Article Author: Ray Thiagarajan, Investment Analyst with Ganim Financial
Imagine you’re applying for a job in 2015 and the interviewer asks, “where do you see yourself in 5 years?”
Would you have said that you’d be in the midst of a global pandemic which destroys one of the longest bull markets in history, causes a toilet paper shortage, and forces you to wear a face mask and stay indoors for three months? The word “unprecedented” seems fitting for 2020. The impact of COVID-19 has blasted through doors of financial markets and economies, exposing weaknesses in certain areas and exacerbating secular strengths in others. The global fiscal and monetary responses were unprecedented. On the surface, a “disconnect” may appear between financial markets and the economy. The question of this disconnect is a lingering one for financial market participants worldwide but warrants a deeper dive and could be explained by the fiscal and monetary responses, improving economic data, and investor psychology.
US discovered its first coronavirus case on January 21st, which skyrocketed to a high of 35,930 new cases on April 24th, only to be eclipsed by new highs over the past month. March 2020 will go down in history as a month of immense layoffs, market drops, and sheer halts in business and industrial activity. It’ll also go down as a time of reckoning, of business models being reconsidered. In February, US unemployment sat at 3.5%, the lowest level in more than 50 years. Just one month later, it rose to 4.4%, and two months later, it surged to nearly 15%, reflecting the extraordinary layoffs concentrated in leisure, hospitality, education, and business service industries. These are shocking statistics, but another measure dwarfs it – initial jobless claims, which are claims for unemployment benefits, shot up to nearly 7 million, a number so high that it blows previous records out of the water. For the record – the previous peak occurred during the Great Financial Crisis and was only 660,000 claims! Certain industries such as finance and professional services will likely undergo structural transformations as a result of the pandemic, like working from home. More economically-sensitive industries, such as retail and hospitality, require a “normal functioning” of society and may undergo less such change. But ultimately, as firms integrate more technology into their operations, future economic growth could benefit as a result of increased productivity, efficiency, and capital allocation.
Consumer spending, which accounts for nearly 70% of the US economy, fell 7% in March and 14% in April. Manufacturing and industrial activity, which by nature is sensitive to economic conditions, contracted nearly 5% in March and 12.5% in April. Global supply chains were disrupted and business investment ground to a halt, amidst an already-uncertain backdrop due to US/China trade tensions, slowing global growth, and a strong US dollar. Throughout the first quarter, the impact of COVID-19 on these economic measures ultimately contributed to a US gross domestic product decline of 5%.
The S&P 500 hit a record high of 3,386 on February 19th, but as the coronavirus roiled financial markets and ruined future economic prospects, the index fell to 2,237 – a decline of 34%. Undoubtedly, this drop was unprecedented, marking the fastest selloff on record and the 4th largest monthly decline in history of the large-cap index. Similarly, the Dow Jones Industrial Average, the concentrated blue-chip index, fell 37% mostly due to its sensitive constituent sectors like financials and industrials. The tech-heavy NASDAQ, a more growth-oriented index, fell 30%. These steep declines were the result of investors pricing in (incorporating into stock prices) the risk of COVID-19 to revenues, business investment, supply chains, and ultimately earnings – the key driver of long term equity valuations. Asset managers typically have stop-losses on equity positions, which are mechanisms that automatically sell when a certain price is reached. March 2020 likely saw droves of stop-losses being triggered. Equity market volatility spiked to the highest levels observed since the Great Financial Crisis, as measured by the CBOE Volatility Index (VIX), also known as the “Fear Gauge.” CNBC summed up this deranged market aptly, coining the term kangaroo market, after the traditional bull/bear market dichotomy wasn’t accurate enough to describe the current conditions.
