The first quarter of 2020 is for sure going to leave its mark on history. Lots of record-breaking news and none of them is good news. Everything that could go wrong went wrong at the same time. In the 33 years history of introducing market-wide circuit breakers, it has been triggered 5 times, 4 of which happened within the month of March 2020. The massive cash outflows from ETFs, municipal bonds, corporate bonds in IG and HY including the depressingly wide spread of mortgage securities backed by US government have stunned the world.
It is clear that this pandemic brings exogenous shock that will cause an unprecedented, extremely deep short-term economic collapse. The question that everyone is asking is “where is the bottom?” If the virus completes its cycle by summer 2020, this recession will be the shortest but hardest in history.
Little do people doubt that the economic performance of Q2/2020 is going to be bad and how asset managers should put money into use is the enquiry that we have received the most in the recent weeks. However, to be completely honest, investment in pandemic period is like making decisions very fast with very limited information. In order to be able to explain what situation that we may face in the future, it is necessary to look back from the experiences that we gained from history. We are to look back how US GDP, job market and financial markets have performed from the previous economic cycles in this article and hopefully to gain some insights.
A quarter for the record
If we take the performance of equity and bond markets as a proxy of the expectation of the economy and policy makers, the largest sell-off in the shortest period of time in March is the worst confidence vote we could get. It is, in our view, what the Black Swan set of events is like.
There is no better description but being in panic. From its peak of February 2020, S&P 500 dropped 32%. You could see from the below chart the hike of VIX and the drop of the S&P 500.
Chicago Board Options Exchange’s Volatility Index (VIX) and S&P 500 month-on-month change %
Source: Bloomberg, Assured AM
The main contributors of the market reaction are twofold:
- The forthcoming economic shock that the pandemic may and will deliver to global markets, and
- The lock of preparation globally to deal with the health, and economic consequence of the virus as COVID-19 crashes into personal and business lives.
There have been 14 recessions since 1930 as stated in the below chart. Each recession followed by price drop in the equity markets, ranges from as little as -9% to as big as -75% (great depression) and the lasting time from 6 months to 45 months. Market tended to find its bottom before the recession was over. However, what strikes us the most about this virus triggered recession is the sharp speed of decline.
There have been 14 recessions since 1930 as stated in the below chart. Each recession followed by price drop in the equity markets, ranges from as little as -9% to as big as -75% (great depression) and the lasting time from 6 months to 45 months. Market tended to find its bottom before the recession was over. However, what strikes us the most about this virus triggered recession is the sharp speed of decline.
There have been 14 recessions since 1930 as stated in the below chart. Each recession followed by price drop in the equity markets, ranges from as little as -9% to as big as -75% (great depression) and the lasting time from 6 months to 45 months. Market tended to find its bottom before the recession was over. However, what strikes us the most about this virus triggered recession is the sharp speed of decline.
S&P 500 performance by years
Source: Macrotrends
It is not difficult to understand, from the VIX chart, why investors dumped shares, bonds, gold, treasuries, ETFs, to get access to cash into their bank accounts.
Chicago Board Options Exchange’s Volatility Index (VIX)
Source: Macrotrends
The desire for cash is exacerbated by panic and also by the need to fulfill redemption, margin calls, and/or obligation for payment due to a sharp drop in business activities. We have seen the complete revaluation of almost every asset class across every market due to this extraneous shock of COVID-19 pandemic, of its silent yet scary impact on societies, countries, economies, rich and poor.
Where there is risk there are opportunities?
A deep global recession is now the baseline forecast for 2020. To date, there are 1,979,477 confirmed cases and 126,539 deaths recorded. In the US, confirmed cases and death numbers continue to grow, there are currently 97% of the population under stay at home orders with around 59% of the US workers paid by the hour, the damage of the pandemic is widespread. According to Fitch Ratings, the world real GDP growth is expected to fall by 1.9% in 2020 with the U.S. down by 3.3%.
Confirmed cases of Covid-19 in the US
Source: The Guardian (last updated 14 April 2020 8:25 pm EST)
Following the information provided by the WHO, this virus is present in 152 countries and territories, just 80 days after it was discovered in Wuhan, China. With 50 states in the US now declared states of emergency, the disruption of life is beyond anyone’s expectation since the first case was discovered in the US in January 2020. While the market is seeking for a sign of recovery from the history of 2008 crisis, we see little in comparison. The 2008 crisis was caused by ill- functional financial industries. The creative structures of toxic mortgaged backed assets underwritten by under-capitalized banks led to a systematic crisis in the financial system that required policy makers to step in.
The virus is beyond human control and it doesn’t and will not just impact one industry only. Merely cutting policy rates or quantitative easing into banking systems will not solve the problems since the issue of liquidity drainage is not caused by the banking system. The Fed has had a very quick response into monetary policy to showcase its commitment to sustain the markets. However, these moves do not provide as much confidence to the market as the Fed expects. The required response from the authorities around the world is to provide the policy response that offers precision targeting for individuals and businesses to ensure their fiscal health, though the impact of the virus may last for months. Governments will need to anticipate a great slowdown at the worldwide level, although they may roll in waves and the slowdown may put pressure on asset prices and hurt future sentiment. Most importantly, also to our main concern, is that the change happens so fast that the data and numbers run before the government can respond. Policy makers will need to make decisions concurrently with very limited information and no prior indicators.
