Commentary from Our CIO—First Quarter 2020 Review & Outlook

April 3, 2020

We are all now living through a period in history none of us will ever forget. The impact on our families, communities, and country has been profound. And it continues. There remains great uncertainty, worry, and fear about the coronavirus and its impact: how widely it will spread, how fatal it may be, how long it will last. When will we see signs of stabilization in its spread and a decline in daily new cases? When will we “flatten the curve”?

While several weeks ago we had reason for cautious optimism that the virus might be largely contained to China, it is now obvious that is not the case. The United States and world are now facing a health crisis and an economic crisis. Both need to be fought with massive government policy responses and individual behavioral changes.

We’ve frequently said that recessions and bear markets are inevitable phases within recurring economic and financial market cycles. And that investors need to be prepared for them to happen, but that their precise timing is consistently unpredictable. We’ve also said there is always the risk of an unexpected “external shock” to the markets and economy (e.g., a geopolitical conflict or natural disaster).

It’s one thing to say it and another to actually live it. And still another when the precipitating event or catalyst for the recessionary bear market is something none of us have experienced before: a global pandemic, which has instigated an extreme societal response—including the indefinite closure of schools and non-essential businesses, shelter-at-home orders, quarantines, lockdowns, and social distancing—and has potentially overwhelmed medical facilities, personnel, and supplies.

We will get through this crisis period. Things will improve and recover. This too shall pass.

In the meantime, events are moving very rapidly, policy responses are in flux, and markets are extremely volatile.

We sincerely hope you and yours are able to remain healthy and manage well through this challenging period.

An Unprecedented Quarter

The first quarter of 2020 has been an unprecedented period in U.S. financial market history across numerous dimensions:

  • The U.S. stock market fell into a 20% bear market in the shortest time ever—just 22 days—and continued further, dropping 30% in a record 30 days. The typical historical bear market peak-to-trough decline has taken around 12 to 18 months.
  • Short-term expectations of stock market volatility, as measured by the VIX index—often referred to as the market’s “fear index”—closed at an all-time high in its 30-year history on March 16. And the market’s actual realized volatility has only been higher in October 1987 (Black Monday) and the late 1920s.
  • The 10-year and 30-year Treasury bond yields fell to all-time lows of 0.54% and 0.99%, respectively, on March 9.
  • Oil prices had their biggest one-day drop since the 1991 Gulf War, plunging 25% on March 9, triggered by a price war between Saudi Arabia and Russia.

First Quarter Portfolio Performance & Key Performance Drivers

Financial markets in 2019 were a positive surprise for many investors; however, the start of 2020 has been the exact opposite. Just three months ago, most investors were astonished to see stocks jump 20% to 30% during the eleventh year of a historic bull market. Even core bonds clocked in a 9% return last year. But things have changed dramatically since year-end. Though one thing is constant: Just as no market pundits expected U.S. stocks to gain 30% last year, none of them expected a 30% drop in the first three months of 2020 and the real possibility of a severe economic recession.

When you diversify across asset classes and consider a variety of potential scenarios, there will always be leaders and laggards in your portfolio. Some positions work well in strong up environments like we experienced last decade, while others benefit portfolios during tougher times like the start to the 2020s. Put together, they build resiliency and protect a portfolio from betting on a single outcome, which can be a disastrous financial result if the opposite happens.

Our tactical positions can be bucketed into three main areas: (1) a modest overweight to European and emerging-market stocks; (2) positions in lower-risk and/or alternative strategies, such as U.S. Treasuries and diversified alternatives; and (3) allocations to active flexible fixed-income funds and floating-rate loan funds.

Foreign Stocks

Positions in foreign stocks have been a headwind in this first quarter. European stocks and emerging-market stocks have underperformed U.S. stocks during this swift and severe downdraft. As markets have fallen, there has been a strong “risk-off” demand for U.S. dollars and a resulting appreciation in the U.S. dollar. This has hurt dollar-based investors in foreign stocks. In fact, European markets have performed in line with U.S. markets in their respective local currencies. And emerging-market stocks have outperformed U.S. stocks in local-currency terms—dropping only 19%. We—and many other respected investors we follow—expect the dollar to weaken as the crisis abates and a global recovery resumes. If so, that will be an additional boost to our foreign stock returns going forward.

