Economy & Markets
Market Thoughts: The resilience of humanity
Today we are playing active defense. Early stage recovery is somewhere on the horizon, but we aren’t there yet.
The video was filmed on April 22, 2020.
Text on screen:
MAY 2020. Market Thoughts: THE RESILIENCE OF HUMANITY
Ms. Rooney:
Text on screen:
Nancy Rooney, Global Head of Managed Solutions. J.P. Morgan Private Bank
Ms. Rooney:
Thank you for joining us for a special edition of Market Thoughts. These are challenging times that we’re in and, and they go far beyond financial markets and, and financial measurement. And while they’re unprecedented and they’re unsettling, the volatility that they’ve brought isn’t new to us. And so, to discuss them, as well as how we’re positioned in our portfolios I’m delighted to be joined, at home, um, by our CIO Richard Madigan. So, Richard, but before we jump into markets, I think it’s helpful maybe to give some context.
Text on screen:
Richard Madigan, Chief Investment Officer, J.P. Morgan Private Bank
Ms. Rooney:
And we began the year overweight equities in our portfolios by about 2%. As the COVID news started to comeout, we moved to neutral in early March. And then, shortly thereafter, went to an 8% underweight as the virus shifted from something that was thought to originally be contained in Asia to something that had the makings of what it is now, which is a global pandemic. And, uh, since that time we have seen equity and fixed income markets bounce around a lot. And, most recently, we’ve seen equities bounce 20 to 25% off their, their lows. As more and more details around, uh. . . emerge around the healthcare implications. And, and so with all eyes kind of rightfully focused on the personal toll that this is taking across the world, I wanna spend some time with you talking about the economic toll and ultimately like what it means for portfolios. So, so maybe a good place for us to start is just around what the Fed and some of the other central governments have done as a response.
Mr. Madigan:
I think it’s important to kind of emphasize, I think, all policymakers learned a lot from the financial crisis and U.S. policymakers in particular. If I had to pick a mantra, uh, for it, I think, it’s now move fast and didn’t break things. Uh, the response has been incredibly comprehensive, and that’s not only from a monetary perspective, so central banks and the Fed, as you emphasized, but also fiscally. And I actually think the fiscal easing, the fiscal response is going to be the one that is the most important in sustaining the economy through the next quarter or two. Um, but I’m saying that recognizing that the Fed is probably, in particular, um, really focused on making sure that liquidity is back in treasury markets and core bonds, and the actions we’ve seen have been incredibly supportive for credit markets, which were almost under distressed conditions in late March and early April. Um, the good and the bad news from Washington’s perspective, uh, and what happens with regard to fiscal policy, I think, is, uh, we’re in a spend-whatever-it-takes mode. And so, while you’re watching the Fed focused on zero interest rates, I think Washington is focused on unemployment checks to keep income coming in as best they can in small and medium-sized enterprises, so that we don’t lose too many businesses along the way. Um, I say all that constructively, but I also want to recognize there’s a cost that’s associated with this. So, there’s going to be a bill to pay with regard to extending debt to GDP, and what that means to the broad ecomony. But, but I think the costs of not acting, uh, as aggressively as we’re seeing policy actions right now, is far greater than no action.
Ms. Rooney:
So the Fed drop rates to zero.
Mr. Madigan:
Yes.
Ms. Rooney:
I think it’s probably fair to say that we’re going to be in a low interest rate environment for a while. If I’m gonna. . .not gonna earn that much on fixed income, wouldn’t I be better off just taking to the easy trade-in and putting that piece in cash?
Mr. Madigan:
So the, the favorite uh, Madigan word is “Optionality,” and you get optionality in bonds. We talk all the time about the fact that interest rates are low, but bonds are actually out-yielding cash, so don’t lose sight of that. Um, the optionality dynamic fills in, with regard to bonds, is a risk diversifier. And, again I know the yield is unexciting, but I can tell you that the duration that we’ve held in portfolios through all of the volatility that we’ve seen, over the course of the last three months and, and longer, um, has helped buffer drawdown. So, bonds are doing exactly what I want them to be doing right now. Now, you start to think about the cash versus the core bond dynamic, when I’m worried about inflation. So as inflation comes back into the equation, uh, then we’ll be much more watchful of that dynamic between full duration and short duration. But, quite honestly, over the next nine to 12 months, I think I’m more concerned about slower growth and disinflation, than I am whatsoever in inflationary shocks.