With regard to bond markets, we witnessed the flight to quality and liquidity (US Treasuries & cash) typically seen during crisis times, but again – at an unprecedented scale. Additionally, a severe dislocation occurred in credit markets via a liquidity crunch, where even investment grade corporate bonds were sold off, while credit securities, such as high yield bonds and bank loans, sold off even more. Credit spreads widened, implying heightened risk aversion to non-Treasury issues, and coupled with the oil price shock resulting from the Russian/Saudi Arabian price war, a “firesale” mentality ensued. Since US Treasuries are backed by the fill faith of the US government, they are deemed credit-risk free, and thus mostly sensitive to interest rates. Because rates fell throughout this period, these securities outperformed. On the other hand, non-Treasury issues (credit securities) naturally contain credit risk. Credit spreads are the differences between yields on credit securities and similar-maturity US Treasuries – so when these spreads rise, the prices of the bonds fall, which is what happened during March’s intense selloff.
Inflation is expected to be lower for longer; the Consumer Price Index (CPI) fell nearly 1.2% through March and April. This was a result of the energy price shock, which is a large drag on prices, and lower consumer and business activity. A strong resurgence in demand is unlikely over the next couple of years, so it may be safe to assume sub-par inflation in the medium term – inflation under the Federal Reserve’s (the Fed) 2% target. Economic growth is also forecasted to be slow and low, and forecasted to return to pre-crisis levels anywhere between two years (optimistic estimate) and 7-8 years (pessimistic estimate). Yields on long-term US Treasuries reflect these macroeconomic data points, so subsequently, yields fell precipitously, signaling the low-growth and low-inflation expectations for the upcoming future, but more importantly – they also reflected the unprecedented stimulus on the Fed’s part, further depressing yields and raising bond prices.
As the impact on corporate profitability unfolds, certain companies will go bankrupt, some will need restructuring, and credit risk will remain elevated. Despite this outlook, the first quarter saw a record high in corporate debt issuance from companies taking advantage of near-zero rates to obtain financing. To illustrate this with data, corporate debt issuance, including investment grade, high-yield, fixed rate and floating rate, callable and non-callable, totaled $550 billion in the quarter.
The question of the disconnect has baffled global market participants worldwide – how come equity markets have completely returned to pre-COVID-19 levels, while Americans are still getting laid off, small businesses continue to go bankrupt, and business and industrial activity continues to slow? A look under the hood brings about four main explanations for the stock market rise amidst the economic fallout: the policy response, improving data, winners vs. losers, and investor psychology.
The Fed is likely the largest contributor to the rise in US equity markets due to their adoption of a “whatever it takes, for as long as it takes” stance to support, build confidence in, and restore normal functioning of, the financial markets. They dropped their benchmark Federal Funds rate to near-zero levels, allowing for an unprecedented balance sheet from their buying of securities. Additionally, the Fed created several lending facilities to target every nook and cranny of financial markets. These facilities provided mission-critical support to commercial paper markets, credit dealers, money market funds, corporate bond markets, and repo (repurchase) markets. Another intention of this sheer financial support was to buoy certain companies from failing or going bankrupt, which could have erupted in a Lehman Brothers-like domino effect in certain industries. Lower interest rates support higher asset valuations via lower demanded returns, or risk premiums. But they also lead to lower yields on fixed income securities, which make equities more attractive versus bonds – not just for the average 2% dividend yield, but also for growth potential. The capital market conditions created by the Fed allowed for more lending, more risk taking, and more capital issuance. On the fiscal side, the CARES Act was passed in late March, delivering an unparalleled $2 trillion stimulus package. It provided stimulus checks to Americans, produced the Paycheck Protection Program which aids small businesses in maintaining their personnel and covering overhead, allocated relief payments to states, municipalities and tribes, and provided incentives/deferrals designed to stem layoffs.
During times of crisis, the focus shifts from absolute numbers (e.g. a certain level of consumer spending) to relative improvements (e.g. consumer spending higher than expected), i.e. when things go from “bad” to “less bad.” The stock market is inherently a forward looking mechanism – stock prices are nothing but investor’s future expectations. When data releases positively “surprise” investors, revisions take place and are incorporated into stock prices. As April and May progressed, we saw improving data on the virus numbers which were falling steadily (cases are rising today, however) but we also saw better economic data. For example, we expected May unemployment to shoot close to 20%, but the Bureau of Labor Statistics jobs report showed only 13.3% unemployment. Although this statistic should be taken with a grain of salt, it showed that a gradual economic recovery could be taking place. As expected, retail sales rebounded, reflecting pent-up demand, with durable goods leading the rise. The housing market demonstrated resiliency. All these economic surprises weren’t reflected in the initial March expectations, and as such, the markets reacted accordingly. Regarding corporate earnings, 65% of S&P 500 companies reported better-than-expected earnings (positive surprises) in the first quarter, again suggesting some resilience. These data suggested, maybe, that the worst of the economic destruction was in the rear-view.
