As we look back on a first quarter that in many ways defies description, we first want to highlight that we welcome further, direct conversation with you, our clients. We will continue to take as much time as you want and need to speak about your specific situations in the context of how we view the future unfolding from an economic, market and planning perspective. From an investment perspective, our team is finding ways to be constructive yet realistic in managing the risk-return paradigm. More on that below.
By way of review, in just 45 days, we have experienced an all-time market high, then the fastest sell-off in market history, followed by the quickest 20% advance since 1938. Typically, when trading becomes emotional and disconnected from variables that are fundamental in nature, opportunities begin to surface. Sometimes these opportunities do not require much ingenuity, while others involve a more sophisticated approach or structure. The major issue with decision-making moving forward is that the discrepancies between the bear case, base case and bull case are very large. As a result, portfolio moves need to be weighed in the context of analyzing bear case scenarios and appropriately managing risk.
It’s worth noting where things stood prior to the market peak on February 19th. The February jobs gains were 278,000, an excellent number. In addition, the banking system entered this coronavirus-induced shock in a very healthy capital position. These points around prior economic strength are important to remember. Unlike in 2008, the banking system at this point is, and will be, part of the solution rather than the source of the problem. The unprecedented stimulus that both the Federal Reserve and the Treasury have unleashed on the economy has helped dramatically lessen lasting, systemic risk. What this means is that, despite the massive economic slowdown, the banking systems and most credit markets are functioning reasonably well under the circumstances. In fact, even cruise-operator Carnival was able to issue debt the week of April 6th.
On the other hand, the U.S. government will have to issue much more debt to cover the cost of programs already announced and likely to come, including forgivable and low-interest loans. The magnitude of debt will have long-term implications as the country attempts to stabilize. Most municipalities and the vast majority of small businesses will need significant help for many months if not longer. At this point, the government is ‘all in’ and it seems likely it will continue to do whatever it takes to keep the economy and the nation from falling further.
As we stated on our recent call for clients and friends of the firm, having the 2008 financial crisis playbook as a reference has made a big difference in guiding the government’s response to the crisis. Without it, the size, scope and speed of the response may have been too little, too late. The market rally off of the recent lows was a function of both the government response and the realization that the worst case scenario of hospitalizations and deaths would not materialize. Still, we are far from a point of clarity or resolution on the ultimate impact of the virus in all respects.
As we write this letter (knowing things are changing on a real time basis), a significant amount of good news has already been priced into the markets on the economic front. It is very unclear what will happen when the economy does a phased-in re-opening (and how that actually looks). Our view is that the economic recovery following the second quarter, a quarter that may be down 30% or more from a gross domestic product (GDP) perspective, will be more muted than current expectations for a variety of reasons.
Reasons for more conservative expectations include very high and growing government debt/deficits, reduced demand for many services (hospitality, travel among them) and a general reluctance for consumers to spend in an environment of uncertainty. As a result, we are somewhat cautious with the markets at current levels. We are finding more opportunity on a risk-adjusted basis in areas of fixed income (bond) credit exposure that are higher up in the capital structure than equities (stocks). What we have identified on the credit side of investments is pricing in more pessimistic expectations than are warranted (in some cases much more pessimistic than during the financial crisis, despite underlying structural strength). This unwarranted pessimism allows us to buy things ‘on sale’ with a margin of safety and attractive income generation, in some cases 10%+ annually.
In many cases and wherever appropriate, we have implemented the use of global allocation funds as part of client portfolios. These funds can tactically and somewhat seamlessly increase or reduce exposures in real time to many different geographic areas, sectors and investment types. We believe this sort of flexibility is paramount as the current situation is volatile and things can change, both positively or negatively, very quickly.
Of course, our investment team has been studying various scenarios on how the virus plays out moving forward. It is our current expectation that a slow phased-in return to work will occur in most areas sometime in late May. However, we would not be surprised if this was delayed until early June. Testing technology and availability will be critical. Health system capacity and ventilator availability will also be essential to the equation. Fortunately, the death rate of this horrible virus is significantly less than that of other pandemics. As a result, enhanced testing and protecting those who are vulnerable will be key.
Longer term, the amount of debt the government has taken on and the inevitable response of both consumers and businesses to spend less going forward will realistically hurt GDP to some degree for years to come. So, even though a large economic rebound should take place in the back half of this year, we have become less optimistic longer term. We will continue to seek out investments, as part of a diversified portfolio, that can (currently and in the future), provide excellent risk-adjusted returns without the backdrop of a dramatic increase in GDP. This is not to say we aren’t looking for appropriate or even growing exposure to equities. To do that, we will need to see lower stock market prices and/or a change in the current paradigm in terms of antiviral therapies. Over the next 12-18 months, a vaccine seems likely and as progress is made on that front, we will continue to reevaluate the situation.
We recognize these are trying times on many levels. We are continuously monitoring the economy, the markets, as well as current and prospective investments. We look forward to providing an update on our next client call, April 23rd at 11am EST (registration below). In the interim, please reach out to your Gries Financial Partners advisor with any questions or concerns or to schedule a conversation with the investment team.
Gries Financial Partners Market Update
Thursday, April 23, 2020 at 11:00 AM EST
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