Ms. Rooney:
Now you, you recently started to build a position in high yield.
Mr. Madigan:
Yep.
Ms. Rooney:
And, when I look at that, I guess I immediately think, Hey, does, does that mean that it’s kind of safe to go back into the market?
Mr. Madigan:
The most important positioning for me right now in portfolios, uh, if you want to read a view is the fact that we’re underweight equities. So, like I’m still playing what I’m gonna call proactive defense around risk-taking in markets. Um, we added the high yield in late March when credit spreads blew out. And we just simply felt that default risk was exaggerated. We sold out of high-yield last year and stepped back from it. We’re now beginning to rebuild positions in high-yield. So, I guess it’s a first salvo to rebuilding risk positions in a portfolio. I’m also using it to barbell against core bonds to add a little bit more yield or carry into portfolios, because I can put a higher probability certainty of return on an income stream than I can the variability of risk assets whether that be extended credit, or its equity markets.
Ms. Rooney:
Yeah.
Mr. Madigan:
So I expect this to continue to build into those portfolios when we’re. . .we see the right opportunities. But there’s an awful lot of things that are still unknown out there.
Ms. Rooney:
You started to build some of those defensive properties within the equity components of a portfolio last year.
Mr. Madigan:
Yes.
Ms. Rooney:
And, as I look at how things are evolving now, it looks like you’re overweight to the U.S., which you’ve had for a while, um, is even higher than it was before, is, is that a statement about the U.S., or a statement about other places?
Mr. Madigan:
Both.
Ms. Rooney:
Yes (laughs).
Mr. Madigan:
Um, and I’m not being cute on that, but I, I think it, it’s meant to be a big statement about some of the policy response that we've talked about and the U.S. probably being the most assertive and proactive. So, ironically, I’m leaning further into the U.S., uh, with the view that it’s the more defensive allocation. And I actually think the one that can come out faster, uh, as we start to stabilize the economy and it gradually begins to recover. Um, within that, you mentioned some of the things that we’ve been positioned around defensively last year. Um, healthcare remains a sector in the U.S. that we’re leaning into strongly with defensive characteristics and feel good about. Technology is as well and specifically within technology the cloud. I think the real wild card right now though for everyone is going to be earnings this year.
Ms. Rooney:
How do I know if markets are expensive or cheap if you don’t have earnings and, and CEOs don’t really want to give guidance because they don’t know?
Mr. Madigan:
The short answer is you don’t. And, so, I question anyone that is pretending to have a view on relative cheapness or how expensive a market is this year right now. We simply don’t have that visibility. You need earnings to have a view on multiples and valuations and we don’t have them. And literally as we’re going through this earning season and talking to companies, the number of companies that are just pulling guidance for this year is astounding. And by the way, they’re doing it for the right reasons, they just don’t have the visibility around it. I think the structural thing that’s changed from the markets perspective and for investors is the policy response we’ve talked about, because it has been so assertive that what investors in the market are doing right now is basically writing off this year. They’ve said, “We don’t have visibility, we don’t understand it, but we believe that the extreme left tail will be curtailed with regard to staying in recession and not that becoming something worse.” What that’s allowing investors to do is look into 2021 and even 2022, just to get an anchoring for the fact on where do they think we recover to and then what multiple can you factor into that? But there’s more guesswork in that from everyone right now than there is any certainty.
Ms. Rooney:
If I’m a client, what I, I guess what I would really want to know is, as you sit here today, would you think stocks are higher as we look out the next year or two?
Mr. Madigan:
I believe they will. And I think that’s a really important point, because if I didn’t, we’d actually have a higher underweight in our equity positions right now. Um, these are really unprecedented times, so any pretense of certainty right now around almost anything, I challenge an awful lot in terms of being caution. And, and that reflects the caution we’re taking in portfolios as well. Um, as I, I’ve kidded you a thousand times, I’m passionate about a lot of things in life, uh, but never around markets.
Ms. Rooney:
As you think about that recovery phase that that would change some of your underlying positions, are you looking at that or, or am I too early in even asking that question?