The main risk we see, other than the development of the virus, is the ability of policymakers to make sure the good part of the economy will not be “infected” by the bad.
One clear fact we need to recognize is that there is certainly no precedence in history. The impact of the event may be unpredictable along its present path and long-term impact. With that in mind, the policies, the execution and the attitude of the authorities will be one of the key factors to determine how soon the economy can go back to normal once the virus cools down.
In the United States
As we mentioned before, up to the current date, there are 97% of the population under a lock down order with 50 states declaring a state of emergency. The disruption in businesses, from manufacturing, supply chain, logistics, and servicing, is huge. While 59% of the US workers, amounting to 78 million people are paid by the hour, therefore the disruption means a huge loss of income. The country lost 701,000 jobs in March, the biggest decline in one single month.
US Employees on Nonfarm Payrolls Total month-on-month Net Change, 1990-2020
Source: Bloomberg, Assured AM
The majority of the deterioration is occurring in service-producing industries with a 459,000 decline in leisure & hospitality jobs followed by 76,000 in health and education, 52,000 in professional and business services. The job market is brutal. We see the biggest jump of the initial jobless claim and the unemployment rate jump by 1% to 4.4% and moving towards the 5% mark. The huge leap in initial jobless claims suggests the impact is real and painful.
US Initial Jobless Claim, 1990-2020
Source: Bloomberg, Assured AM
With more than 200 countries now infected and almost each state in the US, the shock this pandemic presents will no doubt take us into an unprecedented, extremely deep, hopefully short- term, economic collapse across the world.
Federal Reserve Bank of St. Louis President James Bullard predicted the U.S. unemployment rate may hit 30% in the second quarter because of shutdowns to combat the coronavirus, with an unprecedented 50% drop in gross domestic product. If we are to use China’s experience of fighting Covid-19 in Q1 2020 as an indication, the China Beige Book said it’s “not unreasonable” that gross domestic product will contract 10% to 11% in the first quarter and that it will be 40% on an annualized basis. When the short term recession is deemed to happen, the question is how quickly the world can turn things around once the virus is contained?
When individuals are allowed to return to work from mandatory shutdowns, how many of them still have the work will depend on the virus itself with timing likely to be staggered across the world. The key variable to answer that question is how soon the governments and policy makers can react to provide adequate solutions to limit the damage at a manageable scale.
What’s the Fed’s response to the current crisis?
The initial responses that the Fed offered to the market is a prevention action that provides confidence to the market. The Fed lowered rates to practically zero and will follow what they have set as a precedence in the 08/09 crisis to provide the forward guidelines of their policy rate decision. Furthermore, the Fed also adopted the standard QE by providing liquidity into financial system through securities purchasing, repo operations, money market fund liquidity facility, and primary dealer credit facility. However, as we have pointed out before, the making of this crisis is very different from the 08 financial crisis. Banks are well capitalized and banking systems are operating fine. The credit markets are suffering not because of the lack of liquidity in the financial system but more due to the lack of confidence in consumers and corporate lending. Banks are not being able to price any new credit risk following the unprecedent scale of disruption in businesses and so do the credit investors. The massive sell off in any kind of credit securities is the perfect illustration of such concern. Merely providing liquidity into the banking system cannot resolve the key problems of this crisis.
We are dealing with the risks superimposed by the below three elements:
- The impact of the virus,
- Material credit contraction, and
- Sudden stop of global macro economies.
Monetary policy will not stop the spread of the virus and while QE may help the recovery of the economy in the longer run, it doesn’t address the immediate back stop of the credit markets. The diminution of sources of credit in these particularly hard hit segments of the economy will exacerbate the economic down turn. The Fed’s further announcement to provide direct lending to corporates, to purchase commercial paper, and to expand support to consumer and household lending, in our view, is a more direct response to the crisis.
Fiscal policy that will be adopted by each country will also determine if the recession is temporary or a longer lasting nightmare. The volatility of the market is a reflection of the market expectation of the economy, and the sign that markets seem to find its current bottom awaiting further information is a relief. The message of “whatever it takes” by the Fed sends further confidence support to the market.
The light at the end of tunnel
While the degree of globalization and the scale of the impact are different between SARS and COVID-19, we may find some relief from Hong Kong’s recovery of the SARS period.
SARS hit Hong Kong during the period of 11/2002-09/2003 and while the contraction of the economic performance was huge and rapid, the recovery was just as strong.
Hong Kong Hang Sang Index (HSI) and Hong Kong Real GDP annual growth rate
Source: Bloomberg, Assured AM
While we are hopeful that the recovery may start back in Q3, we are realistic to assume not all employment will be recovered to pre-pandemic levels. Assuming there will be 50% of the people returning to work, the US economy will head back to 2017 levels rather than follow a U shape recovery. The recovery of each industry and each company will highly depend upon how rapidly they can adapt to the world that sees digital and technology transformation as a must. The change in re-thinking of supply chains, logistics and globalization may also deem to happen. It is more important than ever to focus on investment philosophy and to maintain a well-diversified portfolio and to avoid the temptation of a sudden change in allocation.
We have confidence that everything will turn around in the next 18-24 months. The country will be well recovered with a series of stimulation responses in place to invite the next cycle of growth. We encourage investors to think positively and react wisely as markets react to the news of the pandemic, its casualties, its impact, and eventually its end.
