Market Commentary

Nicolo Torre PhD CFA, Managing Director, Lloyd Tevis Investments & Archan Basu CFA

With markets having settled up while the pandemic continues to rage, now is an apt moment for careful reconsideration of goals, conditions and quantifiable tradeoffs, both within our broader lives and in our portfolios. 

Major Developments

Worldwide the COVID-19 pandemic remains dominant. This disease combines moderate infectiousness, moderate lethality, and moderate resistance to control. That combination has generated policy debate, indecision, and an ineffective response - most notably here in the United States, currently home to roughly a third of the world’s cases and fatalities.

At this point the data are in, so the correct approach need not simply be a matter of debate. The table below shows three matched pairs of governments, one of which followed the path of early tight lock down while the other did not. In each case the loose approach has resulted in significantly higher mortality.

Here's our logic for the above pairings: the USA and India are both large federal democracies with considerable internal diversity; Sweden and Denmark are both Nordic social welfare democracies with sizes comparable to individual US states; New York City and the San Francisco Bay Area are both large metropolitan regions whose strong international connections brought early outbreaks. Interestingly, each loosely controlled entity enjoys certain natural advantages over its paired opposite, that one might have expected would generate a better outcome. The USA is far richer than India. Sweden enjoys a lower population density than Denmark. And New York City has a centralized government whereas the Bay Area is a loose economic unit without a centralized government. Yet in every case the natural advantage was swamped by flawed policy choices. 

It now appears that, once tight lock down is applied, roughly two to three months are required to halt community spread of the disease. Thereafter lock down procedures can be eased gradually if continuing tight border control is exercised to prevent reintroduction of the virus and an intensive program of test and trace - and if necessary local lock downs - is in place to control sporadic outbreaks. While no country has entirely succeeded with this program to date, enough success has been achieved by New Zealand, Taiwan and Australia to indicate that it can succeed on a larger scale than a city. The cost of control is about 10% of GNP, consisting almost entirely of lost economic productivity, with medical and health measures being a trivial component of total cost. While 10% of GNP is a major expense, it is one that most governments with strong credit can finance. 

America is approximately following this program. Tight lock downs were ultimately implemented by state governors in most of the country. The Federal government has enacted and partially distributed a combination of relief packages amounting to about 15% of GNP. A combination of economic concern, plus restlessness at the lockdown, has led to local resumptions of group activity that could re-ignite the epidemic in places. States following a more cautious approach, despite its heavy economic costs, naturally want to protect the investment they have made - and may ultimately impose border controls, plus require out-of-state visitors to comply with their test-and-trace regimes. Frictions in interstate commerce, broken supply chains and general desynchronization among the different regions could slow economic recovery and increase the costs of lost productivity. Accordingly our economic outlook for the second half of 2020 is a cautious one.

Bilateral and trade concerns have ticked up. With increasing consensus that China knowingly covered up the epidemic in January, hence allowed it to expand to a pandemic, we may see attempts at reprisal. So far China appears to have dealt with this issue in a less than fully conciliatory manner. Overall our geopolitical outlook is for increased tensions.

Focus: Municipals

In domestic politics, April's most peculiar event was Senator Mitch McConnell's statement that states and cities could file for bankruptcy as the Federal government would not be providing them with financial relief. This is a surprising statement from the senate leader of a party considering that municipal bond holders are a core constituency. Labeling capital assets by presumed party of affiliation, and therefore segregating out which ones are okay to liquidate, can invite future reprisals and class warfare. Indeed Sen. McConnell walked his statement back a few days later, so its issuance may simply reflect a high stress level in government circles rather than a major shift in policy.

Lets pause to briefly consider the state of municipal credit. A common, careless mis-statement holds that states aren't allowed to file for bankruptcy, implying that state bonds are default-free. In fact, states are sovereign entities that can simply refuse to pay their debts. Per the 11th amendment to the Constitution, federal courts are closed to bondholders seeking to compel a defaulting state to pay. The bond holder can seek redress in the defaulting state’s courts but cannot expect relief there. Of course, states' desire to issue bonds in the future is sufficient inducement to treat default as a step to be taken in only the gravest circumstances. No US state has defaulted in over a century. By contrast, subsidiary municipal governments - like cities, counties, school districts and special revenue areas - may avail of Chapter 9 of the federal bankruptcy code, as long as their controlling state permits its application, which roughly half do.

Currently all states are experiencing severe shrinkage in tax revenues from personal income tax, sales tax, gasoline excise tax, oil royalties and various user fees. Rising health care costs are adding further pressure to both states and municipalities. The Federal Reserve has extended a credit facility to the states and twenty largest city and county governments. Accordingly we do not expect any bankruptcies in this group of governments. Smaller cities and counties mostly rely on property taxes, and while they may have collection problems, an acute crisis isn't expected. Municipal revenue bonds, however, may present credit problems. While water and power revenues will hold up, revenues at sports arenas, hospitals, and airports are all under pressure. Defaults should be anticipated in weaker credits in these highly impacted sectors. Now it's true that public service pensions are often underfunded and overpromised. But this is a slow moving problem requiring local solutions, so we do not foresee meaningful effort at reform amid a health crisis.