Mr. Madigan:
So, you’re early in asking it and we’re early in looking at it. Um, because I want to manage expectations on, on kind of how we get there. And you’ve heard me also say a thousand times, we’re active managers. So, I always want to be anticipating where I think we’re going in the market cycle and where there are opportunities. Um, wh- the intent is to rebuild risk positions. And we talked a little bit about that with regard to high yield and extended credit. The next logical step is starting to reduce our equity underweight. We’ve actually just begun to do that this week. Um, so again, good leading indicator in terms of stepping back up into markets. Um, I also got a shopping list with the team. And I think that two things that stand out if I had to pick them right now, um, the U.S. financial sector, and industrials. Those are two areas that are. . .have been under tremendous amount of pressure and on that 18- to 24-month horizon, I think offer an awful lot of value, uh, in terms of opportunity.
Ms. Rooney:
I think the news and the events of our times has shaken financial markets and all of us, um, and as you’ve heard from Richard, we’ve responded accordingly in our portfolios.
Ms. Rooney:
So, let me see if I can put all those pieces together. The next few months bring the possibility of, of more downside as markets factor in the economic impact of reopening our global economy, which is why we’re cautiously positioned with an equity underweight. Um, but that has started to shift. Since establishing that original underweight, we’ve added a little bit of equity back, we’ve started, um, most notably in the form of high-yield which offers the ability to gain equity-like returns with potentially less risk in, in that process. And while it is early days, uh, that trade is working as broader fixed-income markets stabilize.
Richard Madigan
Yep.
Nancy Rooney:
Within equities, we maintain our overweight to the U.S., which entered the crisis in the strongest financial position and likewise we’d expect to emerge the fastest. Longer term we remain cautiously optimistic but pragmatic to know that there will be bumps along the way. Um, but we’re prepared for that in our portfolio as we’ve been through previous crises. But all of us are here to help you make informed decisions, not just about your portfolios, but about all of your financial goals. And I know I speak for Richard as well when I say please don’t hesitate to contact us with any questions or concerns as we all do our best to stay ahead of developments in our rapidly changing world. Thank you and thank you, Richard.
Richard Madigan:
Thanks, Nancy.
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Text on screen:
MAY 2020. Market Thoughts: THE RESILIENCE OF HUMANITY
Ms. Rooney:
Text on screen:
Nancy Rooney, Global Head of Managed Solutions. J.P. Morgan Private Bank
Ms. Rooney:
Thank you for joining us for a special edition of Market Thoughts. These are challenging times that we’re in and, and they go far beyond financial markets and, and financial measurement. And while they’re unprecedented and they’re unsettling, the volatility that they’ve brought isn’t new to us. And so, to discuss them, as well as how we’re positioned in our portfolios I’m delighted to be joined, at home, um, by our CIO Richard Madigan. So, Richard, but before we jump into markets, I think it’s helpful maybe to give some context.
Text on screen:
Richard Madigan, Chief Investment Officer, J.P. Morgan Private Bank
Ms. Rooney:
And we began the year overweight equities in our portfolios by about 2%. As the COVID news started to comeout, we moved to neutral in early March. And then, shortly thereafter, went to an 8% underweight as the virus shifted from something that was thought to originally be contained in Asia to something that had the makings of what it is now, which is a global pandemic. And, uh, since that time we have seen equity and fixed income markets bounce around a lot. And, most recently, we’ve seen equities bounce 20 to 25% off their, their lows. As more and more details around, uh. . . emerge around the healthcare implications. And, and so with all eyes kind of rightfully focused on the personal toll that this is taking across the world, I wanna spend some time with you talking about the economic toll and ultimately like what it means for portfolios. So, so maybe a good place for us to start is just around what the Fed and some of the other central governments have done as a response.
