Private Wealth Management.

“Two roads diverged in a wood, and I - I took the one less traveled by, and that has made all the difference.” ~Robert Frost

April 21, 2020

PANDEMIC: Navigating troubled waters 

By: Carl S. Bang, MBA, CFA, Chief Investment Officer at WorkOptional Private Wealth Management and Marc D. Langva, CFP®, Founder & CEO at WorkOptional Private Wealth Management

This article covers the economic impact, market reaction and investment implications of the market today.

ECONOMIC IMPACT

I would like to discuss the effects of the pandemic in terms of economic impact, how governments, central banks and markets have reacted as well as investment implications for managing wealth in this environment.  Let’s take a look at the economic impact of closing down. This has led to the largest economic contraction and unemployment since the great depression.

The graph to the right shows estimates of GDP growth issued the week of April 13, 2020 by the International Monetary Fund, showing 2019 and expected for 2020 and 2021. On the far left you see it shows declines in U.S. and Europe of respectively 6.1 and  7.5 rebounding up 4.5% in 2021  and emerging and developing economies down 1% this year rebounding 6.6% in 2021. More importantly, it will most likely take 3-5 years to be at the level of economic activity before the pandemic.

Some estimate the potential decline of GDP in both the U.S. and Europe for the second quarter of close to 30% and full year 2020 GDP to be in the range of -5% to -11.5%, depending on how fast we can get the pandemic under control and whether a resurgence will take place as we start to get people back to work. We believe things can get worse than what the IMF is forecasting.

The graph the right shows the largest four week jump in unemployment for the past seven recessions. Typically unemployment jumps around 2-2.5 million in the worse four-week period of a recession.  This time around, unemployment jumped by 22 million in a four-week period during March and April 2020, with  unemployment rates expected to touch 15% before stabilizing. When we come out of the current lock down, there is always a risk of  a resurgence, which will prolong economic depression and lengthen time to rebound. The experience coming out of China is a possible resurgence happening along the Russian border, in addition, it is taking longer than expected to get the economy started again.

Greatest oil price decline in history of OPEC

The sharp drop in economic activity has led to a fall-off in the demand for oil.  Some estimate demand falling as much as 30%. This had led to excess supply on world markets when Russia and Saudi Arabia failed to reach an OPEC agreement to cut production.  We witnessed a sharp drop in the price of oil from over $60 per barrel at the start of the year to just below $20 per barrel. This past Monday WTI contracts settling in May actually traded negative $40 per barrel, dropping 320%, the biggest drop in history.   In the US, where shale oil has undergone large expansion, companies are heavily leveraged and cannot operate profitably under current prices.  They face the prospect of bankruptcy.  As a large portion of the high yield debt market is represented by oil companies, this exacerbated the sell-off  we saw in credit prior to the Fed and Government stepping in with a monetary and fiscal response to avert a financial crisis and forestall a worse economic scenario.

Greatest global central bank and fiscal response in history

As business was shut down around the world, there was a global monetary response dropping rates to almost 0% followed by large fiscal measures to support economies to offset the anticipated drop in economic activity.  The U.S. alone announced a $2.3 trillion program which represents close to 11% of GDP. The Fed also relaunched a bond buying program with no potentially limits and also created facilities to directly provide funding to companies to maintain operations. We have seen similar programs announced in Europe and Japan.

MARKET REACTION

Initially bond yields plunged to historic lows and credit spreads blew out, as markets were dislocated.  We also saw disruptive trading activity in commodity and global stock markets, off its highs of 3350 in mid-February to trading a low of 2200.  The monetary and fiscal response has averted a market meltdown and markets have since stabilized.

Interest rates

The graph to the right shows both nominal and real interest rates on a 10-year U.S. treasury bond. You will notice the steep drop in yields to the far right that started in February of 2020. More importantly, it shows that at these nominal yield levels, these bonds are now trading negative real rates.  This means that as an investor holding 10-year treasuries, you are accepting the fact that you will lose money if held to maturity. This has implications we will address later.