The winners won and the losers lost; not all companies were made equal. Therefore, not all companies were equally affected by the pandemic. It’s paramount to remember that stock market indexes only reflect publicly traded companies, which have gone through the required hurdles to be listed on a stock exchange. Even within these public companies, large cap, growth-oriented companies have strongly outperformed due to their less-cyclical nature and status as beneficiaries of secular growth. Conversely, cyclical sectors like discretionary, industrials, and real estate have naturally underperformed. All of those local small/private businesses you know of? Those enterprises have been disproportionately affected by COVID-19, while larger firms with ready access to capital markets (i.e. publicly listed companies) were less effected, or even beneficiaries of the trends and shifts exacerbated by the pandemic. Some of these trends include remote working/learning, food delivery, ecommerce, and medical innovation. Some of the largest US public companies like the FAANGM – Facebook, Apple, Amazon, Netflix, Google, Microsoft – were all beneficiaries of the pandemic, and thus were able to pull the index higher. If there was an index consisting of all companies – public and private, big and small – it’s impossible we would’ve observed this impressive rally.
Last but definitely not least, investor psychology has contributed to this rally like usual. Multiple facets of human nature and behavioral finance can explain psychology’s role. During crises, negative outcomes are assigned excessive probabilities. We saw this in March’s gigantic market drop, attributable to the uncertainty present at the time, and companies withdrawing their own estimates for performance. However, when the light at the end of the tunnel emerges, this sparks optimism, which can spark a “no price too high” mentality– financial markets tend to swing from one excess to the other rather than staying at a happy medium. In this case, investors effectively “forgave” 2020 and looked very, very far into the “brighter” future where the economy would have recovered. When the Fed announced their stance and Americans and businesses received financial support, risk taking ensued, partly because of moral hazard. The attitude turned into, “the Fed is supporting markets no matter what it takes? Great, let’s throw capital into risky assets!”
Two crowds of investors also played a role in adding fuel to the burning stock market inferno – the FOMO crowd and the “buy the dip” crowd. FOMO stands for “fear of missing out” and applies to investors buying equities, later on, to avoid missing any action. The FOMO crowd was unmistakably led by retail (non-high-net-worth) individuals who aren’t professionals. You give these people $1,200 and a brokerage account and they’ll turn into kids in a candy store. The “buy the dip” crowd describes investors who promptly scooped up shares of companies during the pandemic induced selloff, which supported equity markets by providing buyers. Additionally, this excessive trading on behalf of the two crowds combined with computerized or algorithmic trading employed by hedge funds, contributed to heightened volatility we saw during the period.
A final point is that this rally is not driven by strong, robust fundamentals, but rather by extensive liquidity and accommodative monetary policy. In today’s low-yielding world, the TINA mentality (There Is No Alternative) may be eclipsing equity markets. With US equities sitting in top historical quartiles of valuation metrics, future expected returns will likely be low to moderate. The current market environment likely calls for increased selectivity in selecting investments, as well as focusing on high-quality, liquid securities. As always, the time-tested principles of asset allocation, diversification, and portfolio construction apply, even more so. Over the past month, we have seen US virus cases rise again, however it isn’t prudent to expect a March 2.0 because it’s unlikely the economy will be shut down again. The unravelling of these market reactions reveals that any meaningful, sustainable rally in financial markets is hinged on the virus being contained and immobilized. Otherwise, consumers won’t spend, businesses won’t invest for the future, people will get paid off – the economic impact continues. Finally, considering the specific new cases, the death rate seems to be continuing its three-month decline, potentially implying that the new wave of the virus could be concentrated among young people, who have been shown to be less at-risk to the virus.
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