Mr. Madigan:
I think it’s important to kind of emphasize, I think, all policymakers learned a lot from the financial crisis and U.S. policymakers in particular. If I had to pick a mantra, uh, for it, I think, it’s now move fast and didn’t break things. Uh, the response has been incredibly comprehensive, and that’s not only from a monetary perspective, so central banks and the Fed, as you emphasized, but also fiscally. And I actually think the fiscal easing, the fiscal response is going to be the one that is the most important in sustaining the economy through the next quarter or two. Um, but I’m saying that recognizing that the Fed is probably, in particular, um, really focused on making sure that liquidity is back in treasury markets and core bonds, and the actions we’ve seen have been incredibly supportive for credit markets, which were almost under distressed conditions in late March and early April. Um, the good and the bad news from Washington’s perspective, uh, and what happens with regard to fiscal policy, I think, is, uh, we’re in a spend-whatever-it-takes mode. And so, while you’re watching the Fed focused on zero interest rates, I think Washington is focused on unemployment checks to keep income coming in as best they can in small and medium-sized enterprises, so that we don’t lose too many businesses along the way. Um, I say all that constructively, but I also want to recognize there’s a cost that’s associated with this. So, there’s going to be a bill to pay with regard to extending debt to GDP, and what that means to the broad ecomony. But, but I think the costs of not acting, uh, as aggressively as we’re seeing policy actions right now, is far greater than no action.
Ms. Rooney:
So the Fed drop rates to zero.
Mr. Madigan:
Yes.
Ms. Rooney:
I think it’s probably fair to say that we’re going to be in a low interest rate environment for a while. If I’m gonna. . .not gonna earn that much on fixed income, wouldn’t I be better off just taking to the easy trade-in and putting that piece in cash?
Mr. Madigan:
So the, the favorite uh, Madigan word is “Optionality,” and you get optionality in bonds. We talk all the time about the fact that interest rates are low, but bonds are actually out-yielding cash, so don’t lose sight of that. Um, the optionality dynamic fills in, with regard to bonds, is a risk diversifier. And, again I know the yield is unexciting, but I can tell you that the duration that we’ve held in portfolios through all of the volatility that we’ve seen, over the course of the last three months and, and longer, um, has helped buffer drawdown. So, bonds are doing exactly what I want them to be doing right now. Now, you start to think about the cash versus the core bond dynamic, when I’m worried about inflation. So as inflation comes back into the equation, uh, then we’ll be much more watchful of that dynamic between full duration and short duration. But, quite honestly, over the next nine to 12 months, I think I’m more concerned about slower growth and disinflation, than I am whatsoever in inflationary shocks.
Ms. Rooney:
Now you, you recently started to build a position in high yield.
Mr. Madigan:
Yep.
Ms. Rooney:
And, when I look at that, I guess I immediately think, Hey, does, does that mean that it’s kind of safe to go back into the market?
Mr. Madigan:
The most important positioning for me right now in portfolios, uh, if you want to read a view is the fact that we’re underweight equities. So, like I’m still playing what I’m gonna call proactive defense around risk-taking in markets. Um, we added the high yield in late March when credit spreads blew out. And we just simply felt that default risk was exaggerated. We sold out of high-yield last year and stepped back from it. We’re now beginning to rebuild positions in high-yield. So, I guess it’s a first salvo to rebuilding risk positions in a portfolio. I’m also using it to barbell against core bonds to add a little bit more yield or carry into portfolios, because I can put a higher probability certainty of return on an income stream than I can the variability of risk assets whether that be extended credit, or its equity markets.
Ms. Rooney:
Yeah.
Mr. Madigan:
So I expect this to continue to build into those portfolios when we’re. . .we see the right opportunities. But there’s an awful lot of things that are still unknown out there.
Ms. Rooney:
You started to build some of those defensive properties within the equity components of a portfolio last year.
Mr. Madigan:
Yes.
Ms. Rooney:
And, as I look at how things are evolving now, it looks like you’re overweight to the U.S., which you’ve had for a while, um, is even higher than it was before, is, is that a statement about the U.S., or a statement about other places?
Mr. Madigan:
Both.
Ms. Rooney:
Yes (laughs).
Mr. Madigan:
Um, and I’m not being cute on that, but I, I think it, it’s meant to be a big statement about some of the policy response that we've talked about and the U.S. probably being the most assertive and proactive. So, ironically, I’m leaning further into the U.S., uh, with the view that it’s the more defensive allocation. And I actually think the one that can come out faster, uh, as we start to stabilize the economy and it gradually begins to recover. Um, within that, you mentioned some of the things that we’ve been positioned around defensively last year. Um, healthcare remains a sector in the U.S. that we’re leaning into strongly with defensive characteristics and feel good about. Technology is as well and specifically within technology the cloud. I think the real wild card right now though for everyone is going to be earnings this year.
