April 7, 2020
Written by Nathan Erickson, CFA®, CAIA, Managing Partner and Chief Investment Officer
To view and download a PDF of this commentary, click here.
“There are decades where nothing happens; and then there are weeks where decades happen.” – Vladimir Lenin
It is hard to believe that the first case of COVID-19 in the U.S. occurred less than three months ago, on January 20, 2020. While the world was aware of a new virus in China identified earlier in the month, it is unlikely anyone expected to be where we are today. The world seems to have changed in an instant, and yet for a lot of us working from home or under some version of a shelter in place order, time seems to move very slowly. Volatility in markets has increased dramatically, hitting levels last seen in the 2008 financial crisis. While this time seems different, we can draw from history for guidance of what to expect and how to respond.
Where Are We Now With COVID-19
As of the writing of this commentary, there are over 1.3 million cases of COVID-19 in the world, with 370,000 in the U.S. In March, the world learned that China had not been entirely truthful about the number of cases or deaths that had occurred there as a result of the virus, which wasn’t a complete surprise. While there have been some successful examples of countries containing the outbreak, every country truly is different depending on demographics or population density. The U.S. has become the epicenter, due to both the number of cases and the impact our economy has on the global economy. What we’re learning, and must understand as investors, is that we are still early in the process of dealing with the virus.
There are several data points that tell us we will be dealing with this for some time. In the last week of March, the White House coronavirus task force estimated total deaths in the U.S. from the virus to be 100,000 to 240,000. While that is a broad range, the U.S. just recently hit 10,000 deaths. The key to stopping the spread of the virus is social distancing and, while most of the country has instituted some form of a shelter in place order, as of April 3rd, five states remain without any order and four additional with only partial orders. Less than a week ago, there were 20 states without statewide orders. As Bill Gates said in his op-ed in the Washington Post, the entire country needs to work together to slow the growth of cases. By his estimate, this would take at least ten weeks. If we accept that China is now returning to full strength, and we estimate its first cases occurred in November, a similar timeline for the U.S. would have recovery occurring in June. While the beginning of this crisis feels like the distant past, our present reality is likely to persist into the summer.
Containment of the virus is the key catalyst to reversing the economic impact, and the longer the economy is in a forced recession, the harder it will be to recover from it. With an uncertain timeline, the estimated impact on GDP is extremely difficult to predict, as seen below by the range of GDP estimates from six of the largest banks:
Three of the forecasts expect March’s impact to be significant enough to result in a negative GDP for Q1. All of the forecasts expect Q2 GDP to be negative, on average down nearly 17%. All forecasts expect Q3 GDP to bounce back fairly rapidly. Unfortunately, we don’t get the first release of GDP data until a month after quarter end, which means we won’t know how bad Q2 is until late July. While many economists believe we are currently in recession, there is typically a 5-12 month lag between the official start of a recession and when it is announced. For example, in the 2008 financial crisis, GDP went negative in Q4 2008, the market bottomed in March of 2009, but GDP remained negative through Q3 of 2009. The economy experienced four quarters of negative GDP growth but, by the final quarter, the market was well on its way to recovery. The charts below illustrate the same outcome relative to a peak in unemployment in past economic crises:
The point that we are trying to make is that we won’t know how bad things have gotten (cases, deaths, GDP impact, unemployment, etc.) until well after it is past.
As mentioned previously, the impact on markets has been profound. The S&P 500 had the fastest decline from peak ever, which contributed to the highest volatility in a transition to a bear market:
As economic data evolves, markets will continue to respond. As evidenced by the chart on the top left and the one below, we are likely in the beginning stages of this bear market which will continue to include violent moves to both the upside and downside:
While market recovery will precede economic recovery, investors should expect it will take several months to occur. However, markets always recover. Regardless of the cause of a bear market, markets will at some point return to previous highs. This is perhaps the most important fact investors need to remember as we anticipate several months of continued news and market volatility, which will constantly tempt investors to abandon their plans.
Actions MRA Is Taking
As a result of recent market performance, most investors should see the equity allocation in their portfolios at least 5% lower than target, and more likely closer to 10%. The first thing to do is not to reduce risk by selling equities. If previously you had too much in stocks, your portfolio is already less risky than it was before. When markets do ultimately recover, reexamine your risk tolerance to determine if you should maintain a lower overall equity exposure.
By experiencing a material drawdown, the probability of higher returns over the next one, three, and five years is much better:
If probabilities have shifted in favor of higher returns looking forward, the prudent approach for investors to take is to rebalance their portfolios closer to target. For MRA clients, we are already starting to have these discussions. We don’t believe it’s possible to call the bottom, so our plan is to average into a rebalance by adding a little bit to equities within the next month and then reevaluating as markets evolve. If markets have already bottomed, we will benefit from investing more in equities now and seeing a higher allocation recover. If markets continue to trend down, we will have additional capital available from other areas of the portfolio to allocate more to equities as they continue to get cheaper. Having a rational plan in place helps us avoid trying to time markets or responding emotionally to the news of the day. As the chart above shows, over the next one to five years, any rebalancing decisions we make should prove to be beneficial.
As a firm, we are fully engaged in helping our clients manage through this crisis. Our investment department has spoken with every manager with whom we invest to understand the potential impact the current environment will have on their strategy, both in the near term and beyond. One of the benefits of the relationships we’ve built in the broader investment community is that we have access to dozens of resources beyond the managers we use and have participated in one-on-one calls and webcasts with economists and portfolio managers from many of the largest firms in our industry. Along with evaluating the current portfolio, we are looking for opportunities to take advantage of dislocations in markets, some of which we have already implemented in our private credit fund and for clients directly. With the release of the CARES Act, our wealth management, tax, and institutional departments are evaluating how our clients can benefit from the resources provided and how they apply to each client’s circumstances.
We want our clients to know that, while we didn’t predict a pandemic or the impact it would have on the economy and markets, we were prepared for it. Our portfolios were designed to handle a bear market, and now we’re shifting to the offensive to add value with new opportunities. Our MRA team has been working from home for weeks to help prevent the spread of the virus. Our technology infrastructure was in place well in advance of the crisis and our shift to a remote work environment was seamless. We continue to communicate regularly as a team and remain fully available to all of our clients.
Finally, we don’t know how or when the current crisis will end, but we are confident it will. This time may feel different, but it isn’t. America will again be resilient to the latest challenge. A vaccine for COVID-19 will be developed, markets will recover, and the economy will recover. If investors are patient and remain committed to their plan, history has shown that they can endure the current crisis and find success on the other side.