Lower-Risk and Alternative Strategies

Lower-risk and diversified alternative strategies have outperformed during the quarter, providing ballast in the portfolio during the current bear market. Last August, in some portfolios, we initiated a position in an intermediate-term U.S. Treasury bond ETF due to what we deemed to be a growing level of economic uncertainty and heightened risks—including the intensifying U.S.-China trade war—given stretched U.S. equity valuations and low bond yields. Since early August 2019, intermediate-term Treasuries have gained about 9%, with most of that return coming during the first quarter. They have meaningfully outperformed the broad core bond index.

With regard to our positions in managed futures, they have produced strong relative returns so far this quarter—gaining in the mid- to high single digits, depending on the fund. This stacks up very nicely when compared to 20%-plus losses in stocks and a low single-digit return for U.S. core bonds. We know managed futures funds have been challenging positions for many investors to stick with, and it is gratifying to finally see them delivering as we expected. To the extent this equity bear has farther to run before it hibernates, we’d expect further material gains from managed futures.

Other alternative strategies are holding up pretty well against the backdrop of equity returns. But some of them have also been impacted by the credit market dislocations and deleveraging just mentioned. We have a lot of confidence in our managers’ experience and ability to navigate this period, to manage risks on defense and also to act opportunistically to go on offense when the rewards exceed the risks.

Non-Core Income Strategies

Tactical positions in non-core fixed-income have been a headwind during the quarter. Flexible bond funds have also suffered relative to U.S. core bonds in this selloff. Our active bond fund managers have underperformed the core bond index. In general, falling Treasury rates across the curve and widening credit spreads have been a headwind for active bond managers. Floating-rate loans have fallen around 13% this quarter, easily their worst return since falling 23% during the fourth quarter of 2008. At current prices and yields, we expect strong to very strong returns for our non-core bond funds over the next one to three years.

Active Bond Managers

We have been in very active contact with our bond fund managers during this period. What they are telling us, and what we can see from our own research, is that the disruption and dislocation in bond markets over the past month has been severe. One manager told us it has felt like a combination of 9/11 (a drastic and sudden shutdown of economic activity) and the 2008 financial crisis (poor bond market liquidity combined with forced sellers driving prices sharply lower).

The losses so far for high-quality investment-grade corporate bonds are right on par with the financial crisis. And this time the drawdown happened in just 10 days, compared to taking nine months in 2008! This gets to the heart of the Fed’s massive policy response. They are throwing everything they can at supporting bond markets to prevent them from freezing up and spiraling into an economic crisis.

The good news is that by their nature, bonds have a narrower range of return outcomes than stocks. So we definitely view these as short-term drawdowns and not permanent losses of capital. Our bond funds are run by skilled, experienced managers. Most of them were relatively defensively positioned coming into March, because yields were low and they weren’t getting well compensated for taking on credit risk. Despite that, their fund returns have been hammered this month. But this has created some great buying opportunities for them to put some of their cash to work at much more attractive expected returns. So we are excited about that.

And as a reminder, in 2009 as the financial crisis began to ease, there was a huge snapback and very high returns.

Active Stock Managers

Most actively managed stock funds have underperformed during the quarter. Within the U.S. stock market, Growth stocks are again beating out Value stocks this year—outperforming on the downside. This continues their winning streak, which has been a headwind for many of our active U.S. stock managers. Developed international stock pickers have performed similar to the index. And on the whole, active emerging-market stock managers have underperformed.

We continue have confidence in our active stock managers. We believe our patience sticking with them through this period of underperformance will be well-rewarded as we come out of this uncertain and tumultuous time. We maintain exposure to a range of manager investment styles and approaches. We definitely do not believe value investing is dead.

Update on the Macro Outlook

Coming into the year, we saw the potential for a moderate rebound in the global economy (especially outside the United States) on the back of reduced U.S.-China trade tensions and extensive global central bank monetary accommodation. And in January and early February, there were signs the manufacturing sector had bottomed and a nascent global recovery was indeed underway. Stock markets rallied to all-time highs.

However, the arc of the coronavirus and the increasingly aggressive U.S. and global response to try to slow its spread has drastically changed everything. Our base case now—and it seems most investors, economists, politicians, and central bankers agree—is that the U.S. economy is headed into recession in the second quarter. It is likely to be a severe one, with a sharp contraction in GDP and an unprecedented rise in unemployment and jobless claims.

