April Market Update: The Great Lockdown
The month of April brought us a new set of records (mostly negative) on job losses, economic declines, and COVID case increases, yet stocks rose in dizzying fashion as the Fed unleashed monetary stimulus. We did get some positive data such as the New York area moving past the virus peak, and some beneficial viral therapeutics, namely Remdesivir, which showed clinical promise in shortening hospital stays and lowering mortality. Equity markets, which likely overshot on the downside in March, seemed to reverse course just as quickly and culminated in mostly double-digit monthly gains that you see in the summary chart above. However, this rebound was not broad-based and was mostly in large, well-established growth stocks, instead of value and small cap stocks, which typically rally in a recovery. Currently, our view is that the timing and shape of the economic recovery is much longer and flatter than the equity market anticipates and we are not chasing this rally. We believe we are in a +/- 15% trading range for some time until we get a better sense of the path to re-opening and how it will look.
Sandy Cove Actions: De-risk & Move Up the Quality Scale
As the pandemic’s effect on economic growth and prosperity came into early focus, Sandy Cove took the following actions:
Reduced Real Estate Exposure: We eliminated Real Estate Investment Trusts (REITs) from our asset allocation. Many industries within the REIT sector will face a rough road back and a new normal that may not be as attractive (gaming, hotels, senior housing, retail, restaurants, movie theaters, to name a few).
- Reduced Emerging Markets Exposure: We also eliminated a dedicated emerging market asset class to our allocation models. Slowing long-term Chinese GDP, a rise in populism across the developed world, and the need to control more of the supply chain domestically are just a few of the reasons we removed our allocation to these markets. We had already trimmed our weighting to this area of the world in the Fall of 2019 and our desire to further de-risk portfolios 2020 made the removal of emerging stocks a lightly debated decision by our Investment Committee.
- Upgrade Quality via Active Managers: Our last big shift is to invest in active stock pickers versus passive index funds. We plan on using our REIT and EM proceeds for this shift that we will carry out in earnest when we feel it’s appropriate to leg back into equities. When high quality stocks are being sold in the same manner as negative earning stocks with high debt levels and a precarious market share position, it’s time to act and buy quality on sale. That is when the actively managed investment funds should produce superior returns against the benchmarks, and thus far, our active managers on the Sandy Cove Buy List have done just that. Our mid-cap active managers on average are gaining 7.0% points (700 basis points) over their benchmark index. This winning strategy is playing out across all our asset classes with the exception of emerging markets where it seems there was nowhere to hide. Thus, when we are putting cash to work back into equities, it will be mostly in actively managed portfolios.
There are lessons learned from past downturns, that we’ve all experienced and a few are worth mentioning.
- Cash is king
- Quality shines through
- Leadership is critical
- Tough times do lead to better times and there will be a time to play offense
Major Monthly Declines and Rebounds are Clustered Together
Source: WSJ, The Daily Shot
Don’t fight the Fed. That is how we would describe the move in equities in April, as there was very little good news on the pandemic front and terrible news on the economy. Monetary stimulus is a powerful tool and the speed and amount ($10 trillion in 4 weeks) that the U.S. government deployed to bridge the chasm of our shuttered economy gave markets hope it would be enough to get us through. A closer look under the hood, shows that the rally was not broad-based, with consumer staples, financials, industrials, and utilities unable to muster a double-digit return in April. Twenty percent of the S&P 500 stocks are still down 40% from their highs and more than 50% of stocks in the Index are off 25%. We have seen no participation in value stocks or small cap stocks which are usually the first areas of the market to recovery in a recession.
Technology continued to be the bright spot as many large names like Amazon and Netflix were not only immune to the crisis, but are part of the solution in the current stay-at-home conditions. We can see a landscape where the large market share players come out of the crisis even stronger creating groups of winners and losers, which is another reason why we made our active versus passive investment call going forward.
Source: Baird Advisors Fixed Income Market Commentary
The 10 Year Treasury rate fell slightly in April from already low levels ending the month at 0.63%. The month of April saw most of fixed income stabilize after the Federal Reserve stepped in to provide needed liquidity and thus, confidence. The bond market, always more glass-half empty than the equity market, is not signaling a V-shape recovery, but a gradual U-shape that will take us well into 2021.
