March Thoughts from the Research Desk
March 27, 2020 | Simon A. Tryzna
Here are three things that have continually come up in our conversations with strategists, economists, and other financial professionals as well as in various reports that we have been reading.
Disconnect between the economic data & capital market performance
The weekly unemployment claims number that was announced on Thursday came in at 3,283k, by far the largest in history. The number was higher than many anticipated - Goldman Sachs forecasted it being 2,250k while the median forecast was 1,700k. On the flip side, we did hear that a lot of traders had the forecast being as high as 5,000k so maybe the fact that it only came in at 3,283k is a positive. Our understanding is that right now investors are trading on fear and imperfect data. There are a lot of unknown risks that have been priced in and as we all get some clarity (more data points, monetary and fiscal policy), investors will digest that and re-evaluate their models. The disconnect between what intuitively should make sense from an economic perspective and what actually happens in the capital markets is the primary reason why investors should remain invested. The market is hyper efficient and will have high velocity days on both the upside and the downside – as long term investors, we want to make sure we are in the position to take advantage of the up-days.
The Fed & Liquidity Crunch
One of the biggest talking points from investors has been around the Fed. The Fed has been quick to move to provide support to the credit markets who have experienced massive dislocations as investors have sold off, and sold off in a hurry. As an example, Bridgewater alone sold ~$80b of fixed income, while Nuveen sold ~$750m of municipal securities. While other firms didn’t have as large redemption numbers, the asset class as a whole has seen record outflows as investors flocked to cash. Traditionally, fund managers have either cash on hand or a line of credit with a bank to meet redemption requests. However, when there are record number of redemption requests (i.e. investors in the funds wanting to go to cash) and the strategy doesn’t have any more cash or have tapped out their line of credit, they become forced sellers of the underlying securities – in this case bonds.
The problem with bonds is that the majority of them are traded over the counter, meaning the seller needs to go and find a buyer on their own. This has led to significant mispricing, as securities were trading at steep discounts to their value (as an example, $.60/.70 on the dollar as opposed to $.94/.95). This has caused a massive dislocation in the credit markets, as funds who did not participate in the selling are forced to have to “mark to market” (provide a value of the assets based off the most recent market price) their portfolio holdings. This means that bonds that were worth $.94/.95 are now priced as if they are worth $.60/.70 despite the fact that there was no fundamental change to the quality of the bond. This drives the value of the whole fixed income index down.
This dislocation has forced the Fed’s hand in providing liquidity to stabilize bond prices. Over the last two weeks they have rolled out a series of lending facility programs to restore proper function of the credit markets. The Fed is purchasing securities that are being sold at close to fair prices in order to create a floor. We expect the credit markets to subsequently stabilize and begin to recover.
The Government & Their Stimulus
The big driver of the equity market this week was due to the passing of the economic stimulus (another point of clarity). The economists that we spoke with are afraid of the damage done by how slow the government moved. It will take some time for the stimulus to get into the hands of consumers and they felt that any delay will cause further economic issues. That said, it will be important for consumers and businesses to get the stimulus quickly and begin to use it. Now that the bill is signed, businesses should be able to get cash quickly (as soon as this weekend) – the Small Business Administration has been working behind the scenes to ensure that. The worry that economists have is that the velocity of money (the rate at which it is exchanged) will be very slow.
The best way to think about it – if a consumer receives a check, buys a pair of new Nike Running Shoes, and Nike takes the profits and puts in the bank as opposed to re-investing it in their business, it will not have the impact that was intended. The more money that’s being spent and not sitting in the bank, the better it is for the economy. As a reminder, 70% of US GDP is consumer driven. Lastly, the other positive piece of news that we’ve been hearing (and that perhaps also contributed in a positive week in the equity markets) is that while Congress is indeed going on recess, staffers have already started working on the next stimulus bill.
Putting this all together
From talking to various asset management strategists, the consensus is that we are going to continue having equity volatility and we have not hit a “market bottom.” That said, investors are looking “across the valley” to what economic conditions will be on the other side of the pandemic. Any earnings expectation for 2020 is thrown out the window – the focus has now shifted into which companies will be in the best position when we get out of this. This is where careful selection of stocks is crucial and where we are in constant dialogue with our active equity managers. The velocity of equity moves will continue to be high, both on the down and up side, which is why we want to be invested in equities based on the long term strategic asset allocation of the portfolio. If there is a pro-longed sell-off, we will look to once again rebalance and perhaps increase our weight to equities.
On the fixed income side, we feel very confident in our managers’ ability to take advantage of this dislocation. Our fixed income managers had cash on hand heading into 2020 and have begun putting to work, with some managers being the buyers on the other end of forced bond seller trade. As bonds get closer to maturity and “par,” the value of the bond funds will inherently go up. In addition, we feel comfortable with the quality of the issuances that our managers own and are buying. At this moment in time, we expect bonds to recover faster than the equity markets and despite everything that has occurred, they remain and will continue to remain a crucial part of our portfolios.