We hope that you and your families are staying safe and healthy through the COVID-19 outbreak. It is times like these that remind us to appreciate our families, friends, clients, and colleagues. While a timeframe on when the virus may be contained remains uncertain, with increased testing, the U.S. should follow a similar path as some of the Asian countries and Germany who have managed to tamp down spread of the virusi. In the meantime, we are all dealing with a great deal of uncertainty and disruption.
The sudden closure of so many businesses and increase in unemployment is placing a tremendous strain on families as well the economy as a whole. Given how dramatically this crisis has impacted not only people’s health and the healthcare system, but also the worldwide econ-omy, the post virus world could look very different. As the timeframe lengthens, some businesses will have trouble restarting, and many that do will emerge with increased levels of debt.
The U.S. equity markets peaked on February 20thii and have been in rapid decline as COVID-19 started to spread from Asia to Europe and then the United States. Cities in Northern Italy started to lockdown, and by March 8th the entire country was locked downiii. At the end of February, we saw an outbreak of cases in Washington state, and since then, the infection rate has increased exponentially across the U.S.iv, but most notably in New Yorkv. Several states have imposed stay-at-home orders, with work outside the home only permitted for essential industriesvi. President Trump, once hopeful for a return to work by Easter, has extended restrictions to the end of Aprilvii. As a result, huge parts of the economy, including airlines, cruise lines, hotels, restaurants, retailers, and other small businesses have halted with no certain end date in sightviii.
Small and mid cap stocks have been impacted more than large cap stocks, as many of the businesses hardest hit tend be smallerix. Companies with higher levels of leverage are also impacted, as there are concerns over declining cash flows and potential defaultsx. From a sector perspective, energy has been the hardest hit, with oil prices dropping more than 60% this yearxi. Banks have also been hurt by declining interest rates and loan exposure to the worst-hit areasxii. However, banks are in much better shape than 2008 and are well-capitalized to handle this downturnxiii. But there are some bright spots in industries that are benefitting from the work-from-home environment and the race to develop a vaccine. Technology, grocery stores, consumer products, pharmaceutical, medical supplies and testing, web streaming, and communications companies are seeing gainsxiv. Energy and financials are larger sectors in the value indexes, and with both sectors currently underperforming, value continued to underperform growth during the quarterxv.
China and Asia
Before COVID-19, China was struggling to deal with the effects of the two-year trade war with the U.S. Many industries in China, like housingxvi and auto sales,xvii had declined year over year and GDP growth had hit the lowest level in 29 years at 6.1%xviii. It is believed that COVID-19 originated in the Wuhan province of China, where 11 million people livexix. The country went into lockdown at the beginning of January, around the time of the Chinese New Yearxx. In late February, factories started to reopen and are now believed to be fully functionalxxi. Students are just beginning to return to classes, but many residents are still cautious about being in public. While economic signs are starting to improve, it is expected that the Chinese economy will be in a sluggish state for some time, and GDP growth may be low single-digit for the yearxxii. One interesting outcome is that the China A share stock market was only -9.1% for the quarter, which was one of the best performing equity marketsxxiii. Other large Asian economies such as South Korea adopted high levels of testing and quarantining to contain COVID-I9, and it appears they have done a good job controlling it, but their economies are hit equally hardxxiv.
As mentioned, the COVID-19 outbreak in Europe started in Italy and expanded rapidly to France, Spain, U.K., Switzerland, Germany, and Portugal. All of these countries are in total lockdown, with no travel in or outxxv. With the shutdown, GDP growth across the eurozone is expected to be negative for the first and second quarters, with the impact continuing into the summer travel seasonxxvi. There is a concern whether Italy may default on its debtxxvii. The European Central Bank (ECB) did not reduce its interest rate, as the benchmark rate is already at -0.5%xxviii, but they did approve an $850 million bond buying program of both government and corporate debtxxix. In similar fashion to Mario Draghi’s effort in 2012 to save the euro, the ECB’s current President Christine Lagarde has stated: “There are no limits to our commitment to the euro.”xxx We expect that we will see more stimulus programs if the European economies continue to be shut down for extended periods of time.
In addition to COVID-19 stress, Saudi Arabia and Russia, two of the largest oil producers, refused to extend the production cuts that expired at the end of Marchxxxi. Furthermore, Saudi Arabia has indicated it will increase production and has slashed customer prices xxxii. The oil price has declined from $60/barrel to $20/barrelxxxiii. Even the best U.S. oil producers don’t have cost levels that low, and energy company shares have declined by 50% or more this yearxxxiv. Energy production is critical to the U.S., and we believe there will be increased bankruptcies and consolidations the longer oil prices remain this low.
U.S. Fixed Income
While the bond sector tends to have lower returns and lower volatility than equities, we saw more volatility than normal in March. The 10-year U.S. Treasury bond yield fluctuated from 1.5% at the beginning of the yield down to 0.5%, back up to 1.2% and now back to 0.7%xxxv. Meanwhile, bonds with any credit exposure, such as investment-grade corporate bonds, high yield, leveraged loans, and even municipal bonds sold off as investors raced to move money into money market accounts over concerns of rating downgrades and borrower defaultsxxxvi. There were even liquidity issues in the overnight commercial paper and repo markets as the banks were reluctant to lendxxxvii. As a result, the only “safe place” was longer dated Treasury bonds during the quarterxxxviii. Even shorter-term Treasury bonds were trading at negative rates, given how low interest rates have gonexxxix.
U.S. Federal Reserve and Government Stimulus
In response to the volatile equity markets and liquidity concerns in the fixed income markets, the Federal Reserve has taken a series of measures that were last seen in the 2008 Great Financial Crisis (GFC)xl. The Fed reduced interest rates twice in March, so the benchmark interest rate is close to 0%. They have provided unlimited support to the repo market and have increased quantitative easing (QE) by making large scale purchases of all bonds, including investment-grade corporate bonds and ETFsxli. Through all of these measures, the Fed’s balance sheet is over $5.3 trillionxlii. The highest the Fed balance sheet got previously was in May 2016 at $4.6 trillionxliii. The Fed reiterated it would do whatever it takes to support the markets. On the fiscal side, Congress passed the $2 trillion CARESares Actxliv at the end of March. This is supposed to provide individuals with cash payments and extra unemployment benefits, loans for small businesses and corporations directly impacted by the shutdown, as well as to state and local governments responding to COVID-19xlv. We expect that Congress will step in with additional fiscal stimulus.
Safe Havens: Gold /U.S. Dollar
Through the volatility, the real safe havens have been gold and the U.S. Dollar, but even those asset classes fluctuated in price over the quarter. The U.S. Dollar Index (DXY), which stood at $96.85 at the beginning of the year, reached $102.82 in March before dropping to $99.05 at quarter-end, but ended up 3% for the quarterxlvi. Gold was equally up and down, but the $/oz ended up 4.2% for the quarterxlvii.
At Anchor, we view this as an opportunity to invest as we see attractive valuations. The investment team is encouraged by what they are seeing and will buy when others are selling. Anchor has seen clients through these market downturns before, and one of the important things we learn each time is that markets do recover, and it’s important to stay invested. We are here to help, and we are available to talk about whatever is on your mind. Please don’t hesitate to reach out. Stay safe and healthy.
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