Ms. Rooney:
How do I know if markets are expensive or cheap if you don’t have earnings and, and CEOs don’t really want to give guidance because they don’t know?
Mr. Madigan:
The short answer is you don’t. And, so, I question anyone that is pretending to have a view on relative cheapness or how expensive a market is this year right now. We simply don’t have that visibility. You need earnings to have a view on multiples and valuations and we don’t have them. And literally as we’re going through this earning season and talking to companies, the number of companies that are just pulling guidance for this year is astounding. And by the way, they’re doing it for the right reasons, they just don’t have the visibility around it. I think the structural thing that’s changed from the markets perspective and for investors is the policy response we’ve talked about, because it has been so assertive that what investors in the market are doing right now is basically writing off this year. They’ve said, “We don’t have visibility, we don’t understand it, but we believe that the extreme left tail will be curtailed with regard to staying in recession and not that becoming something worse.” What that’s allowing investors to do is look into 2021 and even 2022, just to get an anchoring for the fact on where do they think we recover to and then what multiple can you factor into that? But there’s more guesswork in that from everyone right now than there is any certainty.
Ms. Rooney:
If I’m a client, what I, I guess what I would really want to know is, as you sit here today, would you think stocks are higher as we look out the next year or two?
Mr. Madigan:
I believe they will. And I think that’s a really important point, because if I didn’t, we’d actually have a higher underweight in our equity positions right now. Um, these are really unprecedented times, so any pretense of certainty right now around almost anything, I challenge an awful lot in terms of being caution. And, and that reflects the caution we’re taking in portfolios as well. Um, as I, I’ve kidded you a thousand times, I’m passionate about a lot of things in life, uh, but never around markets.
Ms. Rooney:
As you think about that recovery phase that that would change some of your underlying positions, are you looking at that or, or am I too early in even asking that question?
Mr. Madigan:
So, you’re early in asking it and we’re early in looking at it. Um, because I want to manage expectations on, on kind of how we get there. And you’ve heard me also say a thousand times, we’re active managers. So, I always want to be anticipating where I think we’re going in the market cycle and where there are opportunities. Um, wh- the intent is to rebuild risk positions. And we talked a little bit about that with regard to high yield and extended credit. The next logical step is starting to reduce our equity underweight. We’ve actually just begun to do that this week. Um, so again, good leading indicator in terms of stepping back up into markets. Um, I also got a shopping list with the team. And I think that two things that stand out if I had to pick them right now, um, the U.S. financial sector, and industrials. Those are two areas that are. . .have been under tremendous amount of pressure and on that 18- to 24-month horizon, I think offer an awful lot of value, uh, in terms of opportunity.
Ms. Rooney:
I think the news and the events of our times has shaken financial markets and all of us, um, and as you’ve heard from Richard, we’ve responded accordingly in our portfolios.
Ms. Rooney:
So, let me see if I can put all those pieces together. The next few months bring the possibility of, of more downside as markets factor in the economic impact of reopening our global economy, which is why we’re cautiously positioned with an equity underweight. Um, but that has started to shift. Since establishing that original underweight, we’ve added a little bit of equity back, we’ve started, um, most notably in the form of high-yield which offers the ability to gain equity-like returns with potentially less risk in, in that process. And while it is early days, uh, that trade is working as broader fixed-income markets stabilize.
Richard Madigan
Yep.
Nancy Rooney:
Within equities, we maintain our overweight to the U.S., which entered the crisis in the strongest financial position and likewise we’d expect to emerge the fastest. Longer term we remain cautiously optimistic but pragmatic to know that there will be bumps along the way. Um, but we’re prepared for that in our portfolio as we’ve been through previous crises. But all of us are here to help you make informed decisions, not just about your portfolios, but about all of your financial goals. And I know I speak for Richard as well when I say please don’t hesitate to contact us with any questions or concerns as we all do our best to stay ahead of developments in our rapidly changing world. Thank you and thank you, Richard.
Richard Madigan:
Thanks, Nancy.