Corporate credits rebounded in April to bring the category back to positive territory for the year. As is to be expected, the highest quality, investment grade debt outperformed the junk (high yield) category.
The U.S. Treasury came to the aid of states and local infrastructure with grants and created a $500b facility to purchase short-term notes directly from U.S. states, counties, and cities within certain parameters. The Fed is on record to that it will closely monitor conditions in both primary and secondary muni markets to ensure liquidity and provide more, if needed. Redemptions continued in munis ($15B), but not anywhere near the break-neck speed in March ($32B). Markets did reopen in April for issuers and there was $24B of municipal debt issued in the month. While there will likely continue to be much debate around municipalities’ ability to service and repay the debt, we thought it would be prudent to revisit: the 10-year cumulative default rate for A-rated municipals is 0.11%, compared with 2.10% for A-rated corporates.
Much of the economic data reported during the month was extremely negative, but that was no surprise to anyone given they effectively turned off world economies.
• First Quarter U.S. GDP contracted to -4.8% annualized
• Consumer Spending, down -7.6% for the quarter, was the largest detractor to GPD
• Manufacturing, as measured by ISM PIM fell to 41.5 signaling contraction
• Vehicle sales fell to 7.0 million annual adjusted rate in April vs 17.0 in recent months
• 84% of U.S. small firms are paying less than 50% of rent due in May (WSJ)
The Fed Goes “All In”
U.S. Government action was big and swift because we could not withstand the alternative: a solvency crisis. The U.S. Treasury is borrowing about $3 trillion this quarter to pay for the stimulus and loan program to subsidize the economy in the wake of COVID-19.
Ramifications of the largest deficit in U.S. history are not apparent yet, but will likely include inflationary pressures and the need to increase interest rates, which can stifle growth.
Source: J.P. Morgan
The graph above shows how our shut-down has bent the curve of cases and deaths, but were have flattened at about 30,000 cases per day and not moving off that figure materially. While cases in the NY metro area are declining, there are still on the rise elsewhere in the U.S.
The development of effective treatments for COVID-19 will be an important part in preventing more fatalities and also give the public confidence to begin resuming a normal life. Most drug makers and scientists agree that a vaccine is at least 12-18 months out. There are 16 drug companies currently partnering with the National Institute of Health (NIH) for vaccines and therapies. Major U.S. drug maker, Pfizer, started human trials for its BNT162 vaccine against COVID-19 and Moderna just announced it is in Phase 2 trials for a COVID-19 vaccine, mRNA-1273.
On the therapeutic side of things, there are over 260 drug candidates, but Gilead’s experimental drug, Remdesivir, has shown the most progress thus far and was approved May 1st by the FDA in emergency situations.
The Other Side of Epidemic, Still a Wall of Worry
The key question moving forward is what does the recovery look like and how long will it take. The quick answer, is we don’t know yet. However, we can say with confidence that a recovery will be predicated on healthcare solutions. The speed and shape of demand recovery will be intricately tied to a COVID-19 solution (vaccine) and consumer confidence.
The process of reopening will be complicated and likely fraught with supply-chain disruptions. We don’t believe the post-pandemic economy will look like the old one. There will be modifications in both supply (restaurant capacity) and demand (consumer re-engagement).
If the country reopens slower than expected, we could see a need for more monetary help from U.S. government for municipalities, businesses, and workers. While the Federal Reserve says it will spend “whatever it takes”, there is a limit to its deficit spending.
In summary, we are encouraged that Spring has arrived in New England and we can enjoy the sun on our masked-faces. We are counting down the days until we can reopen our state and begin to adjust to the new normal. Through all this we have witnessed and heard of heroic efforts by our essential workers and charitable actions by our fellow neighbors and are reminded that strength, courage and hope knows no boundaries.
We hope you and your loved ones are safe and healthy. Please know that your Sandy Cove team remains hard at work and we are always available to answer any questions about the markets or your portfolio.