by Connor Darrell CFA, Assistant Vice President – Head of Investments “There are decades where nothing happens; and there are weeks where decades happen.” (Vladimir Lenin)

It may seem counter to open a discussion about financial markets with a quote from a communist leader, but we felt the above was a perfect summary of what market participants have experienced recently (and last week in particular). In this iteration of The Weekly Commentary, we aim to put some of the volatility in context, describe what we view to be a much needed and potentially historic economic policy response, and hopefully address some of the concerns many investors have in this uncertain environment.

Situation Report
In just a few weeks, the COVID-19 pandemic has completely transformed the global economy and caused a massive re-pricing of risk across virtually all markets and asset classes. The uncertainty of the situation is in many ways unprecedented. The world has not faced a pandemic of this magnitude in over 100 years, and the economic costs of government attempts to slow the spread of the virus are likely to be immense. As a result, investors are understandably scared, but the types of market movements we have observed in the past few weeks only occur when panic and fear become the primary determinants of price, rather than fundamentals. The problem for markets is that the fundamentals are very uncertain at this point in time, and it is unlikely that this uncertainty will dissipate for the next several weeks.

With that as a backdrop, it is entirely plausible that markets fall further before finding a bottom. Investors should prepare themselves for poor economic data (particularly with respect to the labor market) and the continued increase in the number of cases to spark further volatility in the weeks ahead. Importantly, the slew of bad news we are likely to see in the coming weeks makes it all the more essential for investors to remain grounded to the core principles of investing discipline. These principles include employing a disciplined rebalancing strategy, maintaining a properly diversified portfolio, keeping focused on the long-term, and avoiding making emotional decisions. As much as it can feel otherwise when we are going through them, bear markets are temporary events. Pandemics are temporary events as well, and we expect that the economy will emerge on the other side without having suffered major damage to productive capacity, which is something that cannot be said for all economic shocks throughout history.

The Policy Response
In our view, this challenge will require a coordinated and targeted response using both fiscal and monetary policy tools. We are looking for (and expect) an historic response to this global crisis from policymakers. We have already seen the Federal Reserve step in to address the first key issue, which is a lack of liquidity in the financial system. Through open market operations which involve buying bonds from those looking to sell them (also known as Quantitative Easing), the Federal Reserve has committed an enormous amount of capital to provide and ensure stability in markets. We anticipate that these policies should provide some relief in the weeks ahead and continue to rate the monetary policy environment as “Very Positive” in our economic heat map. 

There has also been heavy focus on congress as investors have clamored for a fiscal response to the crisis, and we remain optimistic that differences will be worked out and that a bill (possibly more than one) will be passed. The initial task for policymakers is to provide relief to those who need it while quarantines remain in place and the spread of the virus runs its course. This will likely take several weeks. During this time, fiscal policies should be targeted at expanding the social safety net (through increased unemployment benefits and paid family leave) as well as providing bridge loans for cash-strapped businesses unable to operate with society at a standstill. Once the rate of contagion has begun to turn downward (which is likely several weeks away), we then expect the passage of a more traditional stimulus package aimed at spurring economic demand.

Balancing Near-Term Gratification with Missed Opportunity Over the Long-Term
All of this is rather complex, but the crux of the matter is that while the impacts of the coronavirus pandemic are not likely to subside in the near-term, the eventual return to economic activity is likely to be aided by historically powerful fiscal and monetary forces. All of this suggests that it will be exceptionally difficult to time the bottom, and investors who exited risk assets during the worst of the crisis are unlikely to be able to re-enter the market at the right time. If markets continue to slide lower before finding a bottom, those same investors may experience a period of gratification in the near-term as a result of having avoided additional losses, but are just as likely to have made themselves worse off in the long-term as a result of missed opportunities for healthy returns on the back end. In short, maintaining discipline and managing emotions is key. At this point in time, it is safe for investors to approach the current environment as the start of a new economic cycle. This new cycle will bring with it its own set of characteristics and opportunities. Perhaps value stocks will finally regain market leadership? Maybe international equities will once again find their footing relative to domestic stocks? How can I construct my portfolio to maximize my opportunity to achieve my long-term financial goals? The first two questions speak to the concept of diversification. We simply do not know which types of stocks will lead the way in the next cycle (though valuation can provide us with some clues), so a balanced approach is needed. With respect to the third question, bond yields currently stand at historically low levels, making it exceptionally unlikely that goals can be achieved without exposure to equities in a portfolio. All of these questions may seem trifling in the face of a near-term global crisis but are exactly the types of issues that long-term investors should be focused on, because these are the things that ultimately determine investment success over a full-time horizon.