The consensus also appears to believe the recession will be short in duration, with a rebound beginning around the third quarter. But this is by no means a sure thing. To the extent equity markets are not fully discounting a more severe outcome, downside risk remains.

The depth and duration of the recession—and the strength and timing of the ensuing recovery—depend on two key variables:

  • The progression and spread of the virus: how effective our medical response and social-policy efforts are in flattening the curve
  • The fiscal, monetary, and regulatory policy response: how quick and effective new policies will be in supporting households, businesses, and financial markets—mitigating the short-term recessionary damage and preventing a downward spiral into something much worse than a short but severe recession

The effectiveness of the medical response and economic policies (and their impact on human behavior at the societal level), will help answer the fundamental economic question of how severe and how long the economic downturn and recession will be. And the answer to the economic question will help answer the investment question of how severe and how long the equity bear market will be.

The financial markets and the real economy are interconnected—each drives the other and can reinforce or magnify a trend in one direction. A rebounding stock market supports the real economy and vice versa through positive wealth effects, increased incomes, profits and spending, risk-taking, and optimism. But they can also feed off one another on the downside, in a self-reinforcing negative spiral that can ultimately lead to an economic depression if the spiral is not broken.

On the Coronavirus

We are not medical experts, virologists, or epidemiologists. So we have little to say on the medical side of things that others haven’t already said, or that all of us aren’t hearing and reading every day in the news. What we will say is that, as we write this, the data show the virus is continuing to spread at an increasing rate in many countries, including the United States and across Europe. There is still little clarity or certainty as to when this trend will flatten and decline.

We expect financial markets to react positively at the first signs of a flattening in the number or rate of new daily cases reported, as we saw happen in China in February, and as also happened during the SARS epidemic in 2003.

Italy may be a leading indicator of the progression of the virus in other developed countries. Many experts have said the U.S. virus situation is roughly two weeks behind Italy’s. But there are also important differences between the two countries (e.g., medical infrastructure, demographics, policy response) that make for an imperfect comparison.

On the Economy

The near-term economic damage from the United States’ and other countries’ response to the virus now looks almost certain to be severe (barring some unexpected major medical breakthrough in the near future).

On Sunday, March 15, the Federal Reserve held an emergency meeting where they cut the federal funds rate by one percentage point to near zero. The Fed also announced it was restarting quantitative easing (QE) with at least $700 billion in planned purchases of Treasury bonds and mortgage-backed securities.

At his press conference following the meeting, Fed chair Jerome Powell said GDP growth was likely to be negative in the second quarter, and beyond that the economic outlook was highly uncertain, as it depends on how widely the virus spreads: “I would say in fact, unknowable.”

Over the following week, economist after economist slashed their second quarter GDP forecasts deeper and deeper into contractionary territory. They may have changed again by the time this is published, but to give a sense of the magnitude, going into the last week of March, Goldman Sachs was forecasting a 24% annualized decline, Morgan Stanley a 30% decline, JPMorgan a 14% decline, and both Bank of America and Citigroup a 12% decline, to name a few. For comparison, the worst quarter during the 2008 financial crisis was an 8.4% annualized GDP contraction, in the fourth quarter of 2008. (As of quarter-end, Goldman Sachs, for one, has already revised their second quarter GDP forecast to a 34% decline.)

On Sunday, March 22, Federal Reserve Bank of St. Louis president James Bullard topped them all. He was quoted by Bloomberg News citing the potential for a 50% quarterly drop in GDP and a 30% unemployment rate in the second quarter, in the absence of massive fiscal and monetary policy support.

Bullard also said that with an aggressive government response, economic activity should begin to bounce back in the third quarter. And the fourth quarter of 2020 and the first quarter of 2021 could be “quite robust” as Americans make up for lost spending. “Those quarters might be boom quarters,” he said. As another example, Goldman Sachs now forecasts a 19% growth rate in the third quarter, following their expected 34% second quarter plunge (forecast as of 3/31/20).

As mentioned earlier, an economic slowdown—particularly an extremely sharp one due to extreme virus containment efforts—can quickly morph into a self-reinforcing negative spiral. Consumers cut back spending, businesses layoff workers, unemployment rises, incomes drop further, spending drops further, corporate profits drop, companies and households default on loans, companies go out of business, investment and employment drop further, etc., causing an even deeper and longer recession (if not depression) and bear market.