Corporate spread

What the high yield bond graph shows is the behavior of high yield bonds as well as a measure of default rates.  On the far right you can see the move out of high yield debt during the current market meltdown.  And if you look closely, you will notice the reduction in spreads after the Fed announced the extraordinary measures to support financial markets.

One point to notice is that although yields did move out, given the rapid response by the FED, the back up in yields was averted from reaching levels seen during the 2008 financial crash.

More importantly is that markets during 2007 were forecasting default rates close to 12%. In this current environment, spreads have not moved out as much, and the expected default rates do not even reflect recessionary levels. This would seem to indicate huge amount of risk in high yield yet to be priced in as the effect of the slow down starts to show on corporate balance sheets. This market is vulnerable and being held up by the policies instigated by the FED.

Global equity markets

What the equities graph shows are global equity markets (shown in purple) as well as the S&P 500 (shown in grey) going back to 1997. The rebound in U.S. equity markets post financial crisis, has been stronger than global markets.  However, the downturn in March was much larger for global markets than in the U.S., assisted by the far-reaching measures announced by the FED and Washington.

INVESTMENT IMPLICATIONS

The key take away is that although measures taken by the Fed and Washington have averted a financial crisis, we have sustained damage to the economy and the time it will take to get back to where we were before the pandemic is highly uncertain. The steep decline in the second quarter GDP is going to be in line with the great depression, although the rebound will likely to be quicker given the large supportive policy actions.

As an investor, focus on the long term.  The rebound in equity markets is the likes of a bear rally. It is still too early to deploy cash extensively, however, take the time to position capital in the likely slow growth environment that will follow. If you have not raised cash, you may want to consider using the current rebound to raise cash to comfortable levels.

Own quality companies

The financial crisis in 2007 was one of household indebtedness.  The current financial crisis surrounds elevated leverage in the corporate sector.  This means that corporate bonds are vulnerable to the current economic slowdown, and we will see a large part of the investment grade universe downgraded. Rating agencies are moving quicker to downgrade credit than in the past cycle.

Let’s spend some time to see just how vulnerable we are;

This corporate leverage chart shows the universe of investment grade credit in the U.S. Not only has corporate debt tripled since 2007, but the lowest investment grade credit of BBB has gone from 30% of corporate bond universe to close to 60%. Corporate America has offset a traditionally lower return environment by utilizing increased leverage at historically low interest rates. This has fueled stock buy backs and acquisitions that have helped push equity markets to where they are.

Likely there will be a period to follow with large restructuring of companies heavily indebted that cannot support the leverage taken on, and will have difficulty refinancing with operating margins under pressure.

We have already seen marque companies such as Kraft Heinz Foods Co. weakening credit rating to below investment grade and migrating to junk status.  Occidental petroleum is running into problems, and we expect a lot more of this to show up in the coming quarters and weight heavily on equity markets.

The graph to the left shows the price of Kraft Heinz Food Co.’s 2049 bond issued September 2019. As the credit was downgraded from investment grade to junk debt, it fell from $110 to around $95 prior to rebounding after the FED acted in March.

On the flip side to this, given expected market volatility, there will be opportunities to invest in marque companies at a reasonable price.  Look for those that offer strong balance sheets, cash balances and low short-term debt that are in a strong position to weather the storm and continue to grow their business.  You also want to deploy capital opportunistically as compelling value surfaces.

Furthermore, in this environment, it may be helpful to review what you own and consider reconfiguring your portfolio to the current and most likely future environment, as well as looking across asset classes that offer attractive opportunities to position your capital for a long period of lower nominal GDP growth. This should include taking advantage of a strong U.S. dollar and relatively strong U.S. equity markets to evaluate international and emerging market equities.

Now more than ever, working with an experienced wealth professional may be helpful to have an extensive review and proposal on how best to take advantage and properly assess risk in the current environment.

April 22nd, 2020

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