Market Commentary - April 2020

Monthly Update

After a challenging month of March, markets recovered in April with the S&P 500 rallying by 12.7%[1]. It was not just stocks that rallied, but bonds too, particularly corporate bonds; both investment grade and high yield, mortgage-backed securities, commercial paper, asset-backed securities, and collateralized loan obligations to name a bunch[2]. International markets also rebounded, as did copper which is viewed as a great proxy on economic activity[3]. You are likely asking why since the economic situation is still very challenging, but what we’re witnessing is the markets shifting its attention from the shock and panic of the virus spread and economic shut down, to now looking at the other side. The other side includes a gradual reopening of the global economy, along with greatly expanded testing capacity and hope for progress towards effective therapeutics, such as Remdesivir from Gilead, and hopefully an eventual vaccine sometime in 2021.

Each week we’re hearing about another state that has begun the process of reopening, with the pace and timing depending on the industry. There is certainly a heated debate nationally on balancing the important health implications and keeping people safe on one side, with the need to have a functioning economy to go back to on the other side. Fortunately, we’re going to learn a whole lot from those states and countries that are opening up quicker than others. This process will not be easy, it will not be without setbacks, but it is something that needs to happen.

The economic damage from the self-inflicted shutdowns is obvious to us all. We just have to look at our own behavior and know that business everywhere is hurting and many are out of work. However, this was a forced reaction to the Covid-19 spread, so it’s best to shift the economic focus to what things will look like after we reopen. Of course, some things won’t reopen for a while, such as any large gatherings until 2021, but we have to start somewhere.

The other major factor that helped to lift markets in April was the extraordinary actions by the Federal Reserve announced in late March. I say ‘extraordinary’ because they are going to places no Federal Reserve has gone before. After announcing in March that they were embarking on large scale QE, buying US Treasuries, agency MBS, and agency CMBS, along with cutting rates back to zero and backstopping a portion of the commercial paper market, including corporate and munis, they also said they would indirectly buy corporate bonds, both investment grade and high yield[4]. They have become the lender of all resorts.

The Stock Market

A key characteristic of the selloff in stocks in March, outside of the obvious fundamental factors, was forced liquidation via margin calls. It was rampant, and it seemed to have exhausted itself in the latter part of March. Come April, with much of that forced selling out of the way, combined with the hopes that we’ve seen the worst of the virus in terms of containment and shut downs, has helped to lift stocks off their March lows. For perspective, in the S&P 500 the midpoint between the February high and the March low is about 2800[5]. On a closing basis in April we traded as high as 2940 and closed the month at 2912, so we essentially got back half of the loss in terms of points[6].

The critical question for stocks from here is what earnings will shake out to be in 2020 since 2020 can be seen as a lost year. Once that unknown is quantified by everyone’s models, what P/E ratio should we put on that? As earnings for 2019 for the S&P 500 came in around $165 per share, we have to assume that it will be a few years before we can reach that again, and I’ll also argue that we won’t be going back to an 18-20 earnings multiple for a while, either[7]. It is for these reasons that we think the S&P 500 is at the upper end of what could be a trading range for a while, with the March lows around 2200 being the lower end.

The Bond Market and the Federal Reserve

As stated, the Fed lifted the mood of the credit markets that basically froze up in March in the midst of the panic. They are doing so by stretching themselves in ways they never did. From 2007 on, during the last economic recession, they revealed to us an alphabet soup of liquidity programs that they are rolling out again, along with new ones focused on the corporate bond market. New to the markets are the Primary Market Corporate Credit Facility (PMCCF) “for new bond and loan issuance” and the Secondary Market Corporate Credit Facility (SMCCF) “to provide liquidity for outstanding corporate bonds”[8]. Also, the Money Market Mutual Fund Liquidity Facility (MMLF) that will buy short term muni bonds was unveiled along with the Commercial Paper Funding Facility (CPFF) that will now also include munis[9]. Finally, the Fed unveiled the Main Street Business Lending Program that will help facilitate loans to businesses with less than 15,000 employees and $5b of revenue[10]. All of this is to grease the wheels of credit and increase the level of lending to buy businesses time to when the economy improves. The question remains, though, can all this liquidity cure what is seemingly a solvency problem?

The Economy

There is no mystery that the US economy and that of the world has seen a downturn as bad as the Great Depression. The unemployment rate might be as high as 18% in April[11]. The economy contracted by 4.8% q/o/q annualized in Q1[12]. Q2 will likely be much worse. The statistics overseas are certainly challenged, as well. However, keep in mind that we did this to ourselves. Our punch back against Covid-19 was to avoid going outside and also telling many businesses to shut their doors. This was not a naturally driven recession. Thus, as we purposely reopen, which we’re doing right now, the US economy will recover. The pace at which it does remains the most significant question and we can be sure that the pace will be slow. It will take time for both consumers and business to be comfortable living in a world of Covid-19 until there is a vaccine.

The Government

The main lever the US federal government pulled in terms of fiscal action to help the US economy was the Coronavirus Aid, Relief and Economic Security Act (CARES) passed in March. The portion of this bill that was meant to help business was the Paycheck Protection Program, which ran out of money and had to be refilled. The extent at which this will keep businesses alive and employees paid remains to be seen. For those individuals that lost their jobs, they now have a very generous unemployment insurance program to tap into until July 1^st.

We have seen fiscal support from a variety of countries around the world, as everyone tries to buy time for both households and businesses until things economically improve. The consequence is exploding debts and deficits everywhere, but that will be a worry for another day. A day, though, that will eventually come.

Oil

The other big news in April was the implosion in the price of oil. With the backdrop of a collapse in oil demand at the same time there is excess supply, the May WTI crude futures price traded below zero[13]. You’re probably asking yourself how this can be possible, but understand what a futures contract in WTI is. It is an obligation, not a right, to take delivery of barrels of oil if one owns this contract on the expiration day. With storage facilities already filled up in the days leading up to expiration, there is literally no place to put new barrels of oil. Thus, those that couldn’t take delivery sold the futures contract sharply in the day before it expired. This pressure has now been somewhat relieved and there are early signs of an improvement in demand as people hit the road again as economies reopen.

Conclusion

It has certainly been a very unsettling few months as we are living a life none of us have ever seen before. Until there is a vaccine, or at least highly effective therapeutics, it is also a life that will be with us. Therefore, it is imperative that we adjust in the meantime. We do so by living smart and that means wearing a mask, keeping your distance, washing hands, etc… but also will be complemented by widespread testing for both the virus and antibodies. We will also balance this with reopening the economy so we have an economy to go back to. The economy will look quite different for a while so we have to be patient with its recovery.

This is a difficult time, but we will get through it. Of particular importance for clients is making sure they have their short term liquidity needs met over the coming 24-36 month period, which then makes market volatility less relevant during this time frame.

Please do not hesitate to reach out at any time with questions or for any discussion on the economy and markets.

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