In this case of a severe external shock, the government’s economic policy responses are critical. There are two main levers: monetary policy (central banks) and fiscal policy (government spending, tax cuts, unemployment insurance, loans, debt forgiveness, etc.).

One lesson learned from the 2008 financial crisis is: When it comes to the policy response, go big and go fast. Time is of the essence (just as it is with the virus response). Governments need to make a credible commitment to “do whatever it takes” to support the economy and prevent the negative spiral from taking hold.

Monetary Policy

The Fed and other major central banks seem to be all-in to support the fluid functioning of credit, lending, and financial markets, and their critical role as the “plumbing” of the real economy.

As noted above, at an emergency meeting on Sunday, March 15, the Fed cut the federal funds rate to near zero and restarted QE. A week later, it increased the QE program from “at least $700 billion” to essentially an unlimited amount in order to keep interest rates and borrowing costs low. The Fed also initiated a number of programs—going beyond the tools it enacted during the 2008 financial crisis—to try to ensure enough credit, loans, and liquidity are flowing to banks, businesses, households, and the overall global financial system. It is likely the Fed will do still more (e.g., increasing their asset purchases to support the huge fiscal stimulus that is coming or even effectively monetizing the debt or “helicopter money”). Other major central banks are also starting to pull out all the stops, and more will likely come until the crisis period ends (and maybe beyond).

Fiscal Policy

While extremely accommodative monetary policy is necessary, it is not sufficient to mitigate this economic crisis. Only fiscal policy can have a large enough and direct enough impact necessary to support and sustain individuals and businesses until the storm has passed and the virus containment measures show signs of working.

Congressional Republicans, Democrats, and the Trump administration all seem to be in agreement that something massive needs to be done and done quickly. On March 27, Congress passed, and the president signed into law, a $2 trillion stimulus package. Similar support measures are being debated or implemented around the world. Discussions continue about additional steps to take in support of markets and the economy.

Public and business support is also undoubtedly strong. So the political obstacles to getting something done should be relatively low, especially considering how polarized the current political environment otherwise is. There really is no alternative. And, like the monetary policy response, the fiscal stimulus will also be global in scale, with even austerity hawks like Germany now acceding to its necessity.

The fact that most everyone across the political, ideological, and economic policy spectrums agrees that the aggressive measures necessary to slow or contain the virus could tip the U.S. and world economies into a depression is good news. It greatly improves the odds countries will act quickly and forcefully to enact fiscal, monetary, and regulatory policies to prevent that dire outcome from happening.

Current Portfolio Positioning and Potential Additional Changes

In this period of heightened uncertainty and market volatility, we want to give an update on our portfolio positioning. We’ll also discuss how our allocations might change should markets decline further. As always, we remain focused on meeting our clients’ longer-term financial goals and objectives, while managing and balancing nearer-term risks.

In mid-March, after a roughly 25% decline in the U.S. stock market, we added an increment back to our U.S. stock exposure. After this trade, our balanced portfolios are still underweight to stocks overall. We still have a meaningful underweight to U.S. stocks that is partially offset by modest overweights to both international/European and emerging-market stocks.

As markets have dropped further, we have analyzed the next point at which we’d want to add back another increment to U.S. stocks. The primary driver of this decision is our five-year (medium-term) expected return scenario analysis. As stock prices—or any asset prices—drop, the expected (forward-looking) return from investing in them rises. (It’s better to buy something at $75 than $100 if you can sell it later for $150.)

As things currently stand—and our assessment is certainly subject to change—we would intend to add this second increment to U.S. stocks if and when the S&P 500 index drops to roughly the 2100 level. (The market closed on March 31 at 2585.) At that price level, our base-case five-year expected return for U.S. stocks would be in the 9% to 12% range, per year. That is in line with or somewhat better than U.S. stocks’ long-term historical average return. So in adding to stocks at that price level, we believe the odds are strongly in our favor that we’d be well-compensated over a reasonable time frame for their shorter-term downside risk and volatility.

If we do add back to U.S. stocks at that point, most of our balanced portfolios would then be at roughly their neutral or long-term strategic weighting to stocks overall; our most conservative portfolios would still be slightly underweight.

