“Never bet on the end of the world. It only happens once.” — Art Cashin
Photo via Conde Nast
First Quarter Review
Equity markets and almost all risk assets sold off sharply, entering a bear market for the first quarter of 2020. Indeed, only global assets that rose were the safest of the safe – U. S. Treasuries, the German Bund, U.S. Dollar, Swiss Franc, and gold. Even these assets became volatile as most developed economies have entered into a sudden recession caused by a worldwide pandemic not experienced for over a century.
The Global Covid-19 Pandemic
The Coronavirus health crisis first manifested in Wuhan, China last December as a fast-spreading virus transmitted by wet market animals (usually wildlife used as food or exotic pets). By the time the provincial government began taking the disease seriously, the virus had spread to most other parts of China. With the widespread use of air travel, it soon spread to Iran, Italy and the rest of Europe while invading both coasts of the U.S. and then moving inland. Covid-19 has now infected most developed and emerging countries throughout the world.
After initially downplaying the crisis, the central Chinese government enacted draconian measures, shutting down entire cities and provinces. It basically came down to a choice of life versus the economy. After several weeks of new infections, hospitalizations and fatalities, many parts of the country, including Wuhan, have since reopened.
Currently, the U.S. has reported the most Covid-19 cases globally. Shortages of vital medical equipment such as testing kits, masks and breathing ventilators have impacted our ability to contain the disease. Although New York City has been the epicenter of the pandemic for weeks, the rate of new cases is finally slowing. A few states, such as California and Hawaii, have been more proactive in imposing lockdowns and social distancing which have helped slow down the spread. It should be cautioned, however, that trouble spots are appearing in other states such as Louisiana, Florida, Michigan and Illinois. It will take some time before quarantine procedures show results for the rest of the country.
… and an Oil Price War to Boot
Meanwhile, an unexpected petroleum price war broke out in early March when Saudi Arabia and Russia failed to reach an output agreement. Although an emergency ROPEC (Russia + OPEC) agreement resulted in a 10 million barrel per day decrease, the worldwide demand destruction caused by the Covid-19 lockdown probably doubled the loss. At some point, additional production cuts will be needed. Widespread bankruptcies among second-tier fracking companies are now likely, adding to the economic problems from Covid-19.
The Federal Reserve Bank and Congress Provide Massive Assistance
Fortunately, government authorities stepped up to deliver a quick and colossal aid package for the American economy. Besides lowering the short-term Fed Funds Rate to 0.25%, the Fed introduced programs aimed at providing liquidity to every corner of the credit markets including the Treasury, commercial paper, money market, municipal, mortgage and investment grade corporate areas. Additionally, it has taken the unprecedented step of helping “fallen angels”, or recently downgraded corporate bonds that went from investment to high yield (or junk) status due to the Covid-19 crisis.
In addition, Congress approved the $2 trillion CARES (Coronavirus Aid, Relief and Economic Security) Act to aid affected industries such as airlines, aerospace, hospitals, health care and small businesses and consumers, among others. Both the Fed and Congress stand ready to provide more relief if the situation requires it. The speed and size of this response has never been seen in peacetime.
Even though we were not prepared for the pandemic, production of vital medical equipment is ramping up. However, the silver bullet — a vaccine — is still, at minimum, many months away.
The Economic Cost and a Timetable for Recovery
As mentioned earlier, life and health concerns are most important in every society, with the economy coming in second. In order to stop Covid-19, shutdowns and social distancing measures have been necessary to slow the spread. On the other hand, if people cannot gather, work or travel, job layoffs will swell, and people will stop spending.
Here is a sequence of events that must occur before the economy can recover fully:
- The number of new cases, especially in early stricken states such as New York and New Jersey (also countries such as Italy and Spain), must flatten and start to head lower. This will result in the eventual peaking of both hospitalizations and deaths from the disease.
- The partial and subsequent lifting of lockdowns and some pull back of the social distancing actions must occur.
- A recovery period for the consumer to return to some sort of normality must be factored in. This is dependent on whether the bulk of the unemployed can get relief quickly.
- A recovery period for small businesses to receive the relief that the government has promised is necessary.
- Once this information is known, an accurate compilation of forecasts for the economy, earnings, etc. can occur. We’re talking about more than mere guesses in extremely wide ranges — in other words, more visibility in the economic outlook.
We sold most SMID (small and midcap) holdings in March after the news of the oil price war came out. Many small cap stocks carry heavy debt loads and are in the financial or energy sectors, which could be under pressure for a while. For now, we see a wide trading range of between 2200-2900 on the S&P 500 Index, which may tighten to 2400-2800 once there is more clarity. Because the investment environment has changed, we look to sell securities we no longer favor on strength and are buyers of beneficiaries of the new situation on declines. Ultimately, we do see the market recovering to its old highs, although progress may be uneven and take time.