by Connor Darrell CFA, Assistant Vice President – Head of Investments
As the threat of COVID-19, the disease caused by the novel coronavirus, has continued to escalate over the past few weeks, fear and panic have gripped financial markets and society at large. The risks emanating from the fallout of the virus’ spread have wreaked havoc on financial markets and pushed equities well into bear market territory. Since it first became apparent that containment of the virus was no longer reasonably achievable, we have spent a great deal of time trying to assess the long-term economic risks that the virus poses. The unpredictability and fluidity of the situation makes any economic forecasting extremely difficult, and that is part of the reason that markets have reacted the way they have. But in times of stress, it’s imperative that investors maintain perspective. With this edition of The Weekly Commentary, we aim to summarize some of the key facts that we have learned over the past few weeks, share our latest assessment on the economy and markets, and offer perspective on how to look forward rather than backward.

COVID-19: What Do We Know?
As the scientific community has scrambled to ramp up research efforts and gain a better understanding of this novel disease, there has been no shortage of information being shared via news publications, scientific journals, and word of mouth. Despite the amount of resources being dedicated to research, the fact of the matter is that these analyses take time, and much is still unknown about how the virus operates. We do know that based on the data it has available, the World Health Organization recently made the decision to officially declare the current situation a global pandemic; a decision that many believe should have been made much earlier. We also know that scientists are finally beginning to get a handle on exactly how the disease spreads and how it compares to prior pandemic diseases.

A comparison to prior pandemic diseases is one of the simplest ways to assess the potential impacts of COVID-19, but it is important to note that each pandemic is unique by nature. Coronavirus pandemics are a relatively new phenomenon (many other pandemics throughout history have been flu viruses), so there are fewer points of reference for the current situation, but when compared to the virus that caused the SARS outbreak in 2002, the strain of coronavirus causing COVID-19 appears to be less lethal and have a lower rate of transmission. However, this disease has been much more difficult to contain because patients are contagious for a much longer period of time and often while exhibiting no symptoms at all. As a result, modest containment measures that respond only to confirmed cases where patients are exhibiting symptoms have been rendered ineffective. 

The general expectation among experts is that the virus will continue to spread through community transmission, eventually reaching peak levels at some point over the next 6-8 weeks. Faced with that reality, we anticipate widespread school closures and recommended telecommuting by employers. We also expect economic stimulus in the form of both monetary and fiscal policy initiatives aimed at providing stability to markets and assurances for impacted families and businesses. President Trump addressed the nation on Wednesday evening, offering some preliminary measures that did not appear to appease markets, leading to further large-scale losses during Thursday’s trading session. However, we anticipate additional measures will be discussed and eventually passed through Congress.

The Current State of Markets and the Economy
The swift and violent nature with which markets have responded to the threat of COVID-19 has been a result of a variety of factors. First, market sentiment was extremely positive coming into the year as a result of improving economic fundamentals and anticipation for accelerating earnings growth. Those lofty expectations led to lofty asset prices, which meant stocks had further to fall once the full threat of COVID-19 became appreciated. Secondly, the exogenous shock to the economy that COVID-19 represents is not something that can be easily addressed through traditional economic policy initiatives. Lower interest rates and tax relief will not stop the spread of the virus, adding to the uncertainty of the situation. Lastly, the immediate reduction in demand for oil resulting from the spread of COVID-19 has coincided with a political struggle between Russia and Saudi Arabia with respect to oil production capacity. Both nations are looking to exert pressure on other oil producers in order to gain market share, and this has led to a sharp decline in the price of oil. Oil’s decline has resulted in a rush of “risk-off” sentiment in corporate credit markets, of which energy producing companies make up a large share of borrowers. It’s important to note however, that lower oil prices will be a net positive for consumers once the spread of the virus subsides and consumer behavior normalizes.

