Given the pace at which the global economic environment is changing as a result of the spread of COVID-19, we’ve found there is an increased interest in up-to-date insight on the economy and the markets. With volumes of information out there, we aim to cut through the clutter by summarizing the week’s events by producing this brief written by Chief Investment Officer, Rob Edel, published every week
Markets broadly rallied last week, with the S&P 500 gaining +10.4% and the S&P/TSX +7.2% in the best week for stocks since March 2009. Trading remained volatile with daily moves routinely in excess of 1% in both directions. Tuesday, March 24th stood out in particular, with the S&P 500 up over 9%, on its way to a cumulative three day gain of 17.6% after hitting its bear market low on Monday. The Dow actually rallied 21.3% over the same time period, in theory signaling the start of a new bull market. The S&P/TSX was just behind the Dow, with a 19.1% gain.
Other markets also showed progress last week. Fixed income markets exhibited more liquidity, with 2-year U.S. Treasury yields falling seven basis points to 0.31% while 10-year yields dropped 17 points to 0.68%. Same for credit markets, with investment-grade credit and high yield spreads tightened as shown by the iShares iBoxx Investment Grade Corporate Bond Fund and high yield corporate bond ETF’s +14.8% and +10.4% respectively. A more liquid bond market was also evident in currency markets, as demand for U.S. dollars eased with the U.S. dollar weakening just over 4%. The Canadian dollar gained 2.6%. Gold gained 8.1% and oil (WTI Crude) increased just over 3%. For Canadian energy producers the news was less encouraging, with Western Canadian Select dropping 50% to just over $5 a barrel, an all-time low, and literally cheaper than water.
We believe there were three main drivers for markets last week, namely economic forecasts, fiscal and monetary policy, and COVID-19 and efforts to contain the outbreak. We believe this was the case last week and will be the case for the foreseeable future. All are important and will be discussed, but COVID-19 tops the list so we will leave it for last.
Economic numbers are going to get ugly. Forecasters are slashing their estimates for Q2 GDP with Morgan Stanley being the most pessimistic, estimating a 30% contraction. U.S. consumer confidence as measured by the University of Michigan hit a three-year low and unemployment claims soared a record 3.28 million, four times the high watermark set in 1982, though better than the whisper number of more than 4 million. Canadian claims hit nearly 1 million, or 5% of all employees. These are scary numbers, but not unexpected given the virtual shut down of the service industry in the U.S. and Canada.
A recession is largely a given, the real question is how deep and how long? Will it be V-shaped, U-shaped, or L-shaped? The market needs to know how much the economy will ultimately contract and how steep the forward demand curve will be going forward.
We believe the market is starting to discount a U-shaped recovery, but it is the L-shaped, or depression scenario that most fear, but don’t expect. Given the dramatic shut down of much of the economy, a negative feedback loop is possible even if the pandemic is short-lived. If sound and financially viable companies are forced into insolvency and unemployed consumers are unable to pay their bills, a long drawn out downturn could result. Fortunately, much of this risk was taken off the table, for now, with both the Federal Reserve and the Federal Government taking swift action last week.
Lessons learned during the 2008 Financial Crisis enabled U.S. monetary authorities to quickly roll out programs addressing liquidity issues in the global financial system. In a mad dash for cash, and greenbacks, in particular, longer-term interest rates started moving higher, credit spreads widened, and the U.S. dollar moved higher. The Fed quickly cut rates to zero, signaling their intention to buy at least $700 billion in Treasury’s and Mortgages, and introduced five new lending facilities over the course of a week to help ensure corporations and businesses have access to capital. The Federal Reserve balance sheet is expected to swell to over $5 trillion, larger than the $4.5 trillion reached during the Great Financial Crisis, as the central bank commits to doing whatever it takes. They also understand that the demand for liquidity is global, and being the World’s reserve currency carries a responsibility to ensure foreign central banks also have access to US dollars. By re-kindling cross-currency swap lines with 15 foreign central banks, the Federal Reserve helped ease a global shortage of dollars. All these actions helped bond yields, credit swaps, and the US dollar decline last week, which is a good thing.