To summarize so far: COVID-19 continues to stress the world in unexpected ways. Much is unsettled, including even things that had seemed quite set.

Market Review

April followed a bruising first quarter: the S&P 500 Index had peaked near 3,400 in mid February, then plunged to 2,300 on March 23, before ticking modestly upwards in a move that resembled an effect of quarter-end rebalancing (purchases of stocks made to restore their proportion in a balanced portfolio). While many still hoped for a sharp (“V-shaped”) economic recovery, prognostications for continued market pain seemed a reasonable wager.

That gloomy backdrop made April’s robust market performance an especially positive surprise: the S&P 500 ended above 2,900, recovering +12.8% over the month, bringing its year-to-date return to a merely uncomfortable -9.3%. What a quick recovery from the prior quarter’s -20% loss (definitionally a bear market), and moreover from a sharp and viscerally felt -33% peak-to-trough decline! So thanks to government stimulus, investors in US equities are able to enjoy some respite from ever-worsening economic and public-health news.

Other stock markets rallied as well, albeit less convincingly: the MSCI EAFE index of developed international stocks rallied +6.5% over April, while MSCI’s Emerging Markets index rallied +9.2%. These returns and their corresponding year-to-date tallies (per below table) continued a now multi-year pattern of US stocks dominating their international counterparts. Within that overall pattern, nuances of region and timing produced a relatively less painful -4.5% year to date return for China’s CSI 300 index, following its own sharp April rally.

In bond markets, US treasury yields inched further lower from 0.70% to 0.64% delivering total returns (as measured by the Barclays US Aggregate Government index) of +0.6% in April and +8.9% year to date. Holders of corporate credit were rewarded as well, with the Bloomberg Barclays US Aggregate index (which also draws in investment grade corporate and agency bonds) and its High Yield (or so-called junk bond) counterpart both rising in April, by +1.8% and +4.5% respectively. 

All of this is a continuing testament to the remarkable power of the US Federal Reserve, whose broad support of the capital markets now explicitly extends to even low rated corporate debt. With the Fed’s buying activity being mirrored world-wide, assets as far afield as European high yield bonds and emerging country debt rose +6.2% and +2.2% respectively in April, paring their year-to date losses to -9.3% and -9.8% (as measured respectively by B of A/Merrill Lynch Euro Non-financial HY constrained, and JP Morgan EMBIG indexes). And in a further sign of market relief, the US dollar lost further strength relative to its panic-driven March highs.

Market volatility (as measured by the CBOE Volatility index, or VIX) told a similar story: having risen from a quiescent 14 at the beginning of the year, to highs in the 80s in March (matching the October 2008 level), it receded further in April, declining down to the low 30s. However, these are still considered elevated levels, having previously been seen in 2010-’11 as markets emerged from the global financial crisis while Europe still teetered and S&P downgraded US treasuries. All of which suggests that forward caution remains amply warranted today. 

Oil flared up in April, with astonishing reports of its price briefly reaching a NEGATIVE (minus) -$37 per barrel. Already under pressure from a weakening global economy, crude oil prices had halved in March from $44 to $20 per barrel of West Texas Intermediate (WTI) as brooding Saudi frustration toward Russian drilling gave way to an open price war. Now with economies in free fall, and an overwhelming majority of internal combustion engines idling in lockdown, there were few buyers for cheap oil - and even fewer places to store it. So what do opportunistic, albeit likely poorly informed, investors do when prices plummet? Apparently they googled “oil etf” and piled into USO - an ETF that experienced $1.6 Billion in inflows during the third week of April alone - thereby unwittingly obligating themselves to deliver within days some tens of millions of barrels of WTI to a designated storage hub in Cushing, OK. Sometimes ownership proves a liability, and you actually have to pay someone to cart away your “asset” - or in this case, assume your delivery obligation while rolling your futures contract. Investors in USO witnessed -300% decline in one day. Harm was thankfully localized as USO represented smallish allocations in its owners’ portfolios: an expensive education in the special perils that accompany volatility*. Drama notwithstanding, oil closed the month flat.

Gold moved more decisively thru April, from $1600 to $1700 per troy ounce, resuming a pattern of inflation concern that was reawakened last December. Over a history that stretches into distant antiquity, current levels of gold price have only ever been seen in 2011-’13. As was then true in the immediate aftermath of the global financial crisis, we are now again caught between fears of both near-term deflation (think falling oil and airline ticket prices) and longer-term inflation (as the Treasury’s humming presses devalue the money they print). Gold holdings are but an imperfect solution to this recurrent quandary, as is Bitcoin (up +33% in April, +20% year to date).

