health and economic fronts, recent market performance stands in sharp contrast to the still challenging reality. For example, weekly figures for new COVID-19 cases remain high despite lower rates of growth, even in countries such as Italy, which implemented stay-at-home orders well before the U.S. In addition, public health experts are expressing concerns about the potential for COVID-19 to recur in waves throughout the remainder of 2020.
Markets do not move in straight lines, so caution is warranted.
At the same time, capital markets appear to be pricing in a relatively quick reopening of the economy despite many officials cautioning that the economy will likely reopen in stages over the coming weeks and months. Meanwhile, the broader impact of the sudden economic stop is beginning to show up in the data. Total weekly initial jobless claims, for example, have passed 30 million in the COVID-19 period.
As of April 30, calendar year earnings estimates for the S&P 500 already have fallen 25% since the end of 2019. The accompanying chart (see Figure 2) offers another view of the grim reality facing corporate earnings. At the beginning of the year, over 300 S&P 500 companies were expected to have the same or higher calendar year earnings for 2020. In stark contrast, only 53 companies were estimated to have the same or higher calendar year earnings as of April 30, 2020.
S&P 500 Index Earnings Estimates Tumble
(Fig. 2) Number of companies up, down, or unchanged as of April 30, 2020.
Source: Financial data and analytics provider FactSet. Copyright 2020 FactSet. All Rights Reserved.
The bottom line: Market performance has diverged significantly from still deteriorating economic data and corporate fundamentals. Complacency looks to have set in as massive stimulus packages have caused markets to rebound quickly, pricing in little risk of a temporary setback as economies emerge from this truly unprecedented health and economic crisis. At this point, it is important for investors to remember the adage: Markets do not move in straight lines, so caution is warranted.
What Lies Ahead?
All of this—economic shock, capital market turbulence, and policy response—has been exceptionally sharp and extraordinarily fast. Against this fastmoving and uncertain backdrop, we are watching carefully for answers to several key questions in the days and weeks ahead:
- Have investors become too complacent?
- When and where will policymakers strike a balance between public health concerns and economic considerations?
- Will the massive fiscal and monetary stimuli provide sufficient liquidity to stem the economic downturn and maintain order in capital markets?
- Will the point at which new COVID-19 cases plateau and start to decline signal an inflection point for both the global pandemic and capital markets?
Advisor Concerns and Investment Ideas
Recent conversations between our dedicated team of Portfolio Construction Specialists and our partner clients suggest that advisors generally fall into two camps: (1) A majority of advisors are optimists looking to take on risk and position portfolios for an eventual recovery, and (2) a minority are market pessimists looking to de-risk and minimize the potential for further downside. We believe advisors should exercise caution as market pricing may be undervaluing the broader economic and public health risks.
- Risk-On Approach:
Fixed income spread sectors look attractive now due to expectations for monetary and fiscal stimulus to boost liquidity. Spreads for U.S. high yield debt look favorable, and the Federal Reserve will now purchase securities and exchange-traded funds in this space. Floating rate bank loans’ superior position in the capital structure offers an element of stability. At the same time, emerging markets debt, both government and corporate, features attractive yields and should benefit as accommodative monetary policies enhance global liquidity.
Among equities, high-quality growth companies with healthy balance sheets, including those consistently able to grow dividend payments, appear more likely to survive the current downturn and emerge in a strong position to thrive when the economy rebounds. U.S. small-cap stocks—growth and value—have led equities in previous recoveries, although small-cap performance can be a bumpy ride. At the same time, global strategies with broad investment mandates hold potential by allowing their managers to invest wherever they find the best opportunities.
- Risk-Off Approach:
In a nutshell, some advisors are looking to buy whatever assets the Federal Reserve is buying among investment-grade debt. Short-term bonds, for example, offer liquidity and higher income potential than money markets, although low yields and high redemption rates pose risks. For advisors concerned about the impact of falling interest rates on Treasuries, diversified core fixed income can still act as portfolio ballast in volatile markets. Municipal bonds feature low default rates, low correlation to volatile equities, and favorable valuations versus core taxable bonds. In the current environment, municipal risks include the potential for tax revenues to fall just as demand for public services spikes—although we note that states and individual municipalities can apply for grants under the CARES Act, and even more federal help for state and local governments could be on the way. Some advisors could look to upgrade the quality of their equity allocations, while others may consider multi-asset funds with broad diversification.
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Source for Bloomberg Barclays Index data: Bloomberg Index Services Limited.
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