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Oarsman Outlook: April 2020

April 21, 2020

Pandemic 2020: One Month In

The COVID-19 pandemic, an archetypal "black swan" event, has upended the global economy and financial markets (not to mention our daily lives). As the implications of the crisis came into focus in late February, swaths of the financial markets began to seize up as investors scrambled to reduce risk exposure and increase liquidity. The unraveling process was supercharged by the largely unanticipated Saudi-Russian oil price/market-share war that began in mid-March. By the third week of that month, with stock prices gyrating wildly, bids evaporated for even the highest-quality municipal and corporate bonds, making it virtually impossible to sell. Finally, even the market for U.S. Treasury securities – normally the deepest and most liquid in the world – began to show worrying signs of strain. Unprecedented interventions from the Federal Reserve and Congress beginning in late March and continuing through this week have largely unfrozen the channels that facilitate the flow of credit through the economy, providing a welcome reprieve for investors.

Between February 19 and March 23, the S&P 500 Index fell 34% – the quickest such decline in history. A powerful rally – beginning in late March and resuming after a brief dip on either side of quarter-end – has trimmed benchmark losses to less than 20% (a stunning gain of more than 25% from the nadir). Amid the turmoil, many categories of investments were battered far worse than the headline indices: small-company stocks, travel-related stocks, autos, traditional (i.e., not online) retail, energy, financials and industrials were major casualties, with many prices down more than 50%. Non-investment grade corporate bonds and preferred stocks also saw double-digit swoons in the rush for liquidity. The top handful of mega-cap S&P 500/NASDAQ stocks held up surprisingly well, as investors coveted their presumably less disrupted business models and cash-rich balance sheets. Only Treasuries, the very highest-rated (AA and AAA) corporate and municipal bonds and gold escaped essentially unscathed.

Whatever It Takes Policy Response

The policy response to the economic and financial-market implications of the pandemic has been prompt and massive, far exceeding anything enacted during the Global Financial Crisis and setting a new standard for the phrase 'Whatever it takes.' The Fed immediately cut short-term interest rates from 1.59% to just 0.08% and has since rolled out securities-buying programs to support the Treasury, mortgage, commercial-paper, asset-backed, investment-grade (and most recently even junk) corporate and short-term municipal bond markets. Meanwhile, a greater than-$2-trillion (and growing) federal economic stabilization program – equal to more than 10% of total annual economic output – is rushing cash to individuals and businesses, cushioning the economic impact of broadly imposed lockdowns. Similar monetary and fiscal programs have been established across the developed world, while the IMF, World Bank and the Chinese-led Inter-Asian Development Bank are preparing unprecedented assistance programs for developing economies.

The utter novelty of purposely shutting down the global economy for an indeterminate period makes economic and profit projections largely guesswork. That said, the coming downturn, even if potentially brief, will almost surely be the deepest since the end of the Second World War. Wall Street banks and economic consultancies are calling for the U.S. economy to contract at a 10% annual rate in the January-March quarter, with a plunge exceeding 25% penciled in for the April-June period. Even assuming the beginning of a sharp rebound in the second half, calendar 2020 GDP is likely to decline by more than 5%, compared to pre-pandemic expectations of 2% or better growth. Though the range of (gu)estimates is wide, aggregate corporate profits are seen falling at least 25% to 35% in 2020 (grimmer estimates exist), before rebounding by perhaps 25% to 50% in 2021. A putative 30% decline followed by a 40% rebound would leave earnings 2% below the 2019 level, implying two lost years of previously anticipated growth.

What Lies Ahead?

As we think about potential futures, we find it useful to break our analysis into three parts: financial-market function; epidemiological milestones; and understanding the crisis's broad economic impact. Market Function: Acute financial-market dysfunction seems to have peaked in mid/late-March, as worrisome dislocations in fixed-income, currency and derivatives markets signaled growing danger of crisis. The gargantuan central bank interventions of the past three weeks seem to have seen-off this market-contagion threat, which was disturbingly reminiscent of the darkest moments of the 2008-2009 Global Financial Crisis. Though we will be closely monitoring the markets for signs of deterioration on this front, for now we seem to be out of those particular woods.

Epidemiological Milestones: The epidemiological arena is more complicated, but also seemingly hopeful – at least relatively speaking. On one hand, the worst news flow – with infection and death rates increasing exponentially almost everywhere outside Asia – appears to be behind us. Statistics from Italy, Spain and even, in the past few days, New York all seem to show rates of infection and hospitalization peaking. At the same time, however, it remains to be seen whether other worrisome potential hotspots in the U.S. could follow New York's tragic path. Meanwhile, several Asian polities (e.g., Hong Kong, Singapore, Taiwan) are seeing resurgent caseloads following periods of calm. It seems reasonable to expect news on this front to continue to improve, interspersed with occasional disappointing setbacks. Looking farther ahead, salutary milestones will include successful testing of novel treatments and, eventually, a vaccine.

Understanding the Economic Impact: Assessments of economic damage are fluid and will likely remain an area of conjecture due to the lack of historical parallels. The biggest unknown is how, exactly, economic lockdowns will be removed. While a range of ideas have been promoted by public-health and economic experts, few principles or timelines have yet been broadly agreed. Real-world data are just beginning to emerge from the first places to ease restrictions (e.g., China, South Korea and Iran). With Denmark, Austria and the Czech Republic now set to begin lifting constraints, we should know a lot more in three or four weeks – about the time parts of the U.S. will be ready to start down this path. But until we have a meaningfully better idea of how quickly and evenly (or their opposites) the lifting of restrictions will be, any analysis of the economic impact will be badly hampered. Again, we expect bumps on this road, with plenty of opportunity for setbacks and disappointments that could dent investor confidence.

Oarsman Portfolio Strategy

Nearly all risk-asset prices have rebounded dramatically in the past two weeks; does that mean the coast is clear? As noted, the path ahead is likely to be marred by numerous potentially confidence-deflating setbacks. Moreover, bear markets routinely feature multiple eye-catching rallies interspersed with 'retests' of the previous low; the 2007-2009 episode included six rallies approaching 10% before reaching its ultimate nadir. Numerous commentators have also pointed out that U.S. markets have never bottomed less than six months following a decline of greater than 30%. However, as nearly everything about the current scenario is unique, we would not be surprised if it fails to play out by the book. Despite the substantial unknowns, we feel confident pursuing a twofold strategy to enhance the long-term growth potential of our clients' portfolios. First, we will take advantage of the plentiful dislocations within the market to upgrade portfolio holdings, trimming or eliminating positions that seem either overvalued or unnecessarily risky, while adding to holdings of high-quality companies at discounted prices. And second, unless a client's investment horizon is short (e.g., less than five years), we will use the period of lower prices to gradually and systematically build exposure to equities (as well as to other growth-oriented asset-classes) without worrying overly much about getting the timing exactly right. Targeting prudent exposures, in alignment with previously established asset-allocation guidelines, we will deploy a portion of portfolio cash reserves and bond maturities toward those targets over coming weeks and months.

We look forward to updating you as our thinking evolves in the weeks ahead. Please stay healthy and safe.

Best Regards,
Alan Purintun, CFA
Principal and Portfolio Manager

Robert W. Phelps, CFA
Principal and Portfolio Manager