The speed in which the Fed took action was important in helping ease concerns that markets were headed for what Mohamed El-Erian (ex PIMCO Co-CIO) recently referred to as a “self-feeding vicious cycle of accelerated economic and financial deleveraging”, but they needed help from Congress in the way of fiscal policy. By the end of the week, a deal was done with Congress approving a record $2 trillion stimulus package intended to provide relief to both Wall Street and Main Street. At approximately 10% of U.S. GDP, the package won’t prevent a recession, but it should ensure businesses and consumers will be able to get back to work once the economy is restarted. If the shutdown lasts more than two or three months, Congress and President Trump appear more than willing to throw additional funds at the economy to help bridge the gap.
Markets rallied most of the week in anticipation of the stimulus package being approved, but now the focus becomes almost entirely centered on the Virus and efforts to contain its spread and “flatten the curve”. Most traders are typically focused on the financial markets with screens fixated on the tick by tick move in asset prices and yields. Now COVID-19 dashboards, like the one produced by John Hopkins University, and infection model curves, as produced by the Financial Times have become their main focus. As quoted by U.S. Director of the National Institute of Allergy and Infectious Diseases Dr. Anthony Fauci “You don’t make the timeline, the Virus makes the timeline”.
In order to determine how long social distancing measures need to remain in place, signs new infections have peaked and are starting to decline will be necessary before forecasters can become more confident in predicting an end to the recession and start determining the trajectory of the recovery. Italy will be a key barometer, and while it appears growth rates have slowed, new infections continue to rise despite stringent containment measures in place. Unfortunately, the U.S. appears to be following on a similar path.
While it’s true we don’t set the timeline, we do have a role in influencing the timeline. The form and compliance of the containment measures put in force play a large part of the ultimate efficacy in terms of duration and ultimate fatality rate of the outbreak. The success of both China and countries like South Korea and Taiwan appears based not just on social distancing, but aggressive testing and quarantining those infected. The U.S. appears slow to do both. Hopefully Canada is more proactive. Short of a break-thru in finding effective treatments to shorten hospital stays, the U.S. could find current containment measures will be needed for longer, and certain hot spots, like New York, could face a very tough decision in terms of who gets care and who does not.
Last week President Trump appeared to try and set out a timeline for America getting back to work by Easter. Largely denounced by the medical community, there is an economic argument that the cure could become more costly than the virus itself if the economy is shut down for too long. President Trump argues “the U.S. isn’t built to be shut down” and argues, as do others, more lives could be lost to suicide due to social distancing and the economic fallout. The reality is this isn’t really Trump’s call. State Governors and city Mayors will decide when businesses are able to open, and consumers will decide when they want to go back to their normal routine. Both are likely to take longer than anyone wants.
The rally last week was encouraging, as was action taken by central banks and governments. Pension fund rebalancing likely helped increase the demand for stocks and could continue to do so through month-end but volatility remains high. We wouldn’t be surprised if markets turn lower again over the next few weeks and test the lows. It’s what bear markets do, and negative reactions to what will undoubtedly be some horrific economic releases and higher infection rates could lead to eventual capitulation, which we have not seen yet. Perhaps the hardest part will be feeling like we are being held in a prison, waiting at home watching the infection numbers and hoping for parole when the promised turn and flattening occurs. As stated by Red (Morgan Freeman) in the movie Shawshank Redemption, “prison time is slow time”, but so far it hasn’t felt that way. Markets and news reports 24/7 have captivated our attention and elevated our stress levels. A little slow time could be good for all of us.
This material contains the current opinions of the author and such opinions are subject to change without notice. This material is distributed for informational purposes only. Forecasts, estimates, and certain information contained herein are based upon proprietary research and should not be considered as investment advice or a recommendation of any particular security, strategy or investment product. Nicola Wealth is registered as a Portfolio Manager, Exempt Market Dealer and Investment Fund Manager with the required provincial securities’ commissions. All values sourced through Bloomberg.