Spring 2020 Market Perspectives

David S. Lynch, CFA<br />Chief Investment Officer

David S. Lynch, CFA
Chief Investment Officer

April 20, 2020

Market Perspectives

Market Outlook and Q1 Summary

 

Overall Asset Allocation

Nearly all markets are up nicely during April, and the year-to-date returns for portfolios have improved since the March 31st statements.  Despite the market rally thus far in April, we are still cautious and not ready to sound the “all clear” in terms of the overall market.  There is still much more unemployment to absorb, debt to restructure (or default), a gridlocked housing market to figure out and medical hurdles to overcome. We have been active in the market (both buying and selling) and are maintaining a generally conservative stance overall.  We are holding more cash as a buffer to downside and dry powder for future opportunities.  The cash was primarily funded by risk reduction in equities, but we also have allowed some cash to accumulate from the bond side.  We believe the market is likely to bottom in advance of the societal pain subsiding, but we are cautious about rushing to that conclusion. 



The operative question is not really “when will the economy re-open”, but rather “when will customers and demand return?”  Consumers had plentiful job opportunities, rising 401ks, growing equity in their homes, and seemingly serviceable debt loads.  On the other side of this economic shutdown, those favorable conditions will no longer be in place for many, which will likely have a significant negative impact on the willingness and ability to spend.  Corporations will have similar “before” and “after” dynamics in which the stock buybacks, dividends, revenue growth, and healthy profit margins that existed prior to the virus are unlikely to return in the same favorable magnitudes.  Of course, some of this has already been discounted in stock and bond prices, but the debate continues about whether the re-pricing has been enough.  Ultimately, it varies by company and by sector, which argues for Cambridge Trust’s approach of active management and thoughtful security selection.
 
On the positive side, it does seem that the virus data—though tragic—is turning out better than the most dire projections.  Moreover, government and industry appear to be working together to develop treatments and vaccines as well as to manufacture and supply critical medical equipment to where it’s needed most.  We are cautiously optimistic that this will continue.
 
On the negative side, the success of social distancing comes with a dramatic economic cost.  The recent weeks have been characterized by the waning of hope for a nearby and rapid recovery among even the more optimistic strategists and commentators.  The revival of economic activity might be a much slower road than initially hoped.  Oil was down 67% in Q1 on the sharp contraction in economic activity (by contrast, gold was up 5%). 
 
Though we had the subprime crisis in 2008-2009, which is not that long ago, there was not a full reckoning at that time since there were many bailouts, deferments and other “papering over” of vulnerabilities with low interest rates, re-securitizing of shaky credits and a variety of stimulus programs.  In some senses, 2008-2009 was a bit more localized to subprime bad actors; this pandemic is much more global and all-encompassing—there might not be rescue programs big enough to prevent this economic forest fire from burning—and there is a lot more underbrush and tinder in terms of indebted, unprofitable companies that have not been fully weeded out in a long time, as well as vulnerable gig workers and other less secure aspects of society.  Conversely, if it turns out that there is a rescue program big enough to cover all the weak and wounded areas of the economy, then that program probably puts the government on the verge of bankrupting itself or, at the very least, debasing the dollar and compromising the meaning and creditworthiness of US bonds.  While unlimited bailouts could be justifiable if they can be replaced quickly by genuine economic activity, they will perpetuate moral hazard if they become too relied upon as crutches for the economy.  For the moment, authorities are seeking to limit the human suffering with the understanding that they will deal with any financial consequences after the virus is under control.
 
These dynamics lead us to intense daily debates as we seek to opportunistically pursue excellent individual stock or bond opportunities that can upgrade portfolios on a bottom-up basis while also balancing the risk of macroeconomic and societal disruptions that pose systemic, top-down vulnerabilities to the financial system overall.  It is also worth noting that the November election will be rapidly upon us.  It is likely to be a contentious and disputed outcome regardless of who wins, which creates further uncertainty for markets and future government policy.
 

US Equities

The first quarter saw pronounced dispersion in equity returns.  The S&P 500 was down 20%, but the tech-heavy Nasdaq was (only) down 14%.  Small cap stocks, as measured by the Russell 2000 Index, were down 31%.  The Dow Jones Dividend Select Index, normally a safe haven, was down 29% as investors feared upcoming dividend cuts.  In terms of sectors, technology was the best performer down 12% followed by consumer staples and healthcare both down 13%, while the bottom performers were energy down 50% and financials down 32%.
 
Fortunately, we owned many of the well-positioned companies and sectors coming into this crisis and have been able to add to existing positions where appropriate.  In this regard, our stock picking and relative sizing of positions has generally held up well, albeit down, but often less so than the market.
 
Our analyst team is working to find the best individual opportunities.  When we get through this pandemic, there are companies that will have more customers than they had prior to the COVID-19 pandemic (such as Amazon, shipping companies, work-from-home software companies).  There are those that will have fewer customers than they had prior to the COVID-19 pandemic (such as cruise lines, restaurants, convention centers, ticket brokers).  There are those that will have a shift in their customer base (Disney—less theme park attendance, more Disney+ subscribers).  We are working hard to assess and find relative value opportunities through these changes.  We have sold some vulnerable positions—not everything we owned was perfect heading into this volatility, but we have been managing risk effectively. 
 

International Equities

International indexes (as measured by the MSCI All Country World ex-US and the MSCI Emerging Markets Indexes) were both down 24% for the quarter, underperforming the S&P 500.  International indexes also saw their own internal dispersion with Brazil down 50%, while China was noteworthy, down only 10%, despite being the epicenter of the virus outbreak. 
 
The underperformance of international equity is as much about index composition as it is about regional exposure.  International, especially Europe, tends to be more weighted to financials and other vulnerable “old economy” industries, and less weighted to technology as compared to US indexes.

We are generally underweight international and do expect to add some exposure back over time.  Current holdings are tilted toward Asia rather than Europe or Latin America.  
 

Core Fixed Income

Bonds have been a valuable diversifier.  For Q1, intermediate US Treasury bonds were up 10%, and shorter dated US Treasuries were up 3%.  On an index basis, high-grade municipal bonds were down slightly.  Most of our positions have held up quite well and served to balance some of the equity markdowns, such that overall portfolio performance is not down as dramatically as the investment television channels might suggest.  However, bonds were not without their own extreme volatility during Q1, including disruptions to some sectors of the typically quiet municipal bond market.

Municipalities will be receiving federal aid and will likely need more to offset the sharp loss of tax revenue at a time when their spending on public health has skyrocketed.  Our team is carefully monitoring holdings and has rotated up in quality as appropriate.  We have also been adding to select, highly rated corporate bonds for non-municipal bond accounts.


Opportunistic Fixed Income

Opportunistic fixed income positions were down, but those are generally held in much smaller sizes and are expected to recover well with patience.  Lower rated bonds were down 5%-10%.  High yield corporate bonds were down 13% and emerging market debt was down 15%.  We expect there will be further opportunities in the bond market as dislocations continue.  We are watchful for “equity-like” return opportunities in places like bank loans, high yield corporates and emerging markets debt, which all are starting to offer more fair risk/reward levels after a widening of credit spreads that hasn’t been seen in a decade.
  

Conclusion

We are continuously debating outlier possibilities on the upside and downside as we arrive at the best risk-adjusted posture that is appropriate for each client.  We hope that the first coronavirus wave can be managed but must also consider the chances of possible flare ups and reemergence later in the year when social distancing recedes.  

In summary, considering all the various scenarios, we prefer to remain patient and maintain a conservative stance, with some select opportunism and continued research and preparation for even greater opportunistic investing as the recession evolves.