As might be inferred from reading the paragraph above, the variety of threats that have surfaced in recent weeks represent a material risk to economic activity over the next several months. It is not out of the realm of possibility that the global economy falls into a technical recession (defined by two consecutive quarters of negative economic growth rates), but we believe there are a number of reasons for investors to remain optimistic about the ensuing recovery. 

First, we know that the U.S. economy is addressing these threats from a position of strength. As a result of significant reforms enacted following the global financial crisis, U.S. banks are extremely well capitalized and are well positioned to deal with potential stress. Secondly, the risks that the economy faces are quite different from those of a “traditional” recession. Typical recessions result from internal shocks such as an asset bubble, monetary policy missteps, or weaknesses in the financial system. These types of recessions often lead to structural issues within labor markets that force the reallocation of labor and resources to different industries. For example, the housing crash and financial meltdown in 2008 led to a substantial reallocation of resources away from construction and real estate, and many jobs that were lost were permanently eliminated. By contrast, as the economy emerges from the impacts of COVID-19, workers are more likely to be able to simply return to their previous jobs and resume economic output. At the very least, the friction we have seen in prior recessions which has slowed the recovery in labor markets is likely to be significantly less prevalent. As such, we believe it is reasonable to anticipate that confidence would rebound more quickly than analyses of prior periods of economic stress might suggest.

Lastly, given the market’s disappointment in the President’s remarks on Wednesday, we anticipate that the federal government will continue to look at more aggressive policy action moving forward. In fact, we have already seen progress on this front, as the House of Representatives passed a bipartisan legislative package over the weekend which the Senate is expected to vote on this week. This package will be aimed at providing assistance to impacted families and businesses, and there are already discussions in place for further measures to be taken as needed. We believe that the timing of additional fiscal responses will be important, with measures focused on boosting demand being enacted after the disease reaches its inflection point in order to maximize their impact.

Looking Forward
At this point in time, equity markets are about 28% off of their previous highs. Given our assessment of the economic picture and the prospects for a relatively swift recovery (though the timing remains uncertain), we believe that the vulnerability of the human psyche has exacerbated market declines, and that market prices have begun to separate from what might be considered rational. Furthermore, the size of the selloff in equities has likely led to significant portfolio drift in many instances. And while we would never seek to “call the bottom” (and consistently advise our clients against attempting to do so), we have long preached that disciplined investors should seek to rebalance to long-term target allocations whenever portfolio drift becomes significant. This principle is true in both up and down markets. As such, rather than falling victim to the fear and panic which have gripped markets and society, we believe investors should begin looking for opportunities to rebalance portfolios. While it can often be emotionally difficult, this process involves purchasing assets such as equities which have significantly depreciated over the past few weeks. Rebalancing does not necessarily need to be achieved in one trade, but it is an important tool for keeping portfolios aligned with what is required to achieve long-term goals.

The rapidity of the market’s reaction to the spread of COVID-19 has been historic. But as discussed above, our assessment at this point in time is that panic has played a significant role in what we have seen from markets, especially over the past week. When markets are being driven by panic, a disciplined and objective approach to portfolio management is of the utmost importance. As such, it is important for us to focus on what we can control rather than what we cannot. This does not only include details related to our investment portfolios (maintaining an asset allocation that is appropriately aligned with our investment goals), but in the wake of the mounting threat we face as a society, it also includes simple things like proper hand hygiene, taking necessary precautions as recommended by authorities, and working together to protect ourselves and our communities. We do not know when the market will find its bottom or how long it will take for our lives to return to normal, but we do know (because we have seen it in China and in South Korea) that we will emerge on the other side.