Bourgeon Capital Market Insights: Spring 2020
What a difference a quarter makes. Only three months ago we were discussing the phenomenal 2019 stock market performance and questioning whether it could continue. Today the world is at war with the COVID-19 virus, with the stock market down 20% for the quarter (down 30% at one point). We expect that the upcoming months will be full of shock and awe of negative news of loss of life and harsh economic realities of the sudden stop of the global economy. This will be partially offset by the shock and awe of monetary stimulus from the Federal Reserve and fiscal stimulus from the Federal Government. History shows that global health emergencies eventually pass, and we have confidence that we will get to the other side of this nightmare scenario. But we do not know the shape of recovery with any certainty: V or U or L or fishhook. To gauge the eventual pace of recovery, we are watching most closely for a slowing down of new COVID-19 cases, and for a continued easing of credit conditions. It is very possible that we could retest the recent lows in the stock market in the weeks ahead, and that the recovery may take a long time. One can price risk, but one can’t price uncertainty. With that in mind, we are being very cautious in how we deploy your capital. We went into this crisis with cash representing about 15% of the stock allocation for most clients, and we are in a similar position today. We have used the recent few weeks to reposition your portfolios in a barbell manner – adding some healthcare, gold, and alcoholic beverages for protection while also adding mining, industrials, and MLPs for the recovery to come. For those with bond portfolios, we have begun to reinvest maturities given that the US Treasury has pledged to backstop short term investment grade corporate bonds and municipal bonds. Our intent going forward is to selectively add both stocks and bonds to your portfolios slowly and intentionally.
Shock and Awe Meets Shock and Awe
The numbers are full of shock and awe. As of April 5, 2020, there were 1.3 million confirmed cases of COVID-19, 67,260 deaths, and 252,658 recovered. Shelter-in- place has led to significant business disruption globally. In the United States the most recent unemployment rate rose 0.9 percentage points to 4.4%, but there are many analysts who anticipate it rising to 10%-20% very quickly. According to the Wall Street Journal, as of 4/5/20 state shutdowns have taken 29% of the US economy offline. Every day economists lower their expectations of GDP. The most recent was Ed Hyman of ISI who lowered Q2 GDP estimates to an almost unimaginable negative 50%, then -5% in Q3, then up 5% in Q4, and up 5% in 2021. Global growth will be negative for the first time since World War II.
An Alphabet Soup of Recovery Options: V, U, L, or fishhook?
The policy response has been equally full of shock and awe and “whatever it takes”. According to Byron Wein at Blackstone, the size of the stimulus in the United States totaled about 12% of GDP vs. 5% during the Great Financial Crisis. On a global basis the numbers are similar, with stimulus equaling approximately 10% of global GDP with an upside bias.
- From the monetary side, the Federal Reserve has pulled out all the stops as investors began to hoard cash just like they hoarded toilet paper. Within weeks the Fed took interest rates to zero, provided substantial liquidity to the financial markets, and back stopped investment grade corporate debt, municipal debt, and money market funds. It seemed like a weekly expansion of bazooka-like programs and support offered. The size of the Federal balance sheet has already gone from $3 trillion to $5 trillion. Projections forecast a rise to $7-$12 trillion within the coming weeks. The speed and breadth of the response is unprecedented.
- While monetary policy is helpful, it is fiscal policy that is required to move our economy forward after COVID-19 subsides. The Fed treats the symptoms, but Congress has the cure. So far, the government has implemented 3 policy responses, culminating with the CARES Act, which provides $2.2 trillion of stimulus. We anticipate that more “whatever it takes” fiscal stimulus will be coming.
How the shock and awe negatives (social and economic impact) vs. positives (fiscal and monetary stimulus) balance out is dependent upon the virus. While we are confident that there will be a recovery, the shape of that recovery is in question. There is an alphabet soup of recovery options – V, U, L or fishhook, just to name a few. We have two out of the three ingredients necessary to be more confident in deciding on the shape of the recovery: immense fiscal and monetary policy. However, we are missing the most important ingredient: a peak in the number of new cases of COVID-19. We are not scientists, but much of the research we have read points to a peak level in the US being reached by end of April or mid-May. The longer we remain in lockdown, the slower our recovery is likely to be. The faster we develop treatments and expanded testing for both the virus and the antibodies, the sooner we return to work. Vaccines will likely mark the end of the crisis and are likely 12-18 months away. We are in awe with the ingenuity of medical companies around the world.
