The End Of The Beginning
Twenty-three trading days spanning the end of February and most of March is all it took to wipe out three years’ worth of equity market gains. To say the period we just went through was the most dramatic of our collective careers would not be an overstatement – even the ’87 selloff was not as deep or as swift as this one.
As a group, we agree that although the bottom of the 08-09 financial crisis was deeper it was actually less scary than this episode. Certainly, it’s easy to say that now that the Global Financial Crisis (GFC) is but a distant memory, but the point is that at least in 2008/09 the market reacted to data.
We won’t go into much detail about the virus that has brought the world to a standstill – by now, you’ve likely read and seen as much as we have regarding its origin, how it spreads, and who it affects. At this point, we now know that it affects us all in some way.
What we will spend time on is where we think we go from here and what we are watching to confirm or deny our expectations. We will also discuss the monetary and fiscal policy response. We will start by briefly looking at where markets finished the first quarter of this year (YTD), and on a three year and five year annualized basis.
Something is Broken
This time, as is the case in most bear markets, fixed income recognized the concerns first. We entered 2020 with a 10-year treasury yield of just above 1.90%. As US equity markets were hitting all-time highs on February 19th, the 10-year closed at 1.57%. As dramatic as the intraday swings in equities were during the subsequent month, they were equally as violent in fixed income markets.
There were anecdotal reports during the month of March that even “off the run” treasury bonds were seeing wild prices. Every month or quarter, depending on the maturity, the treasury issues new bonds for each of its stated maturities. Off-the-run bonds are simply those bonds that are not the most recent issued bond. For example, the current on-the-run 10-year treasury is the 2/15/30 maturity bond. The most recent off-the-run issue is the bond maturing in 11/15/29. The only difference between those two issues is a maturity date of three months. As selling pressure mounted in March, the off-the-run treasury market froze up as bank balance sheets filled up.
The pain bled into investment grade credit, high yield credit, and ultimately equities. We often forget, but equities are “top” of the capital stack. Pain experienced by credit market participants will manifest itself in equities too – equity holders own the riskiest part of the capital structure, so if there is fear in the credit, there should be greater fear in the equity. One more incredible example of extreme dislocation was in fixed income ETFs. Buried deep in the prospectus of every ETF is a disclaimer that explains that the value of an ETF can deviate from the underlying value of the basket of securities it owns. That can, at times, lead to the ETF trading above the value of the underlying securities (premium) or below (discount). Depending on the fixed income ETF, the historical average is very close to 0%. The iShares National Muni Bond ETF (ticker: MUB) is the largest municipal bond ETF in the world. At one point during this sell off it traded at nearly a 6.0% discount to the underlying value of the securities. Think about how extraordinary that is – investment grade municipal bonds, the majority of which are AA rated, could be purchased through an ETF at a 6.0% discount. Some index-based fixed income ETFs traded as low as a 25% discount. While the pricing of the underlying securities can certainly be murky in times of limited liquidity (and thus make the discount hard to truly evaluate), we didn’t feel as though a discount of almost 6% on investment grade municipal bonds was warranted. So, we bought the ETF, waited for the discount to close, and have since exited the position.
The Response – Monetary & Fiscal Policy
- March 3rd, 2020 – in an unscheduled meeting the Federal Reserve lowered its target range for the federal funds from 1.50-1.75% by half a point to 1.00-1.25%.
- March 15, 2020 – in an unscheduled meeting lowered the target for federal funds by 100bps to 0.00%-0.25% as well quantitative easing of $500B and $200B in US Treasuries and Agency MBS respectively. The Fed also lowered reserve requirements to zero.
- March 17th, 2020 – the Fed reestablished several crisis era facilities: Commercial Paper Funding Facility (CPFF) to support high quality short-term funding markets as well as the Primary Dealer Credit Facility (PDCF) offering short-term funding to trading desks across the street if needed. The Money Market Mutual Fund Liquidity Facility (MMLF) to assist money market funds in meeting redemptions.
- March 20th, 2020 – the Fed expanded the MMLF to include municipal money market funds.
- March 23rd, 2020 – in a statement the Federal Reserve pledged to continue to buy US Treasuries and Agency MBS in unlimited quantities. In addition, the committee expanded MBS purchases to Agency CMBS. Two new facilities aimed at large employers the Primary Market Corporate Credit Facility (PMCCF) and Secondary Corporate Credit Facility (SMCCF) were established to backstop the investment grade credit market including the purchase of ETFs. The Term Asset-Backed Securities Facility (TALF), another crisis era facility, was relaunched to support asset backed issuance of consumer credit (autos, student loans, SBA loans, etc). Further expansion of MMLF to include even more securities. Inclusion of tax-exempt issuers of short-term paper in the CPFF.
- April 6th, 2020 – the Fed announced plans to support the Paycheck Protection Program (PPP) by offering term facilities for financing those loans.
- April 9th, 2020 – the Fed announced explanation and additional details of several of the programs it had previously announced as well as inclusion of high yield corporate bond ETFs in its SMCCF.
