Relatively outperforming sectors in the first quarter, all of which were down by over 10% on an absolute basis, include Information Technology, Health Care, and Consumer Staples while performance lagged the most in Energy, Financials, and Industrials. The unprecedented speed and depth of the market collapse, which resembled those experienced in 1987 and 1929, left investors with few sectors or even asset classes in which to hide.
Volatility and correlation, or the degree to which stocks move together, reached all-time highs in the quarter due to panicked, indiscriminate selling, and was exacerbated by algorithmic/quantitative fund trading. The “VIX” fear gauge, which is normally well below 20, hit a record level above 82. Additional “plumbing” issues arose within the financial markets, and the government was forced to step in and stabilize the market and assist millions of Americans and businesses affected by the forced shutdown of the economy.
China first disclosed the novel COVID-19 in January, just as signs of a global economic acceleration were beginning to emerge, and the virus quickly spread around the world. While aggressive social distancing and quarantine measures were enacted to “flatten the curve” of infections, these actions have had a profoundly negative impact on businesses and consumers throughout the country. Unknowns about the mechanism of transmission, infection rates, and ultimate mortality rates struck fear in investors as the pandemic evolved into a global health care crisis. Reported cases in the US continue to ramp higher as more testing occurs, though, ideally, mitigation efforts will allow the US and other countries to replicate the trajectories of China and South Korea, which have already gotten over the hump, and restarted their economies. It is hoped that social distancing and quarantining measures enacted in the US, along with improving treatments and possibly even the arrival of warmth and humidity this spring, will slow the virus spread enough that people can get on with their normal daily lives.
Another factor contributing to investor panic in the quarter was the collapse of oil markets. Already faced with a virus-related demand shock due to the global shutdown, the sector was hit with a major supply shock due to an oil price war led by Saudi Arabia and Russia. Oil saw its single largest daily drop ever, (24%) on March 18th, as the WTI price moved to the low $20s, an unsustainable level at which many energy companies cannot survive, presenting a significant risk to some lenders. The Houston economy is likely to see a large negative impact as a result.
To deal with the shutdown of the economy, the White House, Congress, and the Federal Reserve all stepped up with significant aid. The Fed, acting with speed that was lacking during the Great Recession of 2008-2009, offered an unprecedented $4 trillion of monetary support. And, Congress approved massive fiscal stimulus in the form of a $2+ trillion virus relief package, which combined with the monetary stimulus, represents about 30% of the country’s gross domestic product. Though more assistance may ultimately be needed to sustain employees and save businesses, it is a desperately needed step in the right direction. There is no better example of the historically poor economic data that is emerging than initial jobless claims, shown in the following chart as the huge spike on the far right. The March 20th figure of 3.3 million newly jobless workers was five times higher than the worst weeks after the 2008 financial crash. The subsequent March 27th figure of 6.7 million was ten times higher.
Having maintained fairly balanced equity portfolios, and following some trims in the early days of the year, we are now finding opportunities to upgrade portfolios with some favorite names with meaningful upside. At this time, the near-term earnings power of most companies is unclear due to the severe impacts of the shutdown, but the long-term outlook of most of our companies is unchanged, and some are even improved, as a result of the pandemic and oil price shock.
Though the virus’s impact on business and consumer spending is profound, we are optimistic that the world will eventually get through the pandemic and economies and markets will eventually rebound. As a result, we anticipate gradually shifting portfolios back towards a slightly more cyclical posture, consistent with our belief that a lessening of virus impact combined with historic global monetary and fiscal stimulus will lead to a re-accelerating economy over the next several quarters.
Corporate bonds were not immune from the economic uncertainty caused by COVID-19. Investor nervousness regarding balance sheet quality in the face of a potentially deep recession and investor thirst for cash pushed even investment-grade bonds down to levels not seen since the financial crisis. Bonds did rebound slightly into the end of the quarter as investor panic subsided and Fed interventions helped calm the fixed income market. Interest rates continued their march lower with 10-year Treasuries yielding 0.70% at quarter-end, compared to 1.92% at the beginning of the year.
In advance of the pending economic fallout from the COVID-19 pandemic, the Fed has embarked on a number of unprecedented measures. In addition to cutting interest rates to essentially zero during two emergency unscheduled meetings, the Fed will inject nearly $4 trillion of liquidity into the financial system. This liquidity is designed to not only keep interest rates low, but also to help facilitate bank lending to households, businesses, and a number of other critical areas within the US economy. These other areas include mortgages, corporate bonds, money markets, municipalities, auto loans, student loans, and even exchange-traded funds. Chairman Jerome Powell has also made it clear in recent interviews that the Fed will provide even more support to the financial markets and economy if the $4 trillion proves insufficient.
Like many other indicators, the credit markets are signaling that a US recession is here. Corporate credit spreads (the incremental yield of a corporate bond over an equivalent-term risk free, i.e. Treasury, investment) have rapidly expanded to levels not seen since the financial crisis, as shown in the chart below. Moreover, while previous recessions saw credit spreads widen out over a multi-quarter period, this time it happened in mere days. In fact, as of late February, spreads were actually sitting near multi-decade lows. The depth and length of the current recession will be determined by both the duration of the global pandemic and the impact of the substantial fiscal and monetary stimulus being pumped into the world economy.
While it is increasingly likely that interest rates will remain at low levels for quite some time, we continue to position our portfolio with mostly short-to-medium duration securities to minimize interest rate risk. The majority of the fixed income portfolio is still comprised of investment-grade bonds. While prices for some of these bonds have moved lower recently, we generally buy bonds with the intention of holding them until maturity or call. This means that investors can expect to receive full interest and principal over time. While the upside potential for fixed income is less than that of stocks, bonds play a critical role in the asset allocation process by providing both current income and stability within a diversified portfolio.