COVID vs. Credit?
In addition to watching the COVID-19 new case numbers, we are also intensely watching the credit markets. Investors began hoarding cash just like they were hoarding toilet paper. This caused intense strain on the bond markets, and yield spreads spiked to levels not seen for a decade. The Fed’s recent actions have begun to calm the credit markets, including the most recent $2 trillion stimulus package announced on April 10, 2020. If the Fed continues to be successful and bond spreads continue to shrink, this would be a big positive for the stock market and the economy. The support is aimed at the investment grade debt and municipal markets and some high yield. Some industries we know will be bailed out, like airlines. There are private equity companies with hundreds of billions of dry powder ready to swoop in to purchase high yield companies in default. Even so, it is likely we will see bankruptcies. There will be unintended consequences.
They Don’t Ring a Bell at the Bottom
Did the stock market bottom in March when it was down 30% year-to-date? We don’t know. Technical analysts often talk about a bottoming being a process, where there are several rallies and at least one retest of a low before the coast is clear. But then again, this doesn’t have to be the case. Given the significant pullback in the markets we believe the time is right to start nibbling at investments – both stocks and bonds. But we will constantly monitor the situation.
Risk vs. Uncertainty
This is a confusing and stressful time for all investors. How does one quantify risk when surrounded by such high levels of uncertainty? When investors talk about risk in an investment, they generally have looked at a series of known outcomes, assigned them probabilities and then discounted them back to create a fair value for that investment. They can then compare this fair value with the current market value to decide whether they should invest. However, today’s environment is driven by numerous uncertainties, and thus it is difficult to decide on fair value until some of the uncertainties are resolved.
We are Taking a Barbel Approach to Slowly Invest
We started this crisis with 15% cash, and we still have 15% cash, although the composition of our investments has changed. In general, as the quarter progressed, we modified our investments to be more barbell in nature, adding to companies that provide more defensive characteristics as well as to companies that will benefit from the strong global fiscal and monetary stimulus that is coming. We thought it would be helpful to walk you through our investment thoughts on a timeline so that you might be better able to understand our thought process.
January 2020: We were having a difficult time putting cash to work in January as valuations were stretched after the 2019 strong stock market performance.
Early February 2020: We took initial positions in companies that we believed should benefit from cutting edge technologies including semiconductors and robotics. We also trimmed one of our positions that had grown to 6% of the total portfolio after strong 2019 performance.
Late February 2020: As concern of COVID-19 was starting to increase we took action to raise some cash.
Since March our investments have fallen into two camps: Defensive and Offensive:
Our defensive actions: These stocks were primarily in healthcare, and spirits. We sold our position in a European ETF as we felt that the US was a better investment opportunity coming out of COVIC-19. We also added to our gold position.
Our offensive actions: We added to positions in media, industrials, and energy. We took an initial position in a mining company that we believe should benefit from global stimulus plans.
We Added Risk to our Mutual Fund Portfolios
Our mutual fund accounts also had 15% cash going into the crisis. During the early part of the quarter we rebalanced all our accounts, diversifying the international funds, and adding to real estate and gold. On March 18, with the stock market down 25% YTD we took our cash allocation from 15% to 10% and added to the S&P 500 fund.
Fixed Income Markets Provide Opportunity
Fixed income markets suffered similar distress as equity markets. As investors rushed to raise cash, many turned toward their bond ETFs. Selling was indiscriminate, and many days there were limited buyers. Once the Federal Reserve announced their willingness to backstop money market funds, short term investment grade bonds, municipal bonds, and most recently select high yield debt, we began buying bonds to take advantage of the higher yields.
We look forward to speaking with you soon and thank you for entrusting us with the management of your money.
Bourgeon Capital's Market Insights