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IN BRIEF:
Market Outlook
- Markets will likely remain volatile as investors digest the effects of COVID-19 on economies, earnings and default risk.
- Policymakers have shown their commitment to supporting the economy through this crisis and preventing a recession from becoming something worse.
- I don’t believe we are seeing a conventional recession. For the next few months, the single most important thing for markets is that investors remain focused on what lies ahead.
Portfolios
- We actively manage portfolios. Right now, we are playing active defense. There are too many unknowns to be aggressively leaning into risk assets.
- The two most important positions we hold are our equity underweight and a full duration allocation to core bonds. All of our equity underweight is in markets outside of the United States.
- We’re no longer “late stage” in the cycle. We’ve just hit reset, we’re in recession. Gradually, investors will begin to shift focus to early-stage recovery. We’re not there yet.
Move fast, don’t break things
I’m in awe of the speed at which U.S. policymakers have been moving when it comes to both fiscal and monetary policy. They learned a lot from having been too slow in responding to the global financial crisis in 2008–2009. Move fast and don’t break things is the policy directive. We’ll reconcile costs later, right now it’s about preventing a recession from becoming something worse. But there’s going to be a bill to pay.
I have never seen a market move at the pace we are seeing currently, or U.S. policymakers act with such force. I wish I could say the same about Europe and other developed and developing economies. Facts—not hope—should drive policy direction and pace, not to mention investment strategy. There is a lot to be said for recognizing what you can’t know in preparing for the worst.
We moved to a significant underweight in equity positions as it became increasingly evident it wasn’t just Asia that was facing a real threat from COVID-19 contagion, but the global economy as well. Any confidence in a quick V-shaped economic recovery faded as COVID-19 began to flare up across Europe and the United States.
We actively manage portfolios, both in how and where we take risk. Right now, we are playing active defense. This event is different from the fourth-quarter of 2018, when we expected equity markets to quickly recover from a panicked year-end sell-off. This is something bad that can get worse. There are too many unknowns at the moment to be aggressively leaning into risk.
The two most important tactical positions we hold across portfolios are our equity underweight and a full duration allocation to core bonds. All of our equity underweight comes from markets outside of the United States. And while there is nothing exciting about core bond yields, high-quality bonds continue to act as an important risk diversifier, helping to cushion portfolios in market drawdowns.
Core bonds are yielding more than cash. Additionally, the optionality they provide as portfolio insurance shouldn’t be understated. There will come a time when it makes sense to shorten portfolio duration, but that will happen when the global economy is in recovery and we begin to see inflationary pressure.
For the next 9–12 months, I am more concerned about stalled global growth and disinflation. Leading indicators including business surveys and consumer confidence data continue to signal that inflation isn’t something to be uneasy about currently.
Unprecedented and historic
Unprecedented and historic seem the operative words for almost everything happening right now. You can only say “bad” in so many ways. I believe we will continue to see as much monetary and fiscal stimulus as needed. Policy easing won’t slow the spread of the coronavirus or directly influence how soon the global economy can be restarted, but it can act as a bridge to help get the economy through this.
The top five U.S. banks have announced over $20bn in initial loan loss and credit provisioning. European banks can’t afford to take the kind of loss provisions we’ve seen in the United States. They don’t have the earnings. The European Central Bank (ECB) has signaled that bank provisioning can assume an economic rebound this year and use ECB economic forecasts made before Europe was put into economic lockdown. That’s troubling.
We’ve begun to see the extraordinarily negative economic consequence of governments putting the global economy effectively into a state of suspended animation. Europe faces a deep recession. We expect to see growth contract by at least 5% this year, but it may end up being as large as an 8–10% contraction. In the United States, I am working with a base case forecast of approximately a 3% contraction this year. Because we don’t know how long the current economic lockdown will continue—or if the virus will return in a second wave—any economic forecast today is at best fluid.
The same can be said about corporate earnings. No one knows, starting with companies, how to give effective earnings guidance. That uncertainty is an important mental marker when you hear someone say equity markets are cheap or expensive. That remains to be proven with 2021 and 2022 earnings.
Worse before better, but then better
It is likely that the current global economic collapse will be the largest since the Great Depression. The IMF said as much when they recently revised down their outlook for global growth this year to a 3% contraction. China announced its economy fell 6.8% y/y in the first-quarter, after more than 40-years of uninterrupted full-year growth.
Reflexivity is a term credited to George Soros. The man behind the theory was Rudi Dornbusch. Dornbusch once said: “In economics, things take longer to happen than you think they will, and then they happen faster than you thought they could.” That’s a fair summary of the challenges investors face today in trying to discern the lasting drag COVID-19 will place on the global economy.
I mention reflexivity because I think it’s a concept worth keeping in mind, in particular if markets remain under pressure. The basic concept behind reflexivity is that technicals can, at extreme points, overwhelm and redefine fundamentals. We’ve seen some of that happen already in bond markets.
One of the things that had me concerned about the downside risk across markets was the pressure we saw building in fixed income. That was the case not only across credit markets, but government bonds as well. When you see both equity and bond markets selling off together, as we saw in periods recently, that’s a very strong sign that things are deteriorating quickly. It is an indication that technicals are beginning to overpower fundamentals.
Do whatever it takes and more
I credit recent stabilization across markets to action taken by the Federal Reserve (Fed) to directly support the critical pain points where the fixed income market was under incredible pressure. Mario Draghi was just “upped” in policy gamesmanship by Jay Powell. Do whatever it takes and more. European policymakers should take notice.
The Fed announced a wide range of new facilities to support the flow of credit across the economy. This includes direct support for large cities, counties and states with up to two-year bridge financing should local governments need it.
They announced the Main Street Lending Facility, which will buy small and medium sized business loans, as well as a program to lend against Payroll Protection Program loans being made via banks. That will help free up bank balance sheets to lend to small and medium sized enterprises. More lending is going to be needed.
The Fed broadened the range of eligible assets they will purchase to include investment grade credit that was downgraded to sub-investment grade since March 22 and ETFs in high yield. They will buy AAA-rated tranches of CMBS and newly issued CLOs. That has helped alleviate some market stress.
What lies ahead
The Fed has stabilized fixed income markets. I believe this has reduced the left-tail risk hanging over markets. It wasn’t simply what they did but the fact that they emphasized their commitment is open-ended. As bad as the economic data gets, the Fed views their role as helping to navigate the U.S. economy through this crisis without allowing it to break. That is reassuring investors.
Several weeks ago the downside to equity markets appeared several times greater than the upside. Now, that balance has improved. The Fed cut the extreme left-tail risk overhanging markets. That’s allowed investors to shift attention from fairly violent intra-day equity market swings to looking ahead.
Because of that shift in tail risk, not only have we modestly trimmed our equity underweight but we’ve started to rebuild an investment position in extended credit. We actively reduced risk across portfolios last year as markets continued to climb higher. That included selling out of all high yield exposure. When credit spreads gapped out in late March, we bought high yield credit. We may continue to add to those positions.
Markets are forward looking; hard economic data is backward looking. While recent economic data has generally been worse than expected, investors right now are looking through it. The next month of market trading is going to be particularly important to watch. Equity markets feel ahead of themselves. They’ve moved far, fast.
The dispersion in views around 2020 earnings is less important today because investors are looking through 2020, into 2021 and 2022. There is going to be some dynamic tension introduced into the investor patience equation should markets press higher as data continues to deteriorate.
I don’t believe we have a short and sharp V-like bounce back in front of us for the global economy. I’m going to jump ahead of the National Bureau of Economic Research and say the U.S. economy is in recession. But I don’t believe we are looking at a conventional recession. I say that as good news, not bad. It all depends on when the global economic engine is restarted.
Something interesting happened that hasn’t yet been fully processed by investors. We’re no longer “late stage” in the macro and market cycle. We’ve hit reset, we’re in recession. Gradually investors will start to shift their focus to early stage recovery. We’re not there yet, but it’s on the horizon.
Earnings matter, so do valuations. But for the next few months, the single most important thing for markets is that investors remain focused on what lies ahead. I expect recurring bouts of volatility. I would be surprised if we didn’t see a few meaningful air pockets. Equity volatility has come down from recent highs but it remains near the top of its historical range.
Just like finding a market bottom is a process, so is rebuilding confidence. I’m counting on the resilience of humanity to see us through this.
