First of all, our prayers are that you and your families are staying safe. We are living through a strange and unprecedented time. Just a few of months ago, we were looking at calm markets with a slowing but growing economy. That quickly changed as COVID-19 hit the US, and the economy basically shut-down. The impact on financial markets was severe. Never have US financial markets displayed the kind of volatility in such a short period of time. In a matter of weeks, the market dropped almost 40% and then quickly recovered much of the ground it had lost. Along the way, we witnessed asset price fluctuations like we have never seen before, including during the 2008 Financial Crisis.
With financial markets struggling, the Federal Reserve stepped in with a massive volume of purchases, expanding its balance sheet by $2 trillion in less than a month. It took years for that to happen after the Financial Crisis in 2008. To provide the economy and individuals some support, the Federal Government also stepped in to provide stimulus checks for individuals and payroll support loans for businesses. Never has there been a greater effort from the Federal Reserve and the Federal Government to prop up an economy.
All of this makes the future more uncertain than usual. The modern world has never experienced a period where the global economy shut down for months, and no one alive today has faced a pandemic of this magnitude. This leaves a lot of questions about how events will play out: How long will it take for the economy to “re-open?” Will there be a resurgence or a second wave of COVID-19? How soon will a vaccine or treatment be available? How much damage has been done to the economy? How willing will people be to return to normal social activities? And longer-term, what effect will all this new debt have on economic growth going forward? These questions are being weighed and considered in the press and by governments around the world but knowing the answers just isn’t possible. The innumerable predictions, the media commentary, and government talking points are all just speculation. Valuable speculation (that’s a rare thing) but still speculation. Even in uncertainty, there are a few things we can have a high degree of confidence in, which have informed and will continue to inform our decisions about how to handle portfolio allocations going forward.
First, the US economy and the global economy will recover but it will take some time. Financial markets seem to be pricing in a “V-shaped” economic recovery: the economy crashed quickly, and it will jump right back up. We see that as optimistic. It may be a V-shaped recovery, but it’s going to look like a V my five-year-old wrote, meaning that the right side of the V is going to look very different than left side. Parts of the economy are at an absolute standstill and re-starting does not happen with the flip of a switch. A strong initial jump is possible, even likely, but it will take time for people to fully return to their normal activities. The 30+ million recently unemployed will not all find their jobs waiting for them. It took 3 years for GDP to recover after the 2008 Financial Crisis. We would not be surprised if this recovery were to take that long, or longer.
Second, and related to the first point, a lot of bad economic data and corporate earnings reports will come out over the next few months. Again, estimates on how bad are all over the board. We have seen estimates ranging from a 10% total reduction in GDP to a 40% total reduction in GDP. Corporate earnings will not look any better. Over the next few months, we will begin to understand the toll levied against the economy. As we have said many times before, we cannot predict what the market is going to do over the next few months, but as of right now, financial markets appear to be overly optimistic. We believe there is more pain to come in the markets as the damage assessment becomes clearer.
Third, this situation will result in winners and losers among countries and companies. Countries with the capacity to spend financial reserves, take on more debt and expand their monetary base without immediate adverse consequences will probably come out of this ok. In contrast, over-indebted countries with insufficient financial reserves will have a much more difficult time. Similarly, companies with strong balance sheets and a capacity to spend during this crisis to increase market share will ultimately come out of this stronger. In contrast, smaller companies or over-leveraged companies will struggle to access cash or, in the event Federal Reserve keeps bond markets liquid, will come out of this with more debt and less cash flow.
Fourth, corporate debt markets will be volatile. Market reactions in March shined a big spotlight on the corporate debt market asset bubble that we noted back in our 2018 Q4 commentary. Certain areas of the bond market dropped precipitously in price. Actions taken by the Federal Reserve brought some calm to those markets, but the problems are not going away. Coming into 2020, corporate defaults were on the rise and Rating Agencies were warning of a coming wave of rating downgrades. Now that the global economy has shut down for two months, we should expect even more corporate defaults and ratings downgrades.
Lastly, the Federal Reserve and the Federal Government will continue to pull out all stops to support the economy. As we noted above, the concerted efforts by these two institutions to provide liquidity in the markets and stimulus to the economy has been unprecedented. This will continue, although the pace of help from the Federal Government will likely slow as the process to pass stimulus packages becomes increasingly politicized.
With those factors in mind, we will continue to hold our high-quality positions and look to be opportunistic about buying high quality growth assets at reasonable prices. We have already executed on a few opportunities and if market volatility persists, more of those opportunities should come around. It’s important to note here that we are looking for good long-term opportunities. New positions may experience immediate priced declines, but if done correctly, these opportunities will pay handsomely in the long run. We have also made some adjustments in the portfolios to take advantage of the dislocations that are likely to occur in the corporate bond market.
Hovering over these decisions are the actions taken by the Federal Reserve which will continue to have implications across financial markets. For comparison, in the wake of 2008 Financial Crisis, as the Federal Reserve pumped liquidity into the financial system, markets shrugged off poor economic data and began to climb. We are mindful this could happen again. Given the uncertainty, we need to carefully manage risk while maintaining exposure to potential market growth. The weeks ahead are likely to be challenging, regardless of what the market does. Each one of us is having to live through this situation in our own way. For some of us, this virus presents very little risk to life or livelihood. For others, the risk is high. Many of us probably haven’t left the house for 5 or more weeks, except to get groceries. That’s hard for some of us but enjoyable for others. Some of us work in healthcare or have an essential job that requires going to work and risking exposure. We want to thank you for risking yourself and your loves one on others’ behalf. Whatever your situation, our prayers are with you. We will continue to look for opportunities to investment capital at acceptable levels of risk.