Our decision to add to U.S. stocks at that level is driven by our expected-returns analysis relative to the shorter-term risk. But as a sanity check, we can also look at it from a different historical perspective. At 2100, the S&P 500 will have dropped about 40% from its February 19 high. Since 1950, there have been three other occasions where the market dropped 40%. It happened in August 1974, July 2002, and October 2008. The subsequent three- and five-year annualized returns from each of those periods were all in the 11% to 15% range.

Of course, we don’t expect to call the bottom of this market cycle. Stocks may not even fall to our next trigger point. But if they do, and we buy, we should all be prepared for them to fall further, given the uncertainties and risks described earlier regarding the coronavirus’s spread and the depth and duration of the economic impact.

The good news is that stock markets now do appear to be discounting a recession, but a relatively short one, not a severe or long-lasting one. According to analysis by Ned Davis Research, severe global recessions have been associated with an average decline of 45% in global equities (albeit there are not many data points). And a reminder: The S&P 500 ultimately dropped 59%, 49%, and 48% in the 2007–09, 2000–02, and 1973–74 bear markets noted above.

If the virus news gets worse in the United States (before it gets better), investor sentiment could take additional hits with further market declines. Such declines—driven by fear, uncertainty, and human herd behavior—can feed on themselves resulting in a major overshoot on the downside compared to the market’s “fair value” on a longer-term fundamental basis (i.e., based on companies’ long-term profitability and dividends).

Therefore, we are also planning when we might take a third swing at the plate and begin to overweight stocks overall. Again, nothing is set in stone—our analysis incorporates relevant new data and information over time and as events evolve. But as it currently stands, we’d look to overweight stocks around roughly a 50% peak-to-trough decline.

At that level, our current base-case five-year expected return for U.S. stocks would be in the 14% to 17% range, annualized—well above historical norms. Even in our pessimistic bearish five-year scenario, we’d be looking at roughly mid-single-digit expected returns. In our view, that’s an acceptable cushion, or margin of safety, to take on the additional risk with the likelihood of much-better-than-historical returns.

We are maintaining our positions in European stocks and emerging-market stocks because their expected returns have also gotten much more attractive on a forward-looking basis after their recent price declines. And, unlike U.S. stocks, they were already at relatively attractive valuations and offered attractive expected returns prior to the virus-related selloff. As we have from the beginning, we remain cognizant of and account for their potentially larger downside risk compared to U.S. stocks in our overall portfolio construction, risk management, and expected-returns analysis.

Closing Thoughts: This Crisis Will End. This Too Shall Pass.

As investors, it is so important to maintain our focus on our long-term financial goals and objectives. As hard as it may be, from an investment perspective we need to try to look through the current environment of fear and concern—emotions which, given the circumstances, are totally justified and felt by all of us—to the almost certain outcome of the virus crisis receding and economic recovery occurring.

Throughout history, the world has faced numerous severe challenges and economic downturns and has always come out the other side. While not minimizing the unique risks and unknowns from the current crisis, we will bet on that being the case again. There is a good chance the recovery may start happening before the end of the year.

As a long-term investor, trying to time market tops and bottoms is a fool’s errand. The evidence is overwhelming that most investors diminish their long-term returns trying to do so. They are more likely to chase the market up and down, and get whipsawed, buying high and selling low. But incrementally adjusting portfolio allocations in a patient and disciplined fashion in response to changing asset class expected returns and risks makes a lot of sense for long-term investors.

The time to be adding to stocks and other long-term growth assets is when prices are low and markets—and most of us personally—are gripped by fear and uncertainty rather than complacency, optimism, or greed. Investing at such times will feel very uncomfortable. It may seem like the market could just keep dropping with no bottom in sight. But that is exactly where research, analysis, patience, experience, and having a disciplined investment process come most into play.

Otherwise, if we invest based on our feelings and emotions, we are very likely to cash out of the market after it has already dropped a lot, locking in those losses. Then, waiting to reinvest after our discomfort and worry are gone, the market will already be much higher. That is not a recipe for long-term investment success, yet it plays out in each market cycle.

Facing the current medical and economic crisis, the situation is probably likely to get worse before it gets better. (We would love to be wrong about that.) But, with some necessary and shared sacrifices from all of us—and clearly those on the medical front lines much more than most—it will get better.

Stay the course.

—Litman Gregory Investment Team (4/1/20)



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