The actions taken by the Federal Reserve over the past month have been historic by any measure. Their recent policy response is easily more aggressive than the Fed ever thought of being during the GFC. It’s not hard to see that many, if not all, of these programs become permanent – can you every really remove accommodation once you’ve started? Similar to social welfare programs, they tend only to grow, and at some point the market/people become dependent upon them. Taking them away would be too painful and that’s what we have seen with monetary policy every time the Federal Reserve has attempted to step away.
Seeing the need for further fiscal accommodation, Congress and the President passed the CARES Act. Broadly, the final bill and previous phases look something like this:
- $500B – lending to businesses large businesses including airlines and assistance to some of the Federal Reserve’s programs.
- $350B – lending to small businesses including the Paycheck Protection Program (PPP).
- $300B – checks to individuals and families making less than $75,000 for single people or $150,000 for a married couple.
- $250B – increased unemployment benefits.
- $150B – state and local government funds used to cover the costs of COVID-19.
- $140B – used for health-related expenses including funding for hospitals, CDC, development of a vaccine, public health, etc.
It goes without saying the size and scope of the fiscal and monetary response are historic. The Trouble Asset Relief Program (TARP) launched in October 2008 under the Bush administration was $700B and the subsequent Recovery Act was estimated to cost $787B under the Obama administration vs. nearly $2T for the CARES Act. Granted, if the economy recovers quickly, the CARES Act is likely to cost substantially less than $2T. It’s still early days, but the monetary side was up and running almost overnight as evidenced by the size of the Fed’s balance sheet. Fiscal stimulus, however, has yet to be deployed and will likely take much longer to rollout.
At this point, consensus among analysts and pundits alike has the US entering a recession. We have no reason to doubt that we will get at least two consecutive quarters of negative GDP growth to put us in a “technical recession.” From the announcement of the first stay at home order, we have believed the question is how much structural damage would be done before the country was allowed to return to work. It’s almost hard to describe, but in a market-based economy driven primarily by personal consumption, there’s a certain centrifugal force that keeps the economy moving. It’s like an economic game of musical chairs where, as long as the music is playing, it doesn’t matter how many chairs remain. In this case, not only did the music stop, but the lights are out.
According the National Restaurant Association, 3% of all restaurants have already made the decision to permanently close and more than 40% have temporarily closed. How many of those restaurants that closed temporarily will open back up if restaurants are required to cut seating capacity by 50% when we open the economy?
Over the next three months, we will be watching jobless claims very closely as we think they will give us the best read on the mood of businesses across the country. We’ve had to adjust the scale of our weekly jobless claims data due to the staggering numbers of claims we’ve experienced in the last three weeks.
Prior to the COVID shutdown, claims had averaged 218K per week over the last year. That happens to be incredibly low compared to historical averages, but prior to the GFC, claims hung in the low to mid 300k’s per week. Claims in that area would still imply job growth and a declining unemployment rate.
Prior to COVID-19 ravaging lives and economies across the globe, we believed the next recession would likely result in a 30-40% drop in US equity markets. That was always our base case and it was premised on a 20% peak-to-trough decline in EPS combined with a 3-4 “turn” decline in Price/Earning multiples (from 19x to 16x). On March 23rd, we closed down 34% from all-time highs. We think that was effectively the low of this sell-off but we base that conclusion the following assumptions. First, that the Federal government and a majority of the states lift most of the restrictions currently in place on or around May 1st. We fully expect groups of 50 will remain in effect for another month and restaurants will have capacity constraints imposed upon them. Second, our conclusion assumes that we do not have a “second wave” of the virus that happens to be worse than the first (like the Spanish Flu). Lastly, we assume we will not experience large corporate defaults. We think the Federal Reserve’s actions make this latter concern remote, but important to bear in mind.
In general, we think the next six months will actually be a good period for risk assets as COVID-19 headlines move from negative to positive and as the record monetary and fiscal stimuli kick in. In a matter of weeks, everything went from rich to cheap. We believe the US entered the global shutdown in a better position than Europe did, and that Emerging Markets will recover more quickly than the developed world outside the US. Although they have bounced off of their cheapest levels, municipal bonds continue to offer value relative to their taxable counterparts and we also think extended credit/high yield has room to run. For the first time in a long time, we think inflation could be a risk in 12-24 months. The record amount of stimulus combined with an overall lower level of production could push prices higher.
The views expressed in this newsletter represent the opinion of Custos Family Office, a Registered Investment Adviser. This material is for informational purposes only. It does not constitute investment advice and is not intended as an endorsement of any specific investment or services. The information provided herein is obtained from sources believed to be reliable, but no representation or warranty is made as to its accuracy or completeness. Investing in equity securities involves risks, including the potential loss of principal. While equities may offer the potential for greater long-term growth than most debt securities, they generally have higher volatility. International investments may involve risk of capital loss from unfavorable fluctuation in currency values, from differences in generally accepted accounting principles, or from economic or political instability in other nations. Past performance is not indicative of future results. Investments are not a deposit of or guaranteed by a bank or any bank affiliate. Please notify Custos Family Office if there have been any changes to your financial situation or investment objectives or if you wish to impose or modify any reasonable restrictions on the management of your accounts through Custos Family Office.