The Broad View
All stock market selloffs share certain traits, starting with the most basic — they feel absolutely terrible while you’re going through them. They’re loaded with uncertainty, grim headlines and dire predictions. That’s especially true when a downturn springs from a sudden shock that yanks the economy toward recession. But past selloffs all shared another fundamental commonality: The economy and stock market overcame the obstacles before them and recovered every time.
That’s an important backdrop to keep in mind as global markets and society at large contend with the coronavirus. COVID-19 hit like a thunderclap, pushing stocks into a bear market and stoking doubt about some of the very mounts upon which the economy rests. It also created temporary upheaval in the bond market, which only eased when the Federal Reserve rolled out a variety of stabilization measures.
But while that’s the story of COVID-19, it was also the tale of the global financial crisis a decade ago and, to varying degrees, other such bolts from the blue. Selloffs tend to foster rampant uncertainty, fear of crippling economic damage and speculation that this time is somehow different. Of course, every bear market has stemmed from distinct causes that required specific policy responses. But they all eventually came to an end.
None of this is intended to diminish the impact of the coronavirus or the challenges that lie ahead. But the current economic situation can be thought of as a valley: The terrain of the canyon floor may be rough and pockmarked, but the other side appears to be visible, and an eventual brighter future lies ahead.
There’s no doubt about the financial pain the virus has caused, with global stocks suffering their worst quarterly drubbing since 2008. That brought an abrupt end to the longest bull market in U.S. history and, in all likelihood, the lengthiest economic upturn as well. Thus far, the decline in U.S. share prices is on par with the average bear market dating to 1929. From its peak on February 19 to its bottom on March 23, the S&P 500 index was down 33.9%, compared with the average 34.6% bear market drop.
This bear market, however, was by far the quickest from a record high. It came in just six weeks, in marked contrast to the 14-month historical average. That owed partly to the unique nature of the threat, as investors worried that forced economic hibernation could drive the world into a long and deep recession.
The news is likely to get worse before it gets better. With sizable portions of the economy on lockdown, unemployment claims have surged and incoming data could show an unprecedented pace of contraction. The pain is likely to be particularly acute in hard-hit industries such as retail and transportation. Profit warnings could be widespread, and overall earnings could fall by as much as 25%, according to a Capital Group estimate. Indeed, the recession could be above average in severity.
All this may mean an extended run of above-average volatility. During bear markets, share prices frequently bob up and down as traders react to daily headlines.
Beyond the coronavirus, the market is weighing the impact of other factors. The U.S. was already late in its economic cycle. The global economy was confronting sluggish growth. And despite an easing of tensions in the U.S.-China trade war, uncertainty remains over the ongoing realignment of relations between the two countries.
The energy sector is grappling with a price war between Saudi Arabia and Russia that has exacerbated the virus-related plunge in demand for crude oil. And U.S. businesses have less financial breathing room after going on a debt binge in recent years to fund stock buybacks, dividend payments and corporate acquisitions. Non-financial corporate borrowing had ballooned to a record high of nearly $10 trillion, or 47% of GDP, by the middle of last year.
The pace of recovery appears to depend largely on the path of the virus, about which much remains unknown. Medically, it’s unclear when the rate of infection will peak, whether subsequent outbreaks will pop up and how quickly progress will be made toward a vaccine. The answers to those questions will influence how long economic activity will continue on intermission amid copious amounts of hand sanitizer and social distancing.
Fiscal and monetary policymakers have taken unprecedented steps to try to cauterize the financial wounds. The Federal Reserve slashed interest rates to near zero, pledged to buy unlimited amounts of Treasury and mortgage bonds, and launched sweeping emergency lending programs for big companies and small businesses. These included buying corporate debt for the first time in history and introducing the Main Street Business Lending Program for smaller companies.
Measures such as a program to backstop U.S. money market funds and another to let foreign central banks convert their currencies into dollars were specifically designed to keep the financial markets calm and functional. Taken as a whole, the Fed actions went even further than the dramatic steps taken during the 2008 financial crisis, which themselves were a collective rewriting of the central bank playbook.
Separately, the White House and Congress passed a $2 trillion economic stabilization package, the largest in U.S. history and more than double the size of the stimulus efforts during the financial crisis. In addition to sending direct payments to millions of American workers, the program substantially expands jobless benefits and extends loans to businesses that can be forgiven if the companies refrain from layoffs. There is discussion in policy circles about the possibility that another large stimulus package will be needed.
Despite the litany of challenges, there are clear positives that may reassert themselves once the immediate shadow of the pandemic passes. The U.S. entered this recession better positioned than most developed countries: Favorable demographics, deep capital markets, cutting-edge technology companies and an innovative spirit bode well for the coming years.
The rapid decline in stock prices could mean the entire market cycle, including an eventual rebound, is on an accelerated timetable, although it’s too soon to tell. In any case, the U.S. could resume its pre-downturn trend of 2% to 2.5% annual GDP growth in 2021 and beyond, according to an estimate from a Capital Group economist.
Some of the sharpest pain has been borne by everyday businesses — such as restaurants, movie theaters and nail salons — that are being battered in the near term. The future of many existing businesses will depend on how long it takes for a recovery to get underway. But if a local eatery was popular before COVID-19, and it can survive the downturn, customers should return.
Developments in China provide reason for cautious optimism, as new infections there have dropped and factories have resumed production. Any recovery will be halting amid reduced demand from the rest of the world, but Beijing has unleashed a variety of measures to prod growth, including tax cuts and cheaper loans.
Regardless of economic or market conditions, our portfolio managers seek to protect and prudently grow client portfolios, with an emphasis on downside discipline in all environments. Since the COVID-19 outbreak emerged, our analysts around the world have worked to identify companies with weakened prospects. As a result, portfolio managers have reduced exposure to certain energy companies, aerospace manufacturers and parts suppliers, hotel operators and travel-related businesses.
At the same time, our investment team has sought to take advantage of opportunities in sectors with promising long-term outlooks and in companies that have suffered excessive short-term drops. Managers have added to positions in health care, including businesses involved in coronavirus-related research, and initiated holdings elsewhere in the sector. They also have boosted exposure to select luxury goods companies where valuations are compelling.
Bonds provided relative safety amid the equity storm, with Treasury yields initially falling as the Fed lowered interest rates and rolled out stimulus measures. Yields for Treasuries of all terms dipped below 1%, a historical first, soon after stocks began to weaken.
However, the upheaval in other parts of the financial world briefly rattled bonds. The traditional flight-to-safety rally was undermined by liquidity strains and concerns about credit quality. Some institutional investors were forced to dump fixed income holdings to meet heavy redemptions from shareholders. This dynamic weighed on multiple corners of the market, including corporate, mortgage and municipal bonds.
Conditions stabilized after the Fed’s bond-purchasing announcement, and the 10-year Treasury yield ended the quarter at 0.70%, just above its historical low of 0.54%, reached a few weeks earlier.
Our managers have been mindful of credit exposure in recent quarters and have maintained a focus on high-quality, lower-risk securities that can help bonds act as a counterweight to more volatile equities. They have also sought to take advantage of volatility to invest in debt at particularly attractive valuations.
Regardless of the market environment, remember that fixed income offers essential benefits, including income generation, capital preservation and diversification from equities. Those traits are especially critical at a time of ongoing uncertainty in the global economy.
The above article originally appeared in the Spring 2020 issue of Quarterly Insights magazine.