So financial markets saw a broad reversion toward optimism in April, with a few weak signals of continued concern.

Outlook

As states contemplate reopening, markets stare at a fork in the road. “Don’t fight the Fed” today implies no retesting of March lows. So pundits have busied themselves rationalizing current valuations ($150 in normalized earnings per share, times a forward Price/Earnings multiple of 20, implies an S&P 500 index level of 3,000). Of course, such a calculation would have to allow for an orderly rotation of profits, say from GM to Tesla, or mall operators to Amazon. Yet the sinister still lurks: with COVID-19’s public-health and economic trough still likely months away, on both a global and US basis, have we truly seen the worst in the markets? This then is the risk management question of the moment.

When legendary investor Warren Buffet reliably held court in early May, at Berkshire Hathaway’s annual shareholder meeting (from Omaha, NE and for many, unprecedentedly online) he reprised his 2008 message that investors shouldn’t ever bet against America. With Berkshire’s own holdings concentrated in consumer, bank, and airline stocks, their Q1 reported loss of -$50 Bn was unsurprising. What did surprise analysts was Buffett’s reticence to spend down the cash hoard (currently $137 Bn) relative to his decisive, uplifting 2008 purchases. Perhaps Buffett, ever cautious risk manager who understands above all that cash is king in crisis times, remains less sanguine than many.

Many 401(k) savers wished, from mid-February thru the March lows, that they had adjusted their portfolios to lock in some gains rather than letting them ride. At least they didn’t face public embarrassment like CalPERS, the nation’s leading public pension plan, whose managers famously gave up $1 Billion in proceeds by prematurely unwinding hedges deemed "too expensive” in a buoyant market. A majority of asset allocation funds, too, emerged bruised. Yet it already seems that investors, having enjoyed a few weeks of reprieve, may rather quickly forget those uncomfortable, yet important existential questions.

We fear the stock market may be expressing the view of its society: an impatience to return to normal and overly optimistic feeling that the pandemic may soon become a distant memory. We would counterbalance that with evident changes in the long-term fortunes of sectors, and in a quickening of some adverse trends of emerging political turmoil and possible peak oil. Prudence remains a virtue.

Guidance

Prudence suggests that investors take a disjointed (some may say “barbell”) view of the market: yes it may continue riding upward with Fed inducement and government relief, while allowing for modest rotations toward businesses poised for the post-Covid world. Think delivery drones and work-from-home, not restaurants and office towers. A possible infrastructure bill, wished for since at least ’08, could further accelerate that. Meanwhile do not skimp on safety: double-digit (and rising) unemployment implies rainy-day funds must extend longer, taking priority even over the retirement nest. Balanced portfolios should explicitly be geared to the possibility of either scenario.

In practical terms this means jettisoning a simplistic (linear or continuous) view of the portfolio’s return prospects, and explicitly reviewing multiple goals and scenarios. It's always challenging to broaden focus to the entirety of what matters, rather than looking at a specific account or objective in isolation. And of course details will depend on each investor’s specific circumstances. We would check that liquidity cushions are adequate; we continue to view bonds as a liquidity reserve and favor modest duration against the risks (arguably closer to symmetric than the consensus view) of interest rate movements. And while always sensitive to valuations, per our March 2020 commentary*, and now per the recent lesson in USO, we would remain slow to bottom fish.

The principles of risk management extend naturally to one’s broader life as well. To risk-proof any business or activity, it helps to: add redundant people in case some fall sick; extra credit lines we expect to never use; parts inventory instead of just-in-time supplies; local manufacturing instead of shipping across oceans; and personal protective equipment galore. At home this can mean: stocking up the pantry; allowing extra time for every trip; prioritizing longer-term tasks; checking on those less fortunate; and enjoying the gifts of being near loved ones. What always matters to investors are peace of mind, plus the confidence to re-engage during periods of market uncertainty, so as to reliably achieve the goals that ultimately define us.

To conclude: now is an apt moment for careful consideration of goals, circumstances and tradeoffs, both within our portfolios and in our broader lives.

*From our March commentary: "What is true about volatile markets is that it is possible to lose a good deal of money quickly through rushed portfolio decisions, poor trade implementation and unforeseen operational glitches. Serious investors generally seek to avoid trading at such times."

THIS IS NOT INVESTMENT ADVICE, WHICH INTER ALIA, WOULD BEGIN WITH AN EXPLICIT REVIEW OF YOUR CIRCUMSTANCES. ALSO NOTE THERE ARE NO SPECIFIC BUY OR SELL RECOMMENDATIONS HEREIN. DATA CITED IS SOURCED FROM 3rd PARTIES AND BELIEVED ACCURATE.