The world’s response to the coronavirus is beginning to limit the spread of the disease, although such drastic containment policies do carry enormous economic costs. As the global economy slows dramatically from mandatory social distancing and lockdowns, we are in the midst of a severe economic contraction.
While US large cap stocks represented by the S&P 500 fell 19.6% in Q1, international developed markets dropped 22.8%, emerging markets fell 23.6%, and US small cap stocks fell 30.6%. In local terms, international markets actually outperformed US markets, as the global rush for stable US currency strengthened the dollar 5.2%, providing a headwind for US investors in foreign markets.
The coordinated crisis response to both save human lives and economies is unparalleled. Concurrent with the Fed, global central banks are pumping liquidity into the system with interest rate cuts, quantitative easing, and emergency lending to avert a credit crisis. The US fiscal policy response via the $2.3 trillion CARES Act is unprecedented in both size (11% of GDP) and the speed with which it was passed by Congress. With such decisive, powerful monetary and fiscal policy intervention, systemic risk appears lower than in 2008, as liquidity is available and consumers entered the downturn in better shape.
The greatest uncertainty facing investors is the length of the shutdown required to contain the virus, and the resulting economic damage. The source of this recession is biological and recovery is dependent on the success of the lockdowns. An eventual return to normal activity will require evidence of slowing new cases. Historically, recessions and bear markets are preceded by business overinvestment, tight monetary policy and excessive valuations. Today we do not see the same conditions present. COVID-19 is the very definition of a “Black Swan” event: a high impact, extremely low probability phenomenon, halting the longest-lasting equity bull market on record. Since this recession stems from an exogenous shock, and not the typical buildup of excesses in the economy, the path of the recovery could be sharp as well.
We are seeing early signs of recovery in countries hit hardest in the beginning of the crisis. China and South Korea, representing 20% of our global population and GDP, are reopening after cases of the virus peaked in February, and economic activity is now improving. As the virus spread slows and global shutdowns are lifted, economic activity will resume. However, the post-COVID world may look different as consumers and businesses adapt behaviors.
Our decades of experience shepherding client portfolios through a variety of crises gives us confidence that this too shall pass. As surely as seasons change, COVID-19 will eventually dissipate, and prosperous days will come again.
For our clients, the sharp market drawdown and eventual recovery could provide an opportunity to rebalance portfolios. As always, we recommend you speak with your adviser to ensure your portfolio is tailored to achieve your goals and reflects your desired risk tolerance.
Year to date, the MSCI US REIT Index (Bloomberg: RMZ) has produced a total return of -27.1%, and from February 21st to March 31st, the RMZ produced a total return of -31.6%. This compares to the prior recession peak to trough of -73.9%. Though it was more severe (and took over two years to reach the trough), the REIT market was very different in 2008. Most importantly, the REITs were not well capitalized and dividend payout ratios were too high, which meant many were on the brink of bankruptcy, even if cash flows were holding up relatively well.
In 2020, REIT balance sheets are healthier than they have ever been, but near term cash flows could be more at risk due primarily to rent deferrals across most core property sectors. In our opinion, the market reaction thus far has been too negative. We believe the market is not giving REITs enough credit for their balance sheets, which will give them ample liquidity to survive a reasonable decline in cash flow. By several measures, REITs are more inexpensive than they were in 2009, despite having much lower risk of bankruptcy. Therefore, we believe there is a unique opportunity to buy high quality commercial real estate at an unwarranted discount.
The painful lessons learned in 2008 for equity REITs have positioned them well for the current crisis. As shown in Figure 1, the margin of safety provided by the average REIT is completely different today. Most importantly, management teams of most REITs learned the perils of too much leverage, and many were forced into two major decisions: sell equity at dilutive prices and/or cut the dividend. With balance sheets in much better shape today with average debt ratios of 32% and a weighted average debt maturity well over five years, we do not envision a repeat of the high number of dilutive equity offerings in order to “save the company.” Dividend cuts to the degree seen in 2008 are unlikely, but certain sectors such as lodging and retail are at risk.
Incoming economic data continues to worsen. Our biggest concerns are job losses, retail closures, bankruptcies, and weakening demand. These conditions are much different than in 2008-2009. Even then, REIT occupancy only fell to 91.8% (in 1Q 2010) and same store net operating income fell by less than 3% in the worst quarter (4Q 2009). While demand will likely fall further than it did in 2009, new supply should grind to a halt in all property types due to less capital availability, albeit with a 1-2 year lag given construction activity is currently robust.
Despite a bleak economic outlook, the valuations today are attractive due to the solid balance sheets and low payout ratios. As shown in Figure 2, the lows in 2009 are near today’s valuations despite the balance sheet enhancements.
Furthermore, a comparison versus 2009 should be caveated with the fact that the REIT averages today are comprised of very different businesses. Traditional property types such as office, retail and apartments, only comprise 60% of the market capitalization in 2020 versus 100% in 2008. Newer sectors such as cell towers and data centers account for the balance and are much less susceptible to being hurt by current economic conditions. As such, performance between property types has varied dramatically year to date, led by data centers at +9%, which compares to regional malls at -60%. In our opinion, this is the time that active management should be stressed in client portfolios given the pitfalls of investing blindly in ETFs that hold positions that are slated to underperform.
Bradley J. Eixmann, CFA, firstname.lastname@example.org, (713) 243-3215
Brandon J. Frank, email@example.com, (713) 243-3271
R. Randall Grace, Jr., CFA, CFP®, firstname.lastname@example.org, (713) 243-3223
Matthew R. Werner, CFA, email@example